Signals from the Markets for Fannie Mae and Freddie Mac Subordinated Debt
OFHEO Working Paper No. 07-4
35 Pages Posted: 17 Jul 2007
Date Written: June 2007
In the first quarter of 2001, Fannie Mae and Freddie Mac, the two largest government-sponsored enterprises (GSEs), began issuing subordinated debt as part of a set of voluntary initiatives announced in October 2000. However, both Enterprises suspended new issuance after public revelations of accounting irregularities and the accompanying upheavals in their senior managements. Last year, the Enterprises reaffirmed their commitment to issuing sub debt through an agreement with their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), which shifts their sub debt issuance from a voluntary initiative to an enforceable commitment. In that context, there has been growing interest in the usefulness of signals from the markets for the Enterprises' subordinated debt as a means of improving regulatory oversight.
While considerable research exists with respect to the subordinated debt of large banks, little research has been undertaken with respect to Fannie Mae and Freddie Mac. Because of the special status of GSEs, the special terms of the Enterprises' sub debt, and other differences relative to banks, market signals related to Enterprise sub debt may not be as strong. This paper explores that topic and how sub debt market signals have evolved as the perceptions of the risk of the two Enterprises has changed following recent revelations of accounting errors and earnings misstatements. To do so, we replicate for the Enterprises the work of Gonzalez-Rivera and Nickerson (forthcoming) developed in the context of large banks. They develop a model of a multivariate dynamic signal that combines fluctuations in equity prices, subordinated debt yields, and senior debt yields to monitor and assess in real time the risk profile of the issuing institution. The signal is a coincident indicator based on a time series model of idiosyncratic yield fluctuations and equity returns. Using this model Gonzalez-Rivera and Nickerson document high-risk events for the Bank of America and Banker's Trust. Our goals are to determine whether such a model for the Enterprises provides reliable indicators of high risk events and, if so, whether we can construct a reliable leading indicator based on spreads between the yields on the sub debt of the Enterprises and the yields on comparable Treasury securities. We also use econometric analysis to examine whether the market behavior of sub debt yields has changed over time.
Keywords: Subordinated debt, market discipline, government-sponsored enterprises
JEL Classification: G21, G28
Suggested Citation: Suggested Citation