CBO

A

P A P E R

Effects of Repealing

Fannie Mae’s and Freddie Mac’s

SEC Exemptions

May 2003

The Congress of the United States O Congressional Budget Office 
 
Preface

This Congressional Budget Office (CBO) paper, prepared at the request of Congressmen

Christopher Shays and Edward Markey, analyzes the likely economic effects of a proposal to

repeal Fannie Mae’s and Freddie Mac’s exemptions from the Securities and Exchange Com

mission’s registration and disclosure requirements. In keeping with CBO’s mandate to provide

objective and impartial analysis, this report makes no recommendations.

David Torregrosa of CBO’s Microeconomic and Financial Studies Division conducted the

analysis, with contributions from Deborah Lucas, under the direction of Marvin Phaup and

Roger Hitchner. Brian Doherty, Patrick Lawler, Forrest Pafenberg, David Pearl, and Robert

S. Seiler Jr. of the Office of Federal Housing Enterprise Oversight; Ron Feldman of the Federal

Reserve Bank of Minneapolis; Wayne Passmore of the Federal Reserve Board; and Mario Ugoletti

of the Department of the Treasury provided helpful reviews. Charles Capone, William Gainer,

Doug Hamilton, Arlene Holen, Ken Johnson, Angelo Mascaro, Robert Murphy, and Jennifer

Smith—all of CBO—made useful suggestions. In addition, staff members of the Securities and

Exchange Commission, Fannie Mae, and Freddie Mac provided assistance, as did Susan

Woodward of Sand Hill Econometrics, Anne Canfield of the Consumer Mortgage Coalition,

Andrew Davidson of Andrew Davidson & Co., and Mitch Flack of Metropolitan West Asset

Management.

Edward Cowan and John Skeen edited the paper, and Christian Spoor proofread it. Rae Roy

produced drafts of the manuscript, and Kathryn Winstead prepared the paper for publication.

Annette Kalicki produced the electronic versions for CBO’s Web site (www.cbo.gov).

Douglas HoltzEakin

Director

May 2003
 
CONTENTS

Summary vii

Introduction 1

The Benefits of GSE Status 1

A Legislative Proposal to Repeal the GSEs’ SEC Exemptions 5

The Basics of Mortgage-Backed Securities 7

Prepayment Risk 8

Increasing Demand for Disclosures About MBSs 12

New Disclosures in the MBS Market 17

The GSEs’ Disclosures Before 2003 17

PrivateLabel Issuers’ Disclosures for MBSs 18

The GSEs’ New Disclosures for MBSs 18

Effects of New Disclosures on the MBS Market 19

Possible Effects on the “Lemons” Discount 20

Possible Effects on the Liquidity of MBSs 20

The Net Effect on the Prices of MBSs 21

Possible Effects of Registration 21

Registration Fees and Administrative Costs 22

The Implied Federal Guarantee 22

The “To Be Announced” Market 24

The Ability to Lock In Mortgage Rates 24
vi EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTION

Tables

1. Fannie Mae’s and Freddie Mac’s Outstanding

MortgageBacked Securities, 19812001 9

2. Selected Details on Fannie Mae’s and Freddie Mac’s

Retained Mortgage Portfolios, 19812001 16

Figures

1. New Issues of MortgageBacked Securities, 19902001 8

2. The ConformingLoan Limit for SingleFamily Loans,

19902003 14

Boxes

1. Understanding MortgageBacked Securities 2

2. What Determines Whether Borrowers

Prepay SingleFamily Mortgages? 10

3. Understanding the “To Be Announced” Market 13

4. The Implications of New Disclosures for Mortgage Rates 22
Summary

Fannie Mae and Freddie Mac are governmentsponsored enterprises (GSEs), established

and granted special exemptions and status by federal statute. Their primary purpose is

to facilitate the flow of funds from the capital markets to finance housing. Congressmen

Christopher Shays and Edward Markey have proposed repealing one of Fannie Mae’s

and Freddie Mac’s privileges as GSEs: the exemptions from the Securities and Exchange

Commission’s (SEC’s) registration and disclosure requirements. Enactment of that

legislation, the Uniform Securities Disclosure Act (which was introduced but not adopted

in the 107th Congress), would subject those GSEs to the legal requirements that apply

to other publicly traded companies and to other issuers of private mortgagebacked

securities (MBSs). Accordingly, those GSEs would be required to pay registration fees

and to disclose information, as specified by the SEC, about their securities. Inasmuch

as the new fees would amount to less than $25 per mortgage, most of the effects of repeal

ing the exemptions would result from the new requirements for the GSEs to register their

securities and to disclose information. Three types of GSE securities would be subject

to the new requirements: common and preferred stock, debt, and MBSs. 

Following the introduction of the legislation to repeal the exemptions, Fannie Mae and

Freddie Mac have taken steps to comply voluntarily with some of the requirements that

would result from enactment. Specifically:

# In July 2002, the GSEs announced that they would register their common stock under

the Securities Exchange Act of 1934 and make the requisite disclosures for equity, and

# In accord with recommendations made by a multiagency task force in January 2003,

the enterprises decided to disclose additional information about their MBS pools. For

example, the enterprises will release loantovalue ratios, borrowers’ credit scores, the

identities of the servicers of the loans, borrowers’ use of properties (as a principal

residence, second home, or investment), and the purposes of loans (to purchase or

to refinance properties). 

Registering those securities is expected to have little effect on the prices of the GSEs’ stock

because the enterprises were already disclosing detailed information on their overall finan

cial condition and performance. Because investors in corporate debt rely on much the

same information as equity investors, any new disclosures that would accompany the

registration of debt would also have little effect on the prices of those securities. However,

the new voluntary disclosures for MBSs may affect the market prices of those securities

if they enable investors to predict more accurately the speed at which the mortgages will

be paid off. In fact, the uncertain rate at which homeowners refinance or sell their homes

and prepay their mortgage balances, or prepayment risk, is an important factor affecting

the value of individual issues of MBSs. But whether the net effect will be higher or lower

security prices is uncertain. To the extent that the new information is useful in identifying

MBS issues with above or belowaverage prepayment risk, the prices of those securities
viii EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

would vary more widely—some rising, others falling, and many staying the same—re

flecting differences in the characteristics of mortgage pools that affect prepayments and

the value of the securities.

Increased disclosures about individual pools could also change investors’ perceptions

about the quality of the MBSs they are buying and perhaps reduce the discount resulting

from a perceived risk of purchasing securities that (in terms of prepayment risk) are of

belowaverage quality. A reduction in that “lemons” discount would raise the average

price of MBSs.

Added disclosures by the GSEs could, however, cause some segmentation of the market

for MBSs by prepayment risk. Rather than being valued as if prepayment risk were vir

tually the same for all issues of the same type (for example, securities based on a pool of

30year fixedrate mortgages) with the same interest rate and age, prices might reflect

whether prepayments were expected to occur at belowaverage, average, or aboveaverage

rates. Finer differentiation of securities by risk of prepayment could lead to smaller vol

umes in submarkets, which could reduce liquidity and thereby lower prices for MBSs.

The potentially offsetting effects of higher prices from a smaller lemons discount and

lower prices from reduced market liquidity make the net effect on average prices ambigu

ous but probably small. 

Fannie Mae and Freddie Mac have not elected to register their debt or MBS issues vol

untarily. Voluntary disclosure is not equivalent to mandatory requirements to which the

GSEs would be subject under the ShaysMarkey bill. That legislation would make the

GSEs’ debt and MBSs subject to enforced disclosure requirements and fees and would

reduce the enterprises’ future discretion. Any further effects of that legislation on the

GSEs’ securities would depend on the specifics of the implementing regulations issued

by the SEC.
1. Fannie Mae was originally created as a wholly owned government corporation (the Federal National

Mortgage Corporation) in 1938, and its securities were federal obligations until 1968, when it was

converted into a governmentsponsored enterprise. Freddie Mac, or the Federal Home Loan Mortgage

Corporation, was created in 1970 as part of the Federal Home Loan Bank System.

2. The conformingloan limits are 50 percent higher in Alaska and Hawaii. Under law, the enterprises

adjust the conforming ceiling annually for the change in house prices. In 2002, the ceiling was

$300,700 on singlefamily residences. The two GSEs also finance multifamily mortgages.

3. In general, the GSEs purchase MBSs through dealers who serve as intermediaries. Some of those dealers

are subsidiaries of the large originators of mortgages.

Introduction

Fannie Mae and Freddie Mac are governmentsponsored enterprises (GSEs), established

by federal law in 1968 and 1970, respectively, to overcome thenexisting legal and

institutional impediments to the flow of funds for housing.1

 They act as financial inter

mediaries, raising funds in the capital markets and channeling the proceeds to lenders,

who in turn provide financing for their customers. Fannie Mae and Freddie Mac are

restricted to financing “conforming” mortgages, which are highquality loans secured

by residential real estate whose original principal amount is no greater than the conform

ing ceiling—$322,700 for singlefamily mortgages in 2003.2 Loans above that limit are

called “jumbo” loans and are bundled and sold in the capital markets by private issuers

as “privatelabel” securities. Although the GSEs receive special benefits from the govern

ment and are restricted in the mortgages that they can finance, they are owned by private

investors, to whom they have a fiduciary responsibility.

Fannie Mae and Freddie Mac supply funds to mortgage lenders in two ways. First, they

borrow money by selling corporate debt securities and use the funds to purchase mort

gages and mortgagebacked securities (MBSs). They profit from that activity because the

income that they earn on those assets exceeds the interest that they must pay on debt

plus their operating costs. Second, Fannie Mae and Freddie Mac guarantee investors

against credit losses on securities backed by pools of conforming mortgages. Those GSE

guaranteed mortgagebacked securities can be held as investments by the sellers of the

loans (in a “swap” transaction) or sold to investors, including Fannie Mae and Freddie

Mac themselves.3 The sale of pools of mortgages, packaged as standardized MBSs, pro

vides lenders with a ready supply of mortgage financing. The GSEs receive fees from guar

anteeing timely payment of principal and interest to the investors in the MBSs. (For more

details, see Box 1.)

The Benefits of GSE Status

Current law treats the GSEs as instrumentalities of the federal government, rather than

as fully private entities. As a consequence, they are afforded exemptions from many taxes,

fees, and regulations; and for many purposes, their securities are treated as government

securities. For Fannie Mae and Freddie Mac, GSE status starts with their federal statutory
2 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

4. States also allow debt issued by the GSEs to be used as collateral for state and local governments’

deposits in commercial banks.

Box 1.

Understanding Mortgage-Backed Securities

Mortgagebacked securities (MBSs) are created when mortgages are packaged, or

“pooled,” and sold as securities. The mortgages in the pool generally are of the same

type (fixedrate or adjustablerate mortgages), have fairly similar interest rates, and

have the same maturities (30 years, 20 years, or 15 years) so that investors can esti

mate the cash flows as if the pool were a single mortgage.1 In most cases, and particu

larly with pools of mortgages by a single lender, the mortgage originators pool the

loans and then obtain a guarantee from either Fannie Mae or Freddie Mac, which

evaluates the loans to ensure that they meet its credit quality standards. In those

transactions, the lender is swapping the pool of loans for MBSs representing

ownership in the same mortgages. Exchanging pools of mortgages for MBSs can be

beneficial to a commercial bank or thrift because the securities have lower capital

requirements and are more liquid. Often, the lender has already agreed to deliver the

MBSs in the market for forward sales, the socalled To Be Announced market (de

scribed in Box 3).

The interest rate paid on the MBSs, the “passthrough” rate, is less than the mortgage

interest rate on the underlying loans because borrowers are indirectly paying fees to

mortgage servicers and the governmentsponsored enterprises. Mortgage loan servicers

(either mortgage originators or other parties) collect payments from borrowers, ensure

1. Linda Lowell, “Mortgage PassThrough Securities,” in Frank J. Fabozzi, ed., The Handbook of

MortgageBacked Securities, 5th edition (New York: McGraw Hill, 2001), pp. 2550. See also

Fannie Mae, “Understanding Fannie Mae MBS,”available at www.fanniemae.com, and Freddie

Mac, “Value in Gold PCs Fact Sheet,” available at www.freddiemac.com/mbs/html/asp_gold.html.

charter, which exempts them from state and local income taxes (but not federal taxes or

local property taxes) and enables them to use the Federal Reserve as their fiscal agent.

In addition, the U.S. Treasury is authorized to lend $2.25 billion to each enterprise either

through purchases of its securities or through direct lending. Like Treasury debt, debt

issued by the GSEs is eligible for use by banks as collateral for both public deposits (for

example, the Treasury’s deposits)4

 and loans from Federal Reserve banks, for unlimited
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 3

5. Board of Governors of the Federal Reserve System, Alternative Instruments for Open Market and

Discount Window Operations (December 2002), available at www.federalreserve.gov/boarddocs/

surveys/soma/alt_instrmnts.pdf.

Box 1.

Continued

that borrowers’ tax and insurance payments are current, and handle defaults. Bor

rowers do not deal directly with the enterprises. The originators pay Fannie Mae and

Freddie Mac guarantee fees equal to a percentage of a pool’s outstanding balance.

Those fees averaged 19 basis points (0.19 percentage points) in 2001.2

While the governmentsponsored enterprises are the sellers in the MBS market, the

buyers are generally institutional investors—investment banks, commercial banks

and thrifts, pension funds, and mutual funds. About 85 percent of the trades in that

market are made by 20 percent of the investors; the retail market is negligible.3

 Most

individuals who invest in MBSs do so through mutual funds. MBSs are attractive

to investors because they offer buyers relatively safe and highly liquid investments

with yields higher than those of comparable Treasury securities.

The size of a pool of mortgagebacked securities varies greatly, and investors may own

all or part of the pool. As of September 2002, the average pool for Fannie Mae’s

MBSs included 58 loans with a combined principal balance of $8.2 million. Some

pools had almost 300 loans, while others had as few as 10 loans. Such figures and

averages vary over time.4

 The minimum value for most pools is $1 million.

2. Office of Federal Housing Enterprise Oversight, Mortgage Markets and the Enterprises in 2001

(Revised/corrected September 16, 2002), pp. 42 and 58.

3. Personal communication to the Congressional Budget Office by Fannie Mae staff, September 13,

2002.

4. Ibid.

investment by federally chartered and insured banks and thrifts, and for purchase by the

Federal Reserve in its openmarket operations.5

 Finally, Fannie Mae and Freddie

Mac—along with the Federal Home Loan Banks and the Farm Credit System (but not

the Federal Agricultural Mortgage Corporation, which is known as “Farmer Mac”)—are

exempt by law from the registration and disclosure requirements that the Securities
4 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

6. Section 304 of the Fannie Mae Charter Act of 1954 (codified at 12 U.S.C. 1719 (2000)) states,

“[Securities] issued by the corporation . . . shall, to the same extent as securities which are direct

obligations of or obligations guaranteed as to principal and interest by the United States, be deemed

to be exempt securities within the meaning of the laws administered by the Securities and Exchange

Commission.” Freddie Mac’s charter contains a nearly identical provision. Banks and thrifts are also

exempt from registration requirements, although bank holding companies, which issue most bank

securities, are not. In addition, state and local governments’ securities are exempt.

7. Fannie Mae was insolvent on a marktomarket basis; that is, the market value of its liabilities exceeded

the market value of its assets. See Congressional Budget Office, Controlling the Risks of Government

Sponsored Enterprises (April 1991), p. 129.

8. The enterprises’ charters also impose restrictions. For example, the enterprises cannot originate

mortgages or buy a bank or thrift.

9. To interpret provisions of federal law as implying a federal guarantee of GSE debt and MBSs, investors

must overlook a contrary provision in Fannie Mae’s and Freddie Mac’s charters: an explicit disavowal

of federal responsibility. As stated in section 304 of the 1954 Fannie Mae Charter Act, Fannie Mae

“shall insert appropriate language in all of its obligations . . . clearly indicating that such obligations,

together with the interest thereon, are not guaranteed by the United States and do not constitute a

debt or obligation of the United States or of any agency or instrumentality thereof other than the

corporation” (codified at 12 U.S.C. 1719 (2000)). That requirement was explicitly extended to

subordinated debt in 1968 and to MBSs and all of Freddie Mac’s securities in 1992. Investors in

subordinated debt are exposed to greater credit risk than other debt investors because their claims are

paid last in the event of default. 

and Exchange Commission (SEC) imposes on nearly all other large privately owned

issuers of publicly traded securities.6

 Fannie Mae and Freddie Mac are also the only issuers

of publicly traded stock that are exempt.

If Fannie Mae and Freddie Mac were federal, rather than governmentsponsored,

agencies, those provisions would be unremarkable. But the enterprises are privately owned

entities that have a possibility of insolvency. Although Fannie Mae is financially strong

now, it experienced a series of losses in the early 1980s that could have caused the failure

of a purely private firm.7

 The statutory provision for the U.S. Treasury to lend to the

GSEs in time of financial distress acknowledges the risk of failure. Indeed, the Office

of Federal Housing Enterprise Oversight (OFHEO), the safety and soundness regulator

of Fannie Mae and Freddie Mac, was established to control GSEs’ risks.

The GSEs receive two distinct but related benefits from their sponsored status.8

 First,

regulatory and tax exemptions reduce their operating costs. Second, and far more im

portant, their treatment in federal law is interpreted by investors as implying that the

credit risk of GSE debt and MBSs is comparable to that of U.S. Treasury debt, which

is regarded as the least risky debt in the financial markets.9 As a consequence, GSEs’ debt
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 5

10. A 1992 interagency report issued by the Department of the Treasury, the SEC, and the Federal Reserve

had recommended that the GSEs’ unsecured debt and equity be subject to the SEC’s registration and

disclosure requirements. See Department of the Treasury, Securities and Exchange Commission, and

Board of Governors of the Federal Reserve System, Joint Report on the Government Securities Market

(January 1992), p. 34. 

11. Farmer Mac issues assetbacked securities and publicly traded stock; however, that GSE is subject to

the SEC’s registration and disclosure requirements. The Department of the Treasury has proposed

that the Federal Home Loan Banks, which are owned by their member banks and thrifts, register their

stock with the SEC. See Rob Garver, “Treasury Rejects FHLB Offer on Disclosure,” American Banker,

December 4, 2002, p. 1. 

12. Letter from Paula Dubberly, Chief Counsel, Division of Corporate Finance, Securities and Exchange

Commission, to Ann Kappler, Senior Vice President and General Counsel, Fannie Mae, July 12, 2002.

issues are traded in the market for federal agencies’ obligations, where interest rates are

somewhat higher than those on Treasury debt but below those on the highestquality

private securities. 

A Legislative Proposal to Repeal the GSEs’ SEC Exemptions

The Uniform Securities Disclosure Act, or H.R. 4071—introduced on March 20, 2002,

by Congressmen Christopher Shays and Edward Markey—would repeal Fannie Mae’s

and Freddie Mac’s exemptions from the SEC’s registration and disclosure require

ments.10Accordingly, the two GSEs would be required to pay registration fees and to dis

close information as specified by the SEC about their securities, just as other publicly

traded companies and other issuers of private MBSs do. The bill does not include changes

to other special provisions of law that favor the GSEs, nor does it refer to the Federal

Home Loan Banks or the Farm Credit System, two GSEs that share the exemption on

debt issues but that do not issue publicly traded stock or MBSs.11

On July 12, 2002, prior to legislative action on H.R. 4071, Fannie Mae and Freddie Mac

reached an agreement with the SEC and OFHEO to register their common stock.

Although registration was voluntary, Fannie Mae and Freddie Mac cannot terminate it.

In addition, voluntary registration triggers mandatory disclosures and the SEC’s review

and enforcement authority.12

Fannie Mae registered its common stock when it filed its registration statement and first

periodic financial report (its Form 10K annual report, which contains audited financial

statements) with the SEC on March 31, 2003, just as nonGSE firms do. Freddie Mac

will register later in the year. Equity investors can obtain those filings through the SEC’s

electronic reporting system, known as EDGAR. In the interim, Freddie Mac’s informa

tion is available on its Web site.
6 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

13. Section 12(g) of the Securities Exchange Act of 1934 (codified at 15 U.S.C. 78l(g)) allows voluntary

registration of any class of equity security—as opposed to particular issues—by firms that are not legally

required to register with the SEC. Consequently, one registration covers any future issues of common

stock. Firms register individual security issues under the Securities Act of 1933 (codified in various

sections of title 15 U.S.C.).

14. Preferred stock pays a dividend that is fixed at the time of issuance. Those dividends are paid before

dividends are distributed to common stockholders. 

15. OFHEO has proposed a securities disclosure regulation—“Public Disclosure of Financial and Other

Information”—that would virtually eliminate the remaining gaps, including those covering proxy

statements and stock transactions by company directors and officers. See Office of Federal Housing

Enterprise Oversight, “OFHEO Proposes Securities Disclosure Regulation for Fannie Mae and Freddie

Mac” (press release, Washington, D.C., January 21, 2003).

16. The SarbanesOxley Act (Public Law 107204) enhances disclosure requirements and reduces to two

business days the time for firms to report insider transactions to the SEC. The new law also requires

a firm’s chief executive and chief financial officer to personally certify its financial statements. See Mark

Jickling, The SarbanesOxley Act of 2002: A SidebySide Comparison of House, Senate, and Conference

Versions, CRS Report for Congress RL31483 (Congressional Research Service, July 26, 2002).

17. Statement of Peter R. Fisher, Under Secretary for Domestic Finance, Department of the Treasury,

before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of

the House Committee on Financial Services, July 16, 2002. Freddie Mac had been making information

about insider transactions available upon request since 1996 and began posting information about

those transactions on its Web site as of April 26, 2002. Fannie Mae also began posting such information

in April 2002. 

Voluntary registration under the Securities Exchange Act of 1934 rather than the

Securities Act of 1933 offers the GSEs certain advantages.13 For example, they were able

to register one class of securities (common stock) without registering their preferred stock,

debt, and MBSs.14 Moreover, registrants under the Exchange Act pay no fees to the SEC.

Further, with voluntary registration, not all of the legal requirements of that law may

apply to the enterprises.15

Registration of those securities is expected to have little effect on the prices of GSE stock

because the enterprises were already disclosing detailed information on their overall

financial condition and performance in the form of monthly, quarterly, and annual

reports and detailed information statements. Under voluntary registration, Fannie Mae

and Freddie Mac will have to make all of the disclosures mandated by the SarbanesOxley

Act of 2002.16 The companies also will voluntarily disclose transactions in company stock

by corporate officers and directors.17
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 7

18. After policymakers had expressed interest in increased disclosures about risk, in October 2000 Fannie

Mae and Freddie Mac announced six voluntary steps to increase their reporting. For example, the enter

prises agreed to provide enhanced disclosures of interest and credit risk and to obtain an annual rating

of their risk from one of the creditrating firms and to disclose that to the government. See W. Scott

Frame and Larry D. Wall, “Fannie Mae’s and Freddie Mac’s Voluntary Initiatives: Lessons from

Banking,” Economic Review, Federal Reserve Bank of Atlanta, vol. 87, no. 1 (2002), pp. 4559; and

Michael Fratantoni, “Fannie Mae’s Voluntary Initiatives After 18 Months: A Report on Implementa

tion and Policy Issues,” Fannie Mae Papers, vol. 1, no. 4 (June 2002). 

Voluntary compliance with the disclosure requirements for debt that would be triggered

by H.R. 4071 might not be a significant burden to the enterprises because few additional

disclosures would be necessary.18 That is because investors in the enterprises’ debt

generally rely on the same periodic financial disclosures already made for the enterprises’

stock. However, SEC registration for those securities would entail additional adminis

trative costs and some fee expenses. 

The Basics of Mortgage-Backed Securities

Mortgagebacked securities are created when a financial institution originates mortgages

and then, rather than holding the loans, pools them and sells shares of the pooled assets

to investors. A mortgagebacked security differs from a debt security—an obligation of

the issuer—in that it represents an ownership interest in the underlying loans. That own

ership interest provides the investors a claim to a pro rata share of the interest and prin

cipal payments from a specified group of individual mortgages rather than a fixed stream

of payments. Payments on MBSs vary depending on the rate at which borrowers sell their

homes and pay off their loans or refinance their mortgages. 

The value of a mortgagebacked security depends on the credit and prepayment risk of

the pool. The potential credit risk on MBSs is reduced through diversification among

many borrowers and various forms of credit enhancement, including mortgage and pool

insurance, and the GSEs’ guarantees of payment. Fannie Mae’s and Freddie Mac’s guar

antees are backed by the capital of the agencies. Because of the perception of an implicit

federal guarantee and the fact that investors in the GSEs’ MBSs have never suffered losses

from default, credit risk is not a major concern for investors in this market. In contrast,

credit risk is a concern for investors in privatelabel MBSs. Prepayment risk, which is

the major source of uncertainty in the cash flows from MBSs, however, is a concern for

investors in both the GSEs’ and privatelabel MBSs. 

The market for the GSEs’ MBSs is large and liquid. New issues have exploded. In 1990,

the enterprises issued $171 billion of MBSs; in 2001, they issued $918 billion—$528

billion by Fannie Mae and $390 billion by Freddie Mac (see Figure 1). Those amounts
8 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

19. The Department of Housing and Urban Development’s Government National Mortgage Association

guarantees privately issued securities that are backed by pools of mortgages insured or guaranteed by

the Federal Housing Administration, Department of Veterans Affairs, and Rural Housing Service.

Those federally guaranteed securities are exempt from the SEC’s registration and disclosure require

ments. For data on issues of Ginnie Mae securities, see Bond Market Association, “Issuance of Agency

MortgageBacked Securities, 19802002” (2002), available at www.bondmarkets.com/Research/

mbsdat1.shtml; and for data on privatelabel issues, see Fannie Mae, “A Statistical Summary of Housing

and Mortgage Finance Activities” (2002), available at www.fanniemae.com/global/pdf/ir/resources/

housingmortgage2002.pdf.

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

0

200

400

600

800

1,000

1,200

1,400

Fannie Mae Freddie Mac

Total

Ginnie Mae

Private-Label Issuers

Figure 1.

New Issues of Mortgage-Backed Securities, 1990-2001

(Billions of dollars)

Sources: Office of Federal Housing Enterprise Oversight, Mortgage Markets and the Enterprises in 2001 (Revised/corrected

September 16, 2002), pp. 41 and 57; Bond Market Association, “Issuance of Agency Mortgage-Backed Securities, 1980-

2002” (2002), available at www.bondmarkets.com/Research/mbsdat1.shtml; and Fannie Mae, “A Statistical Summary

of Housing and Mortgage Finance Activities” (2002), available at www.fanniemae.com.

ran far ahead of the $174 billion of new issues in the privatelabel market in 2001 and

the $175 billion of absorption of issues guaranteed by the federally owned Government

National Mortgage Association, or Ginnie Mae.19 At more than $2 trillion, the GSEs’

outstanding MBSs are equal to about twothirds of the U.S. public debt. Even though

the enterprises are major investors in their own MBSs, retaining more than $730 billion

in their portfolios, holdings by other investors exceed $1.5 trillion (see Table 1).

Prepayment Risk

Mortgage borrowers can generally prepay all or part of their debt at any time without

penalty. That option for borrowers exposes investors in MBSs to a risk that they do not
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 9

20. Investors in callable debt bear call risk. Call risk is similar to prepayment risk, but determining the

trigger level at which it makes economic sense for a firm to exercise a call is easier than assessing pre

payment risk.

Table 1.

Fannie Mae’s and Freddie Mac’s Outstanding MortgageBacked Securities, 1981-2001

(In millions of dollars)

Fannie Mae’s 

Mortgage-Backed Securities

Freddie Mac’s

 Mortgage-Backed Securities

Held by

Investors

Retained in 

Portfolio

Total

Outstanding

Held by

Investors

Retained in

Portfolio

Total

Outstanding

1981 717 0 717 19,897 n.a. n.a.

1982 14,450 0 14,450 42,952 n.a. n.a.

1983 25,121 0 25,121 57,720 n.a. n.a.

1984 35,738 477 36,215 70,026 n.a. n.a.

1985 54,552 435 54,987 99,909 n.a. n.a.

1986 95,568 1,606 97,174 169,186 n.a. n.a.

1987 135,734 4,226 139,960 212,635 n.a. n.a.

1988 170,097 8,153 178,250 226,406 n.a. n.a.

1989 216,512 11,720 228,232 272,870 n.a. n.a.

1990 288,075 11,758 299,833 316,359 n.a. n.a.

1991 355,284 16,700 371,984 359,163 n.a. n.a.

1992 424,444 20,535 444,979 407,514 6,394 413,908

1993 471,306 24,219 495,525 439,029 15,877 454,906

1994 486,345 43,998 530,343 460,656 30,670 491,326

1995 513,230 69,729 582,959 459,045 56,006 515,051

1996 548,173 102,607 650,780 473,065 81,195 554,260

1997 579,138 130,444 709,582 475,985 103,400 579,385

1998 637,143 197,375 834,518 478,351 168,108 646,459

1999 679,169 281,714 960,883 537,883 211,198 749,081

2000 706,684 351,066 1,057,750 576,101 246,209 822,310

2001 858,867 431,484 1,290,351 646,448 301,961 948,409

Source: Congressional Budget Office based on Office of Federal Housing Enterprise Oversight, Mortgage Markets and the

Enterprises in 2001 (Revised/corrected September 16, 2002), pp. 44, 46, 60, and 62.

Note: n.a.= not available.

face when holding noncallable debt securities.20 That risk arises because, unlike non

callable debt instruments, which promise a series of predetermined payments from the

issuer to investors, MBSs pay investors shares of the often uneven and somewhat un

predictable cash flows from the underlying pool of mortgages. The major source of the

uncertainty about those cash flows is the speed with which borrowers—the homeowners

—will prepay the mortgages in the pool.
10 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

21. Investment bankers often unbundle, or separate, principal payments and interest flows. The early return

of principal is always good for investors; investors in principalonly securities gain from higher pre

payment rates. The loss arises from the termination of the interest stream; investors in interestonly

Box 2.

What Determines Whether Borrowers Prepay

Single-Family Mortgages?

The actual cash flows to investors from mortgagebacked securities (MBSs) depend

on the speed at which loans in a pool are paid off as homeowners refinance or sell

their homes, that is, the prepayment rate. A higher prepayment rate means that

investors get their money back more quickly. Because the value of an MBS pool

depends on the timing of cash flows, analysts have developed models to predict

prepayment speeds for different mortgagebacked securities.1

Movements in interest rates are the most important determinant of borrowers’ pre

payments. Borrowers are more likely to refinance and prepay their mortgages when

rates fall sharply than when rates are unchanged or rise. Loanspecific factors also

affect prepayments.2

 In general, borrowers holding mortgages with larger loan

balances are more likely to prepay in response to a decline in interest rates than are

borrowers with smaller balances. Borrowers with bigger loans save more by refinanc

ing at lower rates. In addition, borrowers with more equity in their homes are more

likely to prepay, for several reasons. First, they will find qualifying for refinancing

easier than will borrowers with little equity. Second, they have more equity to take

1. Prepayment models vary in their reliability and accuracy. See Michael Bykhovsky, “Overview of

Recent Prepayment Behavior and Advances in Its Modeling,” in Frank J. Fabozzi, ed., The

Handbook of MortgageBacked Securities, 5th edition (New York: McGraw Hill, 2001), pp. 365

378.

2. In Freddie Mac’s view, pooling smooths out a lot of the loanspecific determinants of prepayments,

and prepayment risk is largely a function of future interest rates rather than of variability among

loans. Hence, by that view, if the sizes of pools are sufficiently large, additional new disclosures

about loans’ characteristics will add only marginally to assessments of prepayment risk. Personal

communications to the Congressional Budget Office by Freddie Mac staff, December 12, 2002,

and January 13, 2003.

Borrowers are especially likely to prepay and refinance their homes when interest rates

fall because refinancing at lower rates saves them money. When that happens, MBS

investors get some of their money back sooner than expected and then face less desirable

opportunities for reinvesting because of the lower prevailing interest rates.21 Conse
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 11

securities are the big losers from an unanticipated increase in prepayment rates. Prepayment risk can

also be differentially allocated through structured MBSs that divide cash flows from a pool of mortgages

into multiple classes with different maturities or risk profiles. Investors can also hedge against prepay

ment risk in a variety of ways. See Roger W. Ferguson Jr., Vice Chairman of the Federal Reserve Board,

“Financial Engineering and Financial Stability” (address given at the Annual Conference on the

Securities Industry, New York, N.Y., November 20, 2002).

Box 2.

Continued

out of their homes in “cash out” refinancings, which accounted for more than half

of the 11.2 million refinancings in 2001.3

 Third, they are more likely to sell their

residence and move to a more expensive one. Consequently, prepayment rates are

sensitive to loantovalue (LTV) ratios. Borrowers with higher LTVs (less equity)

are often less likely to prepay. Prepayments are also more likely in areas with rapidly

rising home values, which raise homeowners’ equity and lower LTV ratios. 

A number of other factors also affect prepayment rates. State laws can come into play;

for example, New York’s tax on refinanced mortgages slows prepayments in that state.

Borrowers’ creditworthiness and the proportion of loans to subprime borrowers, who

are more likely to prepay if their credit standing improves, also have a bearing—as

does the seasoning of loans (the time since origination).4

 Prepayment speeds typically

increase for about 30 months after origination and then stabilize. Finally, a sharp

decline over the past five years in the transaction cost of refinancing, driven by auto

mated underwriting and other technology, has provided an incentive for borrowers

to prepay.5

3. See Akash Deep and Dietrich Domanski, “Housing Markets and Economic Growth: Lessons from

the U.S. Refinancing Boom,” BIS Quarterly Review (September 2002), pp. 3744. 

4. Subprime borrowers prepay and default more frequently than prime borrowers do, but when

interest rates drop, prime borrowers refinance more frequently than subprime borrowers do. See

Anthony PenningtonCross, Patterns of Default and Prepayment for Prime and Nonprime Mortgages,

Working Paper 021 (Office of Federal Housing Enterprise Oversight, March 2002), available

at www.ofheo.gov/docs/working/021cross.pdf.

5. See Deep and Domanski, “Housing Markets and Economic Growth,” pp. 3744.

quently, the likelihood of prepayment of the mortgages in a pool of MBSs is an important

determinant of expected cash flows and hence the value of the securities. Investors are

also at risk when rates rise and borrowers pay off mortgages more slowly than expected
12 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

—extension risk. Thus, unexpected changes in interest rates in both directions can hurt

MBS investors. (See Box 2 on pages 10 and 11 for further discussion of factors affecting

borrowers’ prepayments.) 

Although prepayment risk is an important factor affecting the value of the GSEs’ and

private label mortgagebacked securities, the former have generally traded as though that

risk were virtually the same for all issues of the same type (for example, securities based

on 30year fixedrate mortgages) with the same interest rate and seasoning, or time since

origination. That homogeneity in prices is particularly evident when the MBSs are first

sold in what is known as the To Be Announced (TBA) market. That market currently

prices new MBSs before the underlying pools are assembled; prices are based on the

interest rate to be passed through to investors, which is disclosed in advance by the pooler

(see Box 3 for a description of the TBA market). Consequently, the TBA market prices

MBSs without specific information about the composition of the loan pools, including

factors that affect prepayment risk.

Increasing Demand for Disclosures About MBSs

Investors’ demand for information about securities depends on their ability to use it to

value those investments. Until recently, there was little demand for detailed information

about mortgage pools that might permit investors to differentiate among MBS issues on

the basis of prepayment risk. Investors may have believed either that prepayments were

equally likely on all MBSs or that any systematic differences in prepayment risk among

MBSs could not be identified.

Three changes in the MBS market have increased investors’ demand for information

about GSEs’ mortgage pools: increased diversity in the composition of pools, improved

information technology, and the growing role of Fannie Mae and Freddie Mac as in

vestors in MBSs. That growing role has the potential to disadvantage other investors

because of the GSEs’ greater access to information. 

First, the loans eligible for pooling have become less homogeneous with increases in the

conforming loan limit and the addition of loans to borrowers with higher credit risks.

The enterprises can now purchase mortgages of up to $322,700, reflecting an increase

of more than $95,000 in five years (see Figure 2); and Fannie Mae and Freddie Mac are

now including in the mortgage pools limited numbers of mortgages from borrowers

whose credit histories are blemished or who have little or no credit history and loans from
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 13

Box 3.

Understanding the “To Be Announced” Market

Most of the mortgagebacked securities (MBSs) that Fannie Mae and Freddie Mac

guarantee are traded initially in the “To Be Announced” (TBA) market, as are issues

guaranteed by the Government National Mortgage Association, or Ginnie Mae. That

market prices new MBSs before the underlying pools are assembled and even before

all of the loans have been originated. The liquidity and certainty of prices that the

TBA market offers lenders makes them more willing to offer buyers a firm interest

rate at the beginning of the loan process.

Specifically, the TBA market is a “forward” market in which lenders promise to de

liver in the future—generally, in 30, 60, or 90 days—a package of loans that meets

the governmentsponsored enterprises’ purchase requirements. The terms of delivery

to the TBA market are generic, so the lenders pooling the loans do not need to have

all the information about the loans at the time they commit to sell. Two days before

delivering the package of loans, the sellers identify the specific pools of mortgages

to be delivered to satisfy the commitment.2

 The assumption held by both buyers and

sellers is that individual securities of the same type, interest rate, and maturity are

interchangeable, so the transactions do not need to rely on loanspecific information.

That lack of differentiation lowers transaction costs, increases liquidity, and facilitates

efficient settlement. Because the price of the loans has been fixed before delivery,

lenders can offer home buyers the opportunity to lock in a rate before the closing.

Privatelabel MBSs do not trade in the TBA market; however, borrowers who take

out jumbo mortgages can still lock in their rates prior to closing. Lenders of those

mortgages commit to rates in advance because they can take positions in the TBA

market to hedge their interest rate exposure. Because of the varying credit and other

risks of privatelabel issues, the market sets prices for those MBSs individually. Some

forward trading of jumbo MBSs exists, but the loans have been made before the pools

are formed. In that market, prices can be renegotiated if the delivered pool of loans

is significantly different from the one described in the offering prospectus.

1. The TBA market also allows for stipulated trades so that an investor who wants certain charac

teristics in a pool of mortgages, such as loans in a particular area or of a particular size, can request

them. 

2. For a discussion of how this forward market works for Fannie Mae’s and Freddie Mac’s MBSs,

see Jeffrey D. Biby, Srinivas Modukuri, and Brian Hargrave, “Trading, Settlement and Clearing

Procedures for Agency MBS,” in Frank J. Fabozzi, ed., The Handbook of MortgageBacked Securities,

5th edition (New York: McGraw Hill, 2001), pp. 105114.
14 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

22. Fannie Mae and Freddie Mac have started buying loans made by traditional lenders to borrowers with

a credit quality of A rather than exclusively purchasing loans made to borrowers with the top credit

rating of A. Although disagreement exists over what constitutes subprime loans, Freddie Mac places

loans with A standing in its MBSs but separately securitizes the subprime loans with lower credit

ratings, discloses that information, and keeps those pools out of the TBA market. At the end of 2001,

subprime mortgages were less than 2 percent of Freddie Mac’s total portfolio. See Freddie Mac,

“Information Statement,” March 29, 2002, p. 6, available at www.freddiemac.com/investors/infostat/.

Fannie Mae does not categorize loans in that manner or release similar statistics. The enterprises also

guarantee AlternativeA loans, which are ones with little documentation. Such loans are often made

to selfemployed individuals and others whose income is difficult to verify but who otherwise have credit

scores high enough for the standing. Also, some prime borrowers choose lowdocumentation loans

simply to streamline refinancing. The enterprises generally provide greater disclosures on MBSs

composed of AlternativeA loans.

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

160

180

200

220

240

260

280

300

320

340

Figure 2.

The Conforming-Loan Limit for Single-Family Loans, 

1990-2003

(Thousands of dollars)

Source: Federal Housing Finance Board.

Note: The limit on conforming loans for single-family homes is 50 percent higher in Alaska and Hawaii.

borrowers who generally do not meet the standards for the lowest mortgage rates.22 The

GSEs are also increasing the number of loans with low down payments. As a consequence,

MBS pools are growing more diverse with respect to factors that can affect prepayment

rates, especially loan size and borrowers’ credit quality. That development raises the
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 15

23. Bear, Stearns & Co., “Converging Prepayments Make NonAgency MBS Attractive Versus Agencies,”

NonAgency Mortgage Research, May 29, 2001. 

24. See Andrea Heuson, Wayne Passmore, and Roger Sparks, “Credit Scoring and Mortgage Securitization:

Implications for Mortgage Rates and Credit Availability,” Journal of Real Estate Finance and Economics,

vol. 23, no. 3 (2001), pp. 337364; Wayne Passmore and Roger W. Sparks, “Automated Underwriting

and the Profitability of Mortgage Securitization,” Real Estate Economics, vol. 28 (2000), pp. 285305;

and Wayne Passmore and Roger W. Sparks, “Putting the Squeeze on a Market for Lemons:

GovernmentSponsored Mortgage Securitization,” Journal of Real Estate Finance and Economics, vol.

13, no. 1 (1996), pp. 2743. 

25. According to current estimates, about 20 percent of the volume of MBSs is diverted into customized

pools rather than sold in the generic TBA market. Prices in that secondary market adjust monthly

as information on actual prepayment rates is released, allowing investors to recalibrate their models.

Personal communication to the Congressional Budget Office by Fannie Mae staff, December 10, 2002.

Investors can also request that dealers sell them MBSs with particular characteristics, and they pay a

premium for those MBSs. Personal communication to the Congressional Budget Office by Mitch

Flack, Metropolitan West Asset Company, October 30, 2002. See also Bear, Stearns & Co., “Adverse

Loan Selection and the True TBA Market,” Mortgage Research, April 12, 2001.

26. See Shadow Financial Regulatory Committee, “Statement on ShaysMarkey Bill on GSE Disclosure,”

Statement No. 178 (May 6, 2002), available at www.aei.org/publications/pubID.15128/pub_detail.asp;

Consumer Mortgage Coalition, “H.R. 4071, the Uniform Securities Disclosure Act: Increasing

Information About Fannie Mae and Freddie Mac for Investors” (issue paper, Washington, D.C., April

22, 2002); and Tommy Fernandez, “MBS Market Controversy: GSEs’ Information Edge?” American

Banker, August 23, 2002. 

value of moredetailed information about mortgage pools that could be used in predicting

prepayment rates.23

Second, improved information technology has given analysts the ability to use more in

formation to predict prepayments. In addition, the advent of electronic mortgage appli

cation and processing systems gives the originators and the GSEs’ an ability to quickly

process detailed information about the underlying mortgages.24 Those technical advances

increase the value of information that can be used to estimate prepayment risk.

In fact, lower costs of processing information have enabled large originators and poolers

to sort their loans and create customized pools that are based on the characteristics of

individual loans, including prepayment risk. Such pools are more valuable than those

that are undifferentiated and delivered to the generic To Be Announced market.25

Third, the enterprises are now the largest investors in their own mortgagebacked

securities. Some institutional investors believe that they could be at an informational dis

advantage compared with the large originators of the mortgages and the GSEs.26 Fannie
16 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

27. Fannie Mae’s share of its own MBSs increased from 16 percent of the securities that it guaranteed to

33 percent between 1996 and 2001. Freddie Mac’s share increased from 15 percent to 32 percent over

that fiveyear period. CBO’s calculations are based on data in Office of Federal Housing Enterprise

Table 2.

Selected Details on Fannie Mae’s and Freddie Mac’s

Retained Mortgage Portfolios, 1981-2001

(In millions of dollars)

Fannie Mae’s

Retained Mortgage Portfolio

Freddie Mac’s

Retained Mortgage Portfolio

Year

Loans

Not 

Pooled

Fannie

Mae’s

MBSs

Freddie

Mac’s

MBSs

Total

Retained

Mortgage

Portfolioa

Loans

Not 

Pooled

Freddie

Mac’s

 MBSs

Fannie

Mae’s

MBSs

Total

Retained

Mortgage

Portfolioa

1981 61,411 0 n.a. 61,412 n.a. n.a. n.a. 5,178

1982 71,777 0 n.a. 71,814 n.a. n.a. n.a. 4,679

1983 77,983 0 n.a. 78,256 n.a. n.a. n.a. 7,485

1984 87,205 477 n.a. 88,109 n.a. n.a. n.a. 10,018

1985 97,421 435 n.a. 98,649 n.a. n.a. n.a. 13,547

1986 94,167 1,606 n.a. 97,833 n.a. n.a. n.a. 13,093

1987 89,618 4,226 n.a. 96,746 n.a. n.a. n.a. 12,354

1988 92,220 8,153 n.a. 103,013 n.a. n.a. n.a. 16,918

1989 95,729 11,720 n.a. 110,721 n.a. n.a. n.a. 21,448

1990 101,797 11,758 n.a. 116,628 n.a. n.a. n.a. 21,520

1991 109,251 16,700 n.a. 128,983 n.a. n.a. n.a. 26,667

1992 134,597 20,535 n.a. 158,119 n.a. 6,394 n.a. 33,629

1993 163,149 24,219 n.a. 190,861 n.a. 15,877 n.a. 55,938

1994 170,909 43,998 564 225,057 n.a. 30,670 n.a. 73,171

1995 171,481 69,729 3,233 253,511 43,753 56,006 n.a. 107,706

1996 167,891 102,607 3,623 287,052 46,504 81,195 n.a. 137,826

1997 160,102 130,444 5,262 316,678 48,454 103,400 n.a. 164,543

1998 155,779 197,375 23,453 414,515 57,084 168,108 3,749 255,670

1999 149,105 281,714 25,577 523,941 56,676 211,198 13,245 322,914

2000 152,505 351,066 33,290 610,122 59,240 246,209 28,303 385,451

2001 165,957 431,484 42,921 707,476 62,792 301,961 69,972 494,585

Source: Congressional Budget Office based on Office of Federal Housing Enterprise Oversight, Mortgage Markets and the Enterprises in 2001 (Revised/corrected September 16, 2002), pp. 46, 48, 62, and 64. 

Notes: MBS = mortgage-backed security; n.a.= not available.

a. Includes mortgage-related securities held by Fannie Mae and Freddie Mac that are not shown in this table.

Mae’s holdings of its own MBSs increased from $103 billion in 1996 to $431 billion

in 2001 (see Table 2). Freddie Mac’s holdings of its own MBSs shot up from $81 billion

to $302 billion over that fiveyear period. As a result, the GSEs’ share of the total out

standing issues doubled during that time span, and each now holds more than 30 percent

of the securities that it has guaranteed.27
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 17

Oversight, Report to Congress (June 15, 2002), Table 4, p. 102, Table 5, p. 103, Table 14, p. 113, and

Table 15, p. 114.

28. See Department of the Treasury, Office of Federal Housing Enterprise Oversight, and Securities and

Exchange Commission, Enhancing Disclosure in the MortgageBacked Securities Markets (January 2003),

pp. 4042 and 46, available at www.treas.gov/press. See also Credit Suisse/First Boston, “Mortgage

Relative Values,” Securitized Assets Research, February 15, 2002; and “Hard to Tell If GSEs Are Cherry

Picking Own MBSs,” Inside the GSEs, September 25, 2002, p. 5.

29. The study did not address registration issues and did not imply that registration was needed to enhance

disclosure. Department of the Treasury, Office of Federal Housing Enterprise Oversight, and Securities

and Exchange Commission, Enhancing Disclosure in the MortgageBacked Securities Markets. 

30. Poolbypool prepayment data are widely available through Bloomberg to all investors.

31. The coupon is the annual interest paid and is normally stated in terms of the face value of a security.

Fannie Mae and Freddie Mac deny that they trade on the basis of their superior infor

mation and point to the “information firewalls” that exist between their trading desks

and the rest of the company so that employees making investment decisions on MBSs

do not have access to loanlevel data. In addition, the enterprises’ opportunity to gain

from their superior information may be limited because most of their purchases occur

in the TBA market before the pools have been fully assembled and generally follow a

buyandhold strategy. Moreover, no evidence of a breach of the firewalls has surfaced.28

New Disclosures in the MBS Market

On February 3, 2003, a joint task force consisting of staff from the Department of the

Treasury, the Office of Federal Housing Enterprise Oversight, and the Securities and

Exchange Commission released a report including recommendations for new disclosures

to the GSEs’ MBS market.29 Subsequently, the enterprises agreed to disclose additional

information about—but not register—their MBSs. That agreement continued the trend

toward increased disclosures to investors in the GSEs’ mortgagebacked securities.

The GSEs’ Disclosures for MBSs Before 2003

Fannie Mae and Freddie Mac have always been subject to antifraud provisions of federal

securities law, including rule 10b5 under the Securities Exchange Act of 1934. Those

provisions require the enterprises to disclose material facts to investors and prohibit

fraudulent and deceptive practices. Accordingly, the GSEs have provided data on pre

payments for generic classifications of MBSs (for example, pools of 7.0 percent interest,

30year fixedrate mortgages).30 In addition, Fannie Mae and Freddie Mac have disclosed

the weightedaverage coupon (WAC)31; the weightedaverage remaining maturity

(WARM); the weighted average loan age (WALA); the weightedaverage original loan

term (WAOLT); and the identity of the pooler. They have also provided the distributions
18 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

32. Paul Bennett, Richard Peach, and Stavros Peristiani, “How Much Mortgage Pool Information Do

Investors Need?” Journal of Fixed Income, vol. 11, no. 1 (June 2001), pp. 815.

33. For information on privatelabel issues, see Eric Bruskin, Anthony Sanders, and David Sykes, “The

Nonagency Mortgage Market: Background and Overview” (April 1999), available at http:

//fisher.osu.edu/ ~sanders_12/ch1c.pdf; see also Frank J. Fabozzi and others, “Nonagency CMOs,”

in Frank J. Fabozzi, ed., The Handbook of MortgageBacked Securities, 5th edition (New York: McGraw

Hill, 2001), pp. 267280. For a comparison of disclosures, see Merrill Lynch, The Mortgage Investor,

July 17, 2002, p. 4. 

34. Privatelabel MBSs typically are issued as “structured” securities that reallocate the cash flows from

a pool or pools of mortgages. Structured, or multiclass, securities are designed to meet investors’ specific

requirements concerning prepayments or credit risk. Other forms of credit enhancements, including

thirdparty guarantees, can reduce credit risk. See Mortgage Research Group Lehman Brothers,

“Collateralized Mortgage Obligations,” in Frank J. Fabozzi, ed., The Handbook of MortgageBacked

Securities, 5th edition (New York: McGraw Hill, 2001), pp. 169195. 

of mortgages by state and by year of origination and the average original loan size

(AOLS). In addition, they report changes in WACs and WARMs and actual prepayments

on individual MBSs. Both GSEs also disclose updated distributions of loan size, and

Freddie Mac provides monthly loan delinquency rates. 

Private-Label Issuers’ Disclosures for MBSs

Issuers of MBSs backed by mortgages not eligible for purchase by Fannie Mae and

Freddie Mac, that is, privatelabel issuers, who are subject to the SEC’s oversight,

provided more information to their investors at issuance than the GSEs did before April

1, 2003. For example, privatelabel issuers generally reported and still report both the

weighted average and the distributional ranges for loantovalue ratios; the credit quality

of borrowers as measured by the Fair, Isaac, and Company’s (FICO) scores; the eligibility

of loans for credit under the Community Reinvestment Act (Public Law 95128); and

the location of properties (sometimes by zip code).32 Private issuers also disclose the

purpose of loans (to refinance an existing loan, to refinance and pull the equity out, or

to make a new purchase), the originators of the loans, documentation levels (details about

borrowers’ income, debt, and wealth) for loans, and delinquency history.33 Loans that

are subprime or AlternativeA loans may also be identified. Such extensive disclosure

about borrowers informs the market for privatelabel MBSs about credit risk. Investors

in privatelabel issues generally must look to borrowers rather than issuers for payments.34

The GSEs’ New Disclosures for MBSs

On April 1, 2003, Fannie Mae voluntarily began releasing both the weighted average

and quartile loantovalue ratios and borrowers’ credit scores for the loans making up
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 19

35. See Fannie Mae, “Fannie Mae Announces Additional Disclosures on MBS” (press release, Washington,

D.C., February 3, 2003); a sample disclosure for MBSs is available at www.fanniemae.com. See also

Freddie Mac, “Freddie Mac to Expand Mortgage Participation Certificate Disclosures” (press release,

McLean, Va., February 3, 2003), and “Freddie Mac Provides Formats and Details Around Expanded

Mortgage Participation Disclosure” (press release, McLean, Va., February 13, 2003), available at

www.freddiemac.com/news/archives2003/index.html. 

36. In 1998, about 90 percent of the transactions, as measured by total dollar volume, were executed in

the TBA market. See Bond Market Association, “TBAs: ToBeAnnounced Mortgage Securities Trans

actions” (1999), available at www.bondmarkets.com.

37. Department of the Treasury, Office of Federal Housing Enterprise Oversight, and Securities and

Exchange Commission, Enhancing Disclosure in the MortgageBacked Securities Markets, pp. 4546.

its MBS pools.35 The enterprise also began identifying the servicers for the pools, the

occupancy status of the properties (borrowers’ use of properties as a principal residence,

second home, or investment property), property types (single unit dwellings, or two to

four unit dwellings), and the purpose of the mortgages (to purchase or to refinance prop

erties). Freddie Mac will begin making those same disclosures in June 2003. Such dis

closures will largely be made after sales because most securities are initially sold in the

To Be Announced market before such information is available.36

Some market participants had requested additional disclosures, including the points paid

by borrowers, the level of loan documentation, and borrowers’ debttoincome ratios.

While the interagency task force recognized some difficulties and limitations of that

information, it believed that the enterprises should consider making those additional

disclosures.37

Effects of New Disclosures on the MBS Market

The new voluntary disclosures by Fannie Mae and Freddie Mac could help investors

better estimate prepayment risk on the GSEs’ mortgagebacked securities. Increased dis

closure on individual MBS pools, therefore, could reduce any “lemons” discount that

investors might require as compensation for uncertainty about the quality of those securi

ties (mainly the prepayment risk). The added disclosures by the GSEs might also segment

the market by quality. If so, each submarket necessarily would have less volume than the

entire market, and liquidity might be adversely affected. However, such effects are hard

to estimate. The potentially offsetting effects of a smaller lemons discount and reduced

market liquidity make it impossible to predict whether the net effect of new disclosures

will be to raise or lower the prices of MBSs.
20 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

38. George Akerlof, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,”

Quarterly Journal of Economics, vol. 84, no. 3 (August 1970), pp. 488500.

39. One reason that the enterprises predominately purchase their own securities on the secondary market

is to support their prices. The enterprises have a direct interest in maintaining high prices for MBSs

(balanced by their interest in earning a spread on those investments) because they compete with each

other for business. The higher the prices on the GSEs’ MBSs, the higher the guarantee fees that

wholesale lenders should be willing to pay. However, Fannie Mae and Freddie Mac might have chosen

to not disclose additional information even if the lemons discount was too high because they could

have feared that the adverse effect on liquidity might have outweighed the gains from reducing the

lemons discount before 2003.

40. For a discussion of circumstances under which less information and less research improves market

outcomes, see Jack Hirshleifer, “The Private and Social Value of Information and the Reward to

Inventive Activity,” American Economic Review, vol. 61, no. 4 (September 1971), pp. 561574; and

Sanford J. Grossman and Joseph Stiglitz, “Information and Competitive Price Systems,” American

Economic Review, vol. 66, no. 2 (May 1976), pp. 246253.

Possible Effects on the “Lemons” Discount

The discount that buyers demand to offset the perceived risk of purchasing MBSs that

have higher prepayment risk is referred to as a lemons price discount (or yield premi

um).38 If the new voluntary disclosures change investors’ perceptions of the appropriate

size of that discount, the market price of MBSs will change. If investors discover that

the current discount is too high, for example, market prices will rise. Or if investors feel

more certain about the extent to which the best securities may be being withheld, the

lemons discount could lessen and the average prices of MBSs could rise. Any increase

in prices from that source is likely to be quite small, however, because if the discount had

been large, Fannie Mae and Freddie Mac, as well as the large originators, would have

had incentives to voluntarily disclose more information and thereby raise the price of

their MBSs and the value of their guarantees.39

Possible Effects on the Liquidity of MBSs

MBSs guaranteed by Fannie Mae and Freddie Mac are highly liquid—a valued attribute

that raises their price. But increased disclosures have the potential to reduce the liquidity

of MBSs.40 The GSEs’ MBSs are highly liquid primarily because they are relatively homo

geneous; the large size of the market also helps liquidity. Thus, investors determine value

largely on the basis of generic characteristics such as coupon rate and maturity, rather

than valuing each MBS issue on its own. Additional information that permits investors

to differentiate among MBSs on the basis of expected prepayment rates may fragment

the market and thus reduce MBSs’ liquidity and price. For that reason, Ginnie Mae did
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 21

41. Susan Woodward, “Rechartering Freddie Mac and Fannie Mae: The Policy Issues” (working paper,

Sand Hill Econometrics, Menlo Park, Calif., 2001).

42. Department of the Treasury, Office of Federal Housing Enterprise Oversight, and Securities and

Exchange Commission, Enhancing Disclosure in the MortgageBacked Securities Markets, pp. 4344.

43. See Susan E. Woodward, “Is More Information Always Better?” Wall Street Journal, January 2, 2003,

p. A14.

not disclose the geographic location of loans in pools or other loanlevel characteristics

until a few years ago.41

Increased disclosures may also cause some investors to withdraw from the market because

they will be forced to make use of the new information or risk losing out to better in

formed market participants. Given that choice and the increased cost of the information

—occasioned by hiring more analysts and developing more complex prepayment models

—some investors may switch to less complex investment instruments.

The interagency task force, however, believed that the additional poolspecific disclosures

that it recommended would not have a significant adverse effect on liquidity in the MBS

market. The task force reasoned that greater disclosures in the past had had little adverse

effect on the market but did increase investors’ confidence.42 Indeed, fear of a loss of

liquidity did not stop originators from customizing pools, disclosing additional informa

tion, and selling pools outside the generic TBA market at premiums. 

The Net Effect on the Prices of MBSs

On balance, any adverse effect on the prices of MBSs is likely to be small. That is because

if MBS prices fall, Fannie Mae and Freddie Mac will have a profitable opportunity to

expand their purchases of “cheaper” MBSs with the proceeds of issues of debt, whose

prices are not expected to be affected by the new disclosures. Alternatively, the GSEs

could issue larger and more homogeneous pools of MBSs.43 For similar reasons, the six

new disclosures are unlikely to have much effect on mortgage rates (see Box 4). 

Possible Effects of Registration

Registration would require the enterprises to pay fees to the SEC, might cause some

investors to perceive a weakening of the implied federal guarantee of the GSEs’ debt and

MBSs, and could lead to some changes in the TBA market. Contrary to some claims,

borrowers would still be able to lock in mortgage rates prior to closing. 
22 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

44. Because of the large volume of their securities, the enterprises could end up paying nearly half of the

fees that the SEC is projected to collect under current law. Issues with maturities of less than nine

months, which include nearly 40 percent of the GSE debt, are not subject to the SEC’s registration

requirements.

Box 4.

The Implications of New Disclosures for Mortgage Rates

The prices that investors are willing to pay for mortgagebacked securities (MBSs)

help determine the mortgage rates that are available to borrowers. Higher prices

translate into lower mortgage rates. The effect that new disclosures Fannie Mae has

just begun making and Freddie Mac is due to make soon will have on mortgage rates

is ambiguous for the same reasons that the effect on the prices of MBSs is expected

to be minor.1 Specifically, the effects that those disclosures will have on the “lemons”

discount and on liquidity are unlikely to be detectable. 

Because the increased disclosures could alter the relative prices of individual issues

of MBSs by further differentiating prepayment risk, that change might have a small

effect on mortgage pricing at the retail level. Borrowers who are more likely to prepay

could eventually face slightly higher rates, while those less likely to prepay could see

their rates fall somewhat. But such effects are likely to be limited because lenders

already have the information that will be disclosed to investors. And lenders already

price prepayment risk, however crudely, by offering borrowers the opportunity to

pay points (a percentage fee based on the size of the mortgage) in exchange for a lower

interest rate.2 That tradeoff gives borrowers an incentive to sort themselves according

to their own evaluation of their likelihood of prepayment because borrowers who

anticipate prepaying their mortgages are less likely to be willing to pay points.

1. Department of the Treasury, Office of Federal Housing Enterprise Oversight, and Securities and

Exchange Commission, Enhancing Disclosure in the MortgageBacked Securities Market (January

2003).

2. Investors in the GSEs’ MBSs know only the quartile distribution of interest rates paid but not the

points paid, which lenders do not provide to the enterprises. Thus, some analysts question the

incentive of lenders to price prepayment risk accurately. Personal communication to the Con

gressional Budget Office by a staff member of the Office of Federal Housing Enterprise Oversight,

October 17, 2002.

Registration Fees and Administrative Costs

The direct cost of paying SEC registration fees for debt and MBSs could reach $250

million in 2004.44 In 2002, the Congress reduced the fees from $239 per $1 million in

securities sold to $92 per $1 million and directed the SEC to adjust fee rates annually
EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS 23

45. A basis point is one hundredth of a percentage point.

46. Congressional Budget Office, Cost Estimate for H.R. 1088 Investor and Capital Markets Fee Relief Act,

(April 3, 2001); and PayAsYouGo Estimate for H.R. 1088 Investor and Capital Markets Fee Relief Act,

(January 11, 2002). 

47. See Congressional Budget Office, Federal Subsidies and the Housing GSEs (May 2001). 

thereafter to reach statutory targets for collections. Under H.R. 4071, the enterprises

would pay fees of about 1.25 basis points in 2004.45 If that fee was fully passed on to

borrowers, the closing cost of a $200,000 mortgage would rise by less than $25. Registra

tion could also require the GSEs to have their MBSs rated by one of the creditrating

agencies, which would have a small additional cost.

Charging Fannie Mae and Freddie Mac registration fees generally would not increase

the total fees collected by the Securities and Exchange Commission. The Investor and

Capital Markets Fee Relief Act (P.L. 107123), enacted in January 2002, limits annual

amounts of fees that the Commission should attempt to collect.46 Because of those limits,

collecting fees from Fannie Mae and Freddie Mac would lower the fees paid by all other

issuers of securities.

Repealing the GSEs’ exemption would not impose significant administrative costs on

the enterprises because registration can be done electronically. Moreover, the enterprises

could make use of “shelf registration,” which allows an issuer to register in advance for

an anticipated large volume and repeated issuances of securities. That is, one shelf registra

tion can cover large volumes of mortgagebacked securities or corporate debt issued in

installments. 

The Implied Federal Guarantee

Although many factors affect yields on debt and mortgagebacked securities issued or

guaranteed by the GSEs, the enterprises pay lower interest rates than other private issuers

do as a result of the perception of the implied federal guarantee based on the special

privileges accorded to the enterprises.47 Some observers have suggested that enactment

of H.R. 4071 would reduce the strength of the implied federal guarantee. If so, one effect

could be to raise rates on the GSEs’ securities. However, other analysts disagree. They

note that the legislation leaves intact the GSEs’ other privileges. In addition, investors’

perceptions may be influenced by the size of the enterprises in the capital and housing

markets as well as by provisions of law. If so, investors could conclude that the implicit

guarantee would be unaffected by that statutory change.

The To Be Announced Market

The specifics of the SEC’s implementing regulations would determine how registration

might affect the To Be Announced market, which is currently not subject to regulation.

Transactions in that market are notable in that they involve buying and selling pools of
24 EFFECTS OF REPEALING FANNIE MAE’S AND FREDDIE MAC’S SEC EXEMPTIONS

48. Although jumbo loans do not trade in the TBA market, lenders of those loans use that market to hedge

their exposure to interest rate risk.

49. See Mark Jickling and Barbara Miles, Fannie Mae, Freddie Mac and SEC Registration and Disclosures,

CRS Report for Congress RS21263 (Congressional Research Service, July 16, 2002); and Steve

Thomas, “Securities Disclosures by Fannie Mae and Freddie Mac” (paper presented at the American

Enterprise Institute Conference on “Are Fannie and Freddie Adequately Disclosing What Investors

Need?” Washington, D.C., June 12, 2002), available at www.aei.org. See also Shadow Financial

Regulatory Committee, “The Registration of MortgageBacked Securities of Fannie Mae and Freddie

Mac,” Statement No. 189 (February 24, 2003), available at www.aei.org/publications/pubID.16040/

pub_detail.asp.

Fannie Mae, Freddie Mac, and Ginnie Mae loans before the loans have been made. At

present, the Bond Market Association, an industry trade group, establishes the basic terms

that those contracts must specify to constitute “good delivery,” including the product

type (for example, securities based on 30year fixedrate mortgages), interest rate, settle

ment date, and the total amount of the MBSs to be delivered. If the SEC was given

authority to specify disclosure requirements for the GSEs’ MBSs, that might trigger dis

closure requirements for the contracts traded in the TBA market. Such requirements

could be difficult for the poolers and the enterprises to meet and could curtail the opera

tion of that market. To avoid disclosure requirements that might harm the efficiency

of the TBA market, the SEC might require additional authority applicable to such dis

closures. 

The Ability to Lock In Mortgage Rates

Borrowers in both the market for conforming loans bought by Fannie Mae and Freddie

Mac and the market for jumbo loans bought by privatelabel issuers can lock in mortgage

rates up to 90 days prior to closing.48 Borrowers attach substantial value to being able

to fix their mortgage rate before closing, and they pay for that option through either a

fixed fee (or points) or a higher interest rate. Lenders are willing to provide those commit

ments because the rates locked in reflect the current market rates for forward sale agree

ments in the To Be Announced market, and the fees paid at closing by borrowers

compensate lenders who provide the commitments.

Because the TBA market probably would function in much the same way with registra

tion of MBSs as it does now, the possibility that borrowers would lose the option to lock

in rates seems remote.49 Even if the TBA market changed significantly, mortgage lenders

would have alternative ways of hedging their interest rate risk. But because the alternatives

would probably be less efficient than the current system, borrowers might face somewhat

higher costs to lock in rates.

This publication and others by CBO

are available at the agency's Web site:

www.cbo.gov