Fannie Mae and Freddie Mac and the 2008 Financial Crisis
31 Pages Posted: 24 Jun 2009
Date Written: April 2009
This paper examines the causality link between Fannie Mae and Freddie Mac (F&F) and the housing crisis with particular emphasis on the systemic risk created by F&F. First the paper is premised on the role of F&F in the housing market and the role of securitization as a mechanism for transferring illiquid mortgages from balances sheet to investors to assure a better match between assets and liabilities and to free up capital. The second part of the paper analyses the costs and benefits of the two government sponsored enterprises activities. In the third part, I discuss how the incidence of the absence of market discipline led to moral hazard and to systemic risk. The last section offers proposals for improvements in public policy. I argue that if F&F provide little benefit to homebuyers – beyond enriching their shareholders – and cost a lot to the taxpayer, there is little point in trying to keep them. However, as privatization is very unlikely to happen regarding the political environment, I found that in order to make F&F more efficient, a mandatory subordinated debt issuance program, a receivership authority, and more transparency could change the consensus of investors’ perception of an implicit federal guarantee and therefore strengthen market discipline.
Keywords: Fannie Mae, Freddie Mac, moral hazard, market discipline, systemic risk, implicit federal guarantee, subordinated debt issuance program, GSE, housing market, subprime crisis, mortgage backed securities (MBS), securitization, market of lemons, negative convexity risk, asset liability mismatch
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