Emerging Competition and Risk-Taking Incentives at Fannie Mae and Freddie Mac

W. Scott Frame and Lawrence J. White
Working Paper 2004-4
February 2004

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This paper examines two major forces that may soon increase competition in the U.S. secondary conforming mortgage market: (1) the expansion of Federal Home Loan Bank mortgage purchase programs and (2) the adoption of revised risk-based capital requirements for large U.S. banks (Basel II). The authors argue that this competition is likely to reduce the growth and relative importance of Fannie Mae and Freddie Mac and hence their franchise values and effective capital. Such developments could, in turn, lead to more risky behaviors by these two GSEs. It is this last consequence that warrants greater regulatory awareness.

JEL classification: G21, G28

Key words: government-sponsored enterprises, mortgages, securitization, risk-based capital, moral hazard, charter value

The authors thank Matthew Green, Anjela Kniazeva, Diana Kniazeva, and Heather Zackal for their research assistance and for valuable comments on an earlier draft. Michael Fratantoni, Joseph McKenzie, Wayne Passmore, Larry Wall, and seminar participants at the 2004 ASSA meetings provided additional comments. From 1986 to 1989 White was a member of the Federal Home Loan Bank Board, with responsibilities that included being a board member of Freddie Mac and overseeing the Federal Home Loan Bank System. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to W. Scott Frame, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309, 404-498-8783, 404-498-8810 (fax), scott.frame@atl.frb.org, or Lawrence J. White, Stern School of Business, New York University, 44 West 4th Street, New York, New York 10012-1126, 212-998-0880, 212-995-4218 (fax), lwhite@stern.nyu.edu.