Financial Update (July-September 2001)


Cover Story

2000 Annual Report

Consumer Finance

Board Changes

Circular Letters

Identity Theft

Credit Scoring


Did You Know?

Data Bank

The Docket

Bank Capital Exposure to Government-Sponsored-Enterprise Debt

by Michael Padhi, senior economic analyst

Citizens of the United States value home ownership — a value reflected in U.S. public policy. For example, mortgage interest payments are deductible from federal income tax. But other ways in which the nation promotes home ownership — like the U.S. government’s chartering of government-sponsored enterprises (GSEs) to support mortgage availability — are less obvious.

Public concerns about GSEs

There are three housing GSEs: the Federal National Mortgage Association, commonly called Fannie Mae; the Federal Home Loan Mortgage Corp., known as Freddie Mac; and the Federal Home Loan Bank System (FHL Banks).

These GSEs have a unique relationship with the U.S. government — they were chartered by Congress but are privately owned. Fannie Mae and Freddie Mac stock is traded on the New York Stock Exchange, and the FHL Banks are owned by the financial institutions with which they do business, so Congress does not appropriate funds for them. Instead, these GSEs raise funds through the capital markets. Because the housing GSEs maintain special legal standing through their charters, financial markets treat them as if their securities are implicitly guaranteed by the U.S. government, thereby lowering the GSEs’ funding costs.

Recently some groups have expressed concerns about the GSEs’ unique structure and functions. One of the central concerns involves the potential mismatch between the recipients of the rewards — GSEs and their shareholders — and the government, which may bear the risks incurred by GSE activities.

The preferential treatment that GSE securities receive in U.S. bank regulation is another concern. A frequently cited example is that national banks and federal thrifts are permitted to hold an unlimited amount of securities issued by any of the GSEs but are not allowed to hold more than 10 percent of their capital in a single private issuer’s securities. Another example is that the housing GSE securities receive preferred weighting for banks’ risk-based capital calculations.

This kind of special treatment creates an incentive for banks to hold more GSE securities than they otherwise would, raising two related questions. First, what would be the impact to the U.S. banking system of a default on these securities? Second, how might this exposure influence the government’s response if a GSE were in danger of defaulting? These questions are best answered by reviewing what the housing GSEs are, the public benefits and costs of their government subsidies, the degree to which banks are exposed to GSE securities, and how this exposure by banks may ultimately subject public funds to financial risk.

One of the central concerns about GSEs involves the potential mismatch between the recipients of the rewards — GSEs and their shareholders — and the government, which bears the risks incurred by GSE activities.

Housing GSE structure and functions

The evolutions of Fannie Mae and Freddie Mac differ though their structure and functions are similar today. Both were chartered by Congress and have present mandates to support the secondary market for home mortgages.

The secondary mortgage market consists of mortgage originators such as banks, securitizers (such as Fannie Mae and Freddie Mac) of mortgages bought from the lenders, and investors who buy mortgage-backed securities. (For additional information, see “Fannie Mae and Freddie Mac at Work in the Secondary Mortgage Market,” Financial Update, January–March 2001.) To support this market, Fannie Mae and Freddie Mac may hold mortgages bought from lenders in their own portfolio or sell them in the form of mortgage-backed securities. These agencies fund their portfolio business by issuing general debt obligations and equity.

The FHL Banks support mortgage lending in a different way. Instead of securitizing mortgages as Fannie Mae and Freddie Mac do, the FHL Banks make loans to their member banks, collateralizing the loans with member banks’ mortgages.

Though the government does not explicitly guarantee the obligations of GSEs, it does provide certain statutory and regulatory benefits to them. For instance, the GSEs have access to lines of credit from the Treasury Department, their securities are exempt from registration with the Securities and Exchange Commission and they are exempt from local and state taxation. Additionally, the housing GSEs’ securities are traded over the Federal Reserve’s wholesale wire transfer service, Fedwire.

The existence of these explicit subsidies and the agencies’ government sponsorship could suggest a government guarantee to the buyers of their securities. Because investors in GSE securities expect the government to intervene if the GSEs ever default on any of their bonds, investors accept a lower interest rate, which reduces the companies’ cost of funds.

Benefits and risks

Because the GSEs do not pay the government for their advantages, including the implicit guarantee, such advantages can be seen as a subsidy. The primary cost of the subsidy, critics argue, is the mismatch between the recipients of the profits and the bearers of the risks produced by the GSEs. Profits go to shareholders — public in the case of Fannie Mae and Freddie Mac and private in the case of the FHL Banks — but the government implicitly bears the risks.

This mismatch, say some critics, creates a moral hazard problem because it allows the GSEs to behave in a riskier fashion than would be socially optimal. But these risks may be contained by regulatory oversight already in place and by the prospect of tighter regulation and changes to their charters.

GSE supporters argue that society benefits from the government subsidy because it allows the GSEs to buy mortgages at higher prices (lower interest rates) or to make lower rate advances to mortgage lenders. How GSE subsidies are distributed between consumers and shareholders, however, is subject to debate. A 2001 Congressional Budget Office study estimated that 51 percent of the government subsidy provided to the housing GSEs in 2000 was passed on to consumers.

GSE Debt as a Percent of Total Capital
Bank Asset Size Less than 10% 10–50% 50–100% Greater than 100% Total Number of Banks
Less than $500 Million    947 1,478 1,874 3,177 7,476
Percent of Total (12.67) (19.77) (25.07) (42.50)  
$500 Million–$10 Billion    142    179    142    158    621
Percent of Total (22.87) (28.82) (22.87) (25.44)  
Greater than $10 Billion       39       26        6        6      77
Percent of Total (50.65) (33.77)   (7.79)   (7.79)  
All Banks 1,128 1,683 2,022 3,341 8,174
Percent of Total (13.80) (20.59) (24.74) (40.87)  
Source: March 31, 2001, Bank Call Report

Bank capital exposure

As of March 31, 2001, about 41 percent of all U.S. commercial banks had investments in GSE debt that exceeded their total capital, and about 25 percent more had between 50 and 100 percent of their capital invested in these securities.

Small banks generally had more exposure than their larger counterparts. Among those banks with assets under $500 million, about 42 percent had invested in GSE debt beyond their total capital. About 25 percent of banks with assets between $500 million and $10 billion held more GSE debt than capital. Only about 8 percent of banks with assets greater than $10 billion were so exposed (see the table). Among similar-sized banks in the Southeast (Alabama, Florida, Georgia, Louisiana, Mississippi and Tennessee), the pattern was similar.

Restrictions on the percentage of capital that a bank holds in securities issued by a single company do not apply to GSEs. The bulk of these securities are issued by Fannie Mae, Freddie Mac and the FHL Banks. For the purposes of risk-based capital calculations, GSE securities are weighted at 20 percent, private obligations carry a 100 percent weighting and U.S. Treasury securities are weighted at 0 percent.

In the event that one of the housing GSEs defaults on its obligations and the government does not intervene, banks heavily exposed to GSE securities could lose the capital necessary to satisfy their depositors making withdrawals. Such a scenario could have significant repercussions.

To help a bank honor its liabilities, the Federal Reserve might consider making a discount loan to the bank, the Federal Deposit Insurance Corp. could close the bank and pay depositors from its own funds, or Congress might even decide to intervene with taxpayer dollars to protect uninsured depositors. In testimony before Congress, former Treasury Undersecretary Gary Gensler demonstrated his belief that this exposure is a serious problem, saying, “GSE debt obligations are exempt from banks’ investments securities limits. We believe that Congress should seriously consider the best way to repeal such exceptions.”

GSE supporters argue that society benefits from the government subsidy because it allows the GSEs to buy mortgages at higher prices.

Future considerations

While the housing GSEs exist to promote home ownership, some groups have raised concerns about the GSEs’ special relationship to the U.S. government. These critics argue that this relationship gives the GSEs funding advantages that create the potential for moral hazard at the government’s expense.

Beyond these concerns, there may be banking system and safety net risks arising from the advantages that GSE securities receive from bank regulators. Given that over 40 percent of the nations’ banks have more GSE debt than total capital, the risk incurred by the banking sector is credible. This issue should be included in future discussions on the status and regulation of GSEs.

Scott Frame, financial economist, also contributed to this article.