A Government-Sponsored Crisis: How Fannie and Freddie Caused the Recession
34 Pages Posted: 6 May 2010
Date Written: May 3, 2010
Abstract
Fannie Mae and Freddie Mac are government-sponsored entities (GSEs) designed to facilitate a secondary market for mortgages. A secondary market makes mortgages more liquid, increasing the available pool of funds for mortgages and the willingness of originators to initiate loans. Since the supply of loanable funds is larger, mortgage rates are lower than would otherwise be the case and the quantity of loans (in number and dollar value) is larger. Historically, the GSEs’ issues of debt (constituting their source of funds) were viewed as carrying an implicit federal government guarantee. Furthermore, a series of policy innovations beginning in 1992 encouraged the GSEs to pursue increased home ownership rates, especially in low-income and/or underserved areas, ahead of prudent evaluation of risk. Since originators (e.g., banks) could readily sell mortgages to the GSEs, they ignored adverse selection problems.
Buyers of GSE debt, trusting in the implicit government guarantee, ignored the moral hazard associated GSE policy. Given that both originators and the ultimate funders faced little of the downside risk associated with mortgages, the crisis was predictable.
Keywords: Fannie Mae, Freddie Mac, GSEs, commercial banking system, financial crisis
JEL Classification: G21, G01, E44, E02, E5
Suggested Citation: Suggested Citation
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