CRS-2

Fannie and Freddie are government-sponsored enterprises (GSEs) whose charters
limit them to buying single family and multifamily home mortgages originated by others.
This lack of diversification makes them more exposed to housing and mortgage market
problems than other financial institutions such as commercial banks that have other lines
of business. The GSEs have a special relationship with the federal government,
sometimes called an implicit guarantee, that has allowed them to borrow at interest rates
only slightly above those paid by the federal government.
The two GSEs are very highly leveraged versions of banks: they borrow money to
lend, and they maximize profits by keeping their capital reserves close to the minimum
permitted by their regulators. Unlike banks, they can only purchase home mortgages that
others have made. Like banks, the GSEs are required by law and by their regulators to
maintain a certain ratio between their loans and reserves to protect against loan losses.
A key component of reserves is shareholders' equity or the current value of the
shareholders' investments.
What Risks Do Fannie Mae and Freddie Mac Face in Today's Economic
Environment? Fannie Mae and Freddie Mac purchase home mortgages. They package
some for sale as mortgage-backed securities (MBS) and hold others in their investment
portfolios. The GSEs guarantee timely payment of principal and interest of the mortgages
in their MBS. As mortgage foreclosure rates have climbed since 2006, and as home
prices have fallen, the value of the mortgages and MBS that the two firms hold in their
portfolio has also fallen. Uncertainty about the duration or severity of the housing slump
means that markets cannot now gauge the riskiness of the GSEs with any degree of
confidence or precision.
The GSEs finance their portfolios of long-term (typically 30-year) mortgages with
short-term borrowing (typically three months to five years). This increases the GSEs'
profits because short-term borrowing is usually less expensive than longer term loans.
This creates interest rate risk, which is the risk that if short-term interest rates increase,
profitability can be reduced or can even turn to losses. To try to reduce these risks, the
GSEs use a variety of financial derivatives.
In a worst case scenario, the interest rate on short-term loans to the GSEs could
increase enough to cause substantial losses and investors could stop entering into
derivative contracts with the GSEs.1 This would leave the GSEs, who anticipated being
able to roll over their short term debt, unable to refinance.
What Are Some Possible Market-Based Solutions? One part of a market-
based solution for this would be for the GSEs to sell part of their mortgage portfolios to
pay off their debts. But fears over default risk have reduced the market value of these
existing mortgages. Fannie Mae's portfolio has relatively high credit quality overall, but
1 A derivative is a financial contract whose value is linked to another financial instrument, price,
or variable. For example, two companies could trade a derivative whose value was linked to the
difference in the interest rates on two-year and ten-year Treasury bonds.