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Fannie Mae and Freddie Mac: Risk-Taking and the Option to Change Strategy

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Abstract

We analyze causes of the surge in defaults experienced by Fannie Mae and Freddie Mac during the Great Recession. Our data are consistent with the following: The two faced a trade-off between subsidized risk-taking (due to a guarantee implied by their charters) and franchise value (due to the scarcity of their charters). Around 2005 there was a change in the relative benefits of the two due to increased competition from “private label” securities. Along with declines in house prices, the increase in defaults is best explained by exercising an option to change strategy, before regulators fully caught on, toward newer, riskier loan types, after the decline in franchise value.

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Notes

  1. Frame et al. (2015a) discusses the conservatorship and some background and implications.

  2. The preferred stock carried a 10% dividend, which was funded out of later capital injections from the Treasury.

  3. See Wall (2014) for a discussion of what was paid back. Since 20,120 dividend payments have stopped and Treasury takes all the net income.

  4. The market value of the PLS dropped quickly as the crisis hit, but subsequent losses to the GSEs were small. As of the last (2013) Conservator Report they had made a small cumulative “profit” (cash flow) on PLS of around $20 billion.

  5. This market is the one where mortgage-backed other than those guaranteed by Fannie, Freddie and Ginnie Mae trade. These were typically structured deals set up by Wall Street banks.

  6. The FICO score comes from a proprietary algorithm formulated by the Fair Isaac Corporation. According to the Federal Reserve (2007), payment history accounts for about 35% of the FICO score’s predictive accuracy; consumer indebtedness accounts for about 30%; length of credit history, 15%; and types of credit used and acquisition of new credit, each about 10%.

  7. Occasional “stand-alone” ratings usually put the two in the low AA range.

  8. It has at times been an issue. For instance in the late 1970s and early 1980s Fannie Mae suffered large losses from funding long term mortgages with short term debt. Pass-through securities have very little interest rate risk.

  9. Deals with Alt-A and Jumbo loans had lower levels of subordination. See FCIC ( 2011).

  10. For instance not having to document the source of downpayment makes it easy to fund the downpayment with a second mortgage, which increases default probability in itself and may be an indicator of other risks.

  11. Even managements that always want to maximize the probability of survival will sometimes switch to large risk-taking if they have been sufficiently unlucky for instance because safe strategies will ensure losses.

  12. They do not explicitly consider Alt-A loans, but as can be seen from Fig. 2 the Alt-A market moved in more or less the same way as the subprime market.

  13. C.f. Fannie Mae Presentation, “Single Family Guarantee Business- Facing Strategic Crossroads,” June 27, 2005 and Chapter 9 of FCIC Final Report: “Fannie Mae and Freddie Mac: Two Stark Choices.”

  14. Capital requirements were essentially the maximum of capital needed to pass a stress test and a separate minimum capital ratio. On the GSE stress tests and their performance see Frame et al. (2015b). They came to results similar to ours of a shift in the default function.

  15. There were also contract provisions that allowed GSE to put mortgages back to sellers for contract violations.

  16. For the remaining 10% there was some sort of risk-sharing (required by charter). Contracts with sellers often required buybacks when contract terms had been violated.

  17. Note again that differences are even larger than depicted in the table because these raw data do not adjust for later vintage loans having less time to default. We make an adjustment for this in our estimation in the next section.

  18. Negative amortizing loans were not the issue as much as other factors. They defaulted at a 39% lower rate than the overall book of business. Loans with no-or-negative amortization features are more likely to be underwater because they have a higher residual unpaid principal balance, but this effect is negligible given the timeframe involved.

  19. PSA or Public Securities Administration is a simple benchmark that is often used for quoting yields on mortgages based on a simple model of prepayments.

  20. This is the parameter estimate exponentiated, i.e. e1.36 = 3.9.

  21. This is the parameter estimate exponentiated minus one, i.e. e-0.75 = 0.47–1 = −0.53.

  22. Deng et al. (2000) find a similar result.

  23. This is the parameter estimate exponentiated minus one, i.e. e-0.78 = 0.45–1 = −0.54.

  24. In unreported regressions, the results in this section are replicated using a logit model instead of the proportional hazards and a “probability of underwater” variable in place of Market LTV.

  25. We conjecture that the very high coefficients for the first two years come from the very low probability of loans form this vintage had negative equity, and that the Gaussian distribution underestimates tail events. There are still effects for LTV at 80 and at 90, suggesting as before that these loans have something to hide.

  26. The very high coefficients for probability of negative equity for 2001 and 2002 probably reflects shortcomings in the negative equity measure.. That is our measure makes that number very small, but there were still defaults, so high coefficients are needed to fit those two years.

  27. They have loan level data and know exposure year as well as origination year and simultaneously estimate prepayment

  28. In an earlier version of this paper we performed Granger Causality tests, which confirm what is clear from looking at the timing.

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Authors and Affiliations

  1. The Carlyle Group, Washington, DC, USA

    Jason Thomas

  2. George Washington University, Washington, DC, USA

    Robert Van Order

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Thomas, J., Van Order, R. Fannie Mae and Freddie Mac: Risk-Taking and the Option to Change Strategy. J Real Estate Finan Econ 60, 270–307 (2020). https://doi.org/10.1007/s11146-018-9679-7

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