CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

CBO

Fannie Mae, 

Freddie Mac, and 

the Federal Role in 

the Secondary 

Mortgage Market

DECEMBER 2010

© Shutterstock, LLC
Pub. No. 4021
The Congress of the United States O Congressional Budget Office

A

STUDY

CBO

Fannie Mae, Freddie Mac, and the

Federal Role in the

Secondary Mortgage Market

December 2010
CBO

Note

Numbers in the text and tables for outstanding amounts of mortgage-backed securities 

(MBSs) guaranteed by Fannie Mae and Freddie Mac exclude the two institutions’ holdings of 

their own MBSs. Those securities are instead reported in the institutions’ mortgage portfolio 

holdings, which are mostly financed by issuing debt. 
Preface

CBO

In September 2008, the federal government assumed control of Fannie Mae and Freddie 

Mac, two federally chartered institutions that last year guaranteed three-quarters of new residential mortgages originated in the United States. This Congressional Budget Office (CBO) 

study—prepared at the request of the Chairman of the Senate Committee on Banking, Housing, and Urban Affairs—examines various alternatives for the federal government’s future role 

in the secondary (resale) market for residential mortgages. In keeping with CBO’s mandate to 

provide objective, impartial analysis, the study does not make any policy recommendations.

This study was written by Deborah Lucas and David Torregrosa of CBO’s Financial Analysis 

Division. Priscila Hammett compiled the figures, and Rebecca Rockey fact-checked the manuscript. Kim Cawley, Chad Chirico, Juan Contreras, Mark Hadley, Kim Kowalewski, Joe 

Mattey, Damien Moore, Larry Ozanne, Aurora Swanson, and Steven Weinberg of CBO 

provided helpful comments on earlier drafts, as did various people outside CBO, including 

Robert Collender, Patrick Lawler, Paul Manchester, Joseph McKenzie, and Robert Seiler Jr. 

of the Federal Housing Finance Agency; Ron Feldman of the Federal Reserve Bank of Minneapolis; W. Scott Frame of the Federal Reserve Bank of Atlanta; Diana Hancock and Wayne 

Passmore of the Federal Reserve Board; Dwight Jaffee of the University of California at Berkeley; Donald Marron of the Urban-Brookings Tax Policy Center; Joseph Tracy and Joshua 

Wright of the Federal Reserve Bank of New York; Robert Van Order of George Washington 

University; and Paul S. Willen of the Federal Reserve Bank of Boston. Staff members of 

Freddie Mac also provided information, as did Michael Fratantoni of the Mortgage Bankers 

Association. (The assistance of outside participants implies no responsibility for the final 

product, which rests solely with CBO.)

Christian Howlett edited the study; Kate Kelly, Leah Mazade, and Sherry Snyder proofread it. 

Maureen Costantino prepared the report for publication, with assistance from Jeanine Rees, 

and designed the cover. Monte Ruffin printed the initial copies, Linda Schimmel coordinated 

the print distribution, and Simone Thomas prepared the electronic versions for CBO’s Web 

site (www.cbo.gov). 

Douglas W. Elmendorf

Director

December 2010

Contents

CBO

Summary vii

1 Overview of Fannie Mae, Freddie Mac, and the Secondary Mortgage Market 1

The GSEs’ Roles in the Secondary Mortgage Market 1

Changes in the Secondary Mortgage Market Through Mid-2008 3

Operations of Fannie Mae and Freddie Mac Under Conservatorship 9

2 Possible Rationales for a Federal Role in the Secondary Mortgage Market 15

Promoting a Stable Supply of Mortgage Financing 16

Promoting Affordable Housing 18

3 Weaknesses of the Precrisis Model for Fannie Mae and Freddie Mac 21

Adverse Consequences of the Implicit Federal Guarantee 21

Limited Effects on Affordable Housing 23

Weak Regulation 24

Tensions Between Public and Private Purposes 24

4 Alternative Approaches for the Future of the Secondary Mortgage Market 27

Managing the Transition to a New Approach 28

Major Design Issues 31

A Hybrid Public/Private Model 42

A Fully Federal Agency 43

A Fully Private Secondary Mortgage Market 45

Other Mortgage-Financing Approaches 47

A History of the Secondary Mortgage Market 51

B The Federal Home Loan Banks 55
CBO

VI CONTENTS

Tables

S-1. Key Features of Alternatives for the Secondary Mortgage Market xii

S-2. Key Factors for Assessing Alternatives for the Secondary Mortgage Market xiv

4-1. Key Features of Alternatives for the Secondary Mortgage Market 28

4-2. Key Factors for Assessing Alternatives for the Secondary Mortgage Market 30

Figures

1-1. Outstanding Mortgage-Backed Securities and Portfolio Holdings as a Percentage 

of the Total Mortgages Backed or Held by the GSEs 6

1-2. Mortgage-Backed Securities, by Issuer 7

1-3. Growth of the GSEs’ Outstanding Mortgage-Backed Securities and Debt 8

1-4. Indexes of Prices for Single-Family Homes, January 1991 Through 

September 2010 9

1-5. The GSEs’ Holdings of Private-Label Mortgage-Backed Securities 10

1-6. Outstanding Mortgage Debt 11

1-7. Extent to Which Interest Rates on Freddie Mac’s Ten-Year Debt Exceeded Rates 

on the Treasury’s Ten-Year Debt, January 2007 Through September 2010 12

1-8. Interest Rates on Jumbo and Conforming Mortgages, January 2007 Through 

September 2010 13

Boxes

1-1. CBO’s Budgetary Treatment of Fannie Mae and Freddie Mac 4

4-1. The Market for Private-Label Mortgage-Backed Securities 36

4-2. Preserving the TBA Market and Other Regulatory Features of the Status Quo 38

4-3. Comparing the Public-Utility Model with the Competitive Market-Maker Model 40
CBO

Summary

Two years ago, the federal government assumed control of the ailing Federal National Mortgage Association 

(Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), two institutions that facilitate the 

flow of funding for home loans nationwide. The cost to 

taxpayers of that takeover, and the structural weaknesses 

that contributed to the institutions’ financial problems, 

have prompted policymakers to consider various alternatives for the government’s future role in the secondary 

(resale) market for residential mortgages.

This study looks at how Fannie Mae and Freddie Mac 

evolved into the institutions they are today. As context for 

discussing future options, the study also examines both 

the rationales that are often cited for federal involvement 

in the secondary mortgage market and the problems with 

Fannie Mae and Freddie Mac that existed before the 

recent financial crisis. The secondary market channels 

funds to borrowers by facilitating the resale of mortgages 

and mortgage-backed securities (MBSs). In that market, 

lenders such as banks, thrifts, and mortgage companies 

obtain funding for the loans they originate by selling the 

loans to purchasers such as Fannie Mae, Freddie Mac, 

and other financial institutions (including banks and 

insurance companies). 

Alternative proposals for the secondary mortgage market 

involve different choices about whether the federal government should continue to guarantee payment on certain types of mortgages or MBSs and, if so, what the 

scope, structure, and pricing of those guarantees should 

be. The proposals also involve choices about support for 

affordable housing and the competitive structure and regulation of the secondary market. This study examines the 

trade-offs involved in making those key design choices 

and evaluates the strengths and weaknesses of three broad 

approaches for the future of the secondary mortgage 

market: 

 A hybrid public/private model in which the government would help to ensure a steady supply of mortgage financing by providing explicit guarantees on 

privately issued mortgages or MBSs that met certain 

qualifications;

 A fully public model in which a wholly federal entity 

would guarantee qualifying mortgages or MBSs; or

 A fully private model in which there would be no 

special federal backing for the secondary mortgage 

market.

This analysis focuses primarily on the long-term strengths 

and weaknesses of the alternative approaches, not on the 

transition from the status quo to a new model. Transitional issues—such as what to do with the existing portfolios and obligations of Fannie Mae and Freddie Mac—

are important in their own right, but they are largely separate from the questions about the long-term future of 

the secondary mortgage market that are examined here. 

In particular, alternative ways of resolving the transitional 

issues probably would not substantially affect the relative 

long-term merits of different models for the secondary 

market, and the different models do not appear to require 

any particular resolution of the transitional issues—

choices about each could be combined in various ways. If 

changes were made in the next few years, care would need 

to be taken not to disrupt the housing and mortgage markets further. Those markets remain fragile: The sharp 

decline in housing prices since mid-2006 has left many 

homeowners owing more on their mortgages than their 

homes are worth, foreclosure rates are still high, and 

obtaining a mortgage continues to be difficult for many 

households. 
VIII FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Fannie Mae, Freddie Mac, and the 

Secondary Mortgage Market

Four decades ago, Congressional charters set up Fannie 

Mae and Freddie Mac as government-sponsored enterprises (GSEs)—privately owned financial institutions 

established by the government to fulfill a public mission. 

The two GSEs were created to provide a stable source 

of funding for residential mortgages across the country, 

including loans on housing for low- and moderateincome families.1

 Fannie Mae and Freddie Mac carry out 

that mission through their operations in the secondary 

mortgage market. They purchase mortgages that meet 

certain standards from banks and other originators, pool 

those loans into mortgage-backed securities that they 

guarantee against losses from defaults on the underlying 

mortgages, and sell the securities to investors—a process 

referred to as securitization. In addition, they buy mortgages and MBSs (both each other’s and those issued by 

private companies) to hold in their portfolios. They fund 

those portfolio holdings by issuing debt obligations, 

known as agency securities, which are sold to investors.

Until recently, the GSEs’ debt securities and MBSs were 

not officially backed by the federal government. Nevertheless, most investors believed that the government 

would not allow Fannie Mae and Freddie Mac to default 

on their obligations. That perception of an implicit federal guarantee stemmed from the very prominent role the 

two entities played in the housing market and in the 

broader financial markets. It also stemmed from the specific benefits that the two entities received because of 

their status as GSEs, such as not having to register their 

securities with the Securities and Exchange Commission, 

being exempt from state and local corporate income 

taxes, and having a line of credit with the Treasury. 

Because of their implicit federal guarantee, Fannie Mae 

and Freddie Mac could borrow to fund their portfolio 

holdings at much lower interest rates than those paid by 

fully private financial institutions that posed otherwise 

comparable risks, and investors valued the GSEs’ credit 

guarantees more highly than those issued by fully private 

guarantors. Some of those benefits from federal support 

flowed to mortgage borrowers in the form of greater 

availability of credit and somewhat lower interest rates. 

The GSEs’ other stakeholders (shareholders, managers, 

and employees) also reaped some of the gains. The advantages of implicit federal support allowed Fannie Mae and 

Freddie Mac to grow rapidly and dominate the secondary 

market for the types of mortgages they were permitted 

to buy (known as conforming mortgages). In turn, the 

perception that the GSEs had become “too big to fail” 

reinforced the idea that they were federally protected.

Fannie Mae and Freddie Mac were profitable in most 

years until recently, when the United States experienced 

its most severe financial crisis since the Great Depression 

of the 1930s. As housing prices dropped nationwide and 

foreclosures increased, the two GSEs suffered large losses 

on various investments in their portfolios, such as subprime mortgages (loans made to borrowers with poorerthan-average credit) and “private-label” MBSs (securities 

issued and insured by private companies without government backing). The GSEs also faced heightened uncertainty about the magnitude of the ultimate decline in 

housing prices and increase in unemployment and thus 

about the size of credit losses on their outstanding guarantees (which in September 2008 totaled $3.8 trillion). 

Those factors impaired the GSEs’ ability to issue low-cost 

debt to fund their mortgage purchases, and doubts arose 

about whether they had enough capital to cover potential 

losses. 

The enactment of the Housing and Economic Recovery 

Act of 2008 (Public Law 110-289) established the Federal 

Housing Finance Agency and gave it the authority to 

place Fannie Mae and Freddie Mac in conservatorship—

a step it took in September 2008. The Treasury was 

granted the authority to provide the GSEs with unlimited 

capital (by purchasing their stock) in order to maintain 

their solvency through 2012. Those actions gave the government control over the two institutions and effectively 

made the government’s backing of their debt securities 

and MBS guarantees explicit.

As a result of that aid and the explicit federal guarantee, 

Fannie Mae and Freddie Mac were able to continue channeling funds to the mortgage market, even as private 

financial institutions were faltering. Consequently, in 

2009, the two GSEs owned or guaranteed roughly half of 

all outstanding mortgages in the United States (including 

a significant share of subprime mortgages), and they 

1. The Federal Home Loan Bank System, which is also a GSE, once 

played a significant role in mortgage finance. But because its focus 

has broadened beyond housing, and because options for changing 

that system involve different considerations than options for the 

future of the secondary mortgage market, this study focuses on 

Fannie Mae and Freddie Mac. (The Federal Home Loan Bank 

System is discussed briefly in Appendix B.)
SUMMARY FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET IX

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financed three-quarters of new mortgages originated that 

year. Including the 20 percent of home loans insured by 

federal agencies, such as the Federal Housing Administration (FHA), more than 90 percent of new mortgages 

made in 2009 carried a federal guarantee. 

Possible Rationales for a Federal 

Role in the Secondary Market 

In assessing future options for Fannie Mae and Freddie 

Mac, a fundamental issue is what role, if any, the federal 

government should play in the secondary mortgage market. Historically, support for that market has been part of 

a broader federal housing policy aimed at encouraging 

home ownership and, to a lesser extent, at making housing more affordable for low- and moderate-income families. The activities of Fannie Mae and Freddie Mac have 

been an important aspect of that policy, although the 

largest federal subsidies for home ownership have generally come from favorable tax treatment for housing.2

Federal policies that affect the secondary market are 

mainly intended to achieve two public purposes: 

 Helping to ensure a steady supply of financing for 

residential mortgages, and 

 Providing subsidized assistance for mortgages on 

housing for low- and moderate-income families. 

The government has pursued those goals largely through 

policies that increase the liquidity of mortgages and 

mortgage-backed securities. In a liquid market, investors 

can quickly buy or sell large quantities of an asset without 

affecting its price. The government can enhance the 

liquidity of the secondary mortgage market by providing 

credit guarantees, which make MBSs safer and thus easier 

for investors to value, and by standing ready to buy and 

sell MBSs. Such government support has the greatest 

impact on the availability and price of mortgage funding 

during disruptions in the financial markets. At such 

times, interruptions in the supply of mortgage credit can 

spill over to the market for new-home construction and 

weaken the broader economy. Such interruptions can also 

impede labor mobility by making it more difficult for 

people to buy and sell homes when they want to move.

Supporting liquidity in the secondary mortgage market 

through federal credit guarantees tends to lower interest 

rates only slightly for most mortgage borrowers under 

normal market conditions. When mortgages are unsubsidized, the cost of providing a credit guarantee is offset by 

the fees charged to investors, and those guarantee fees are 

passed on to borrowers. Nevertheless, borrowers may 

benefit because investors are willing to pay somewhat 

higher prices (or, equivalently, accept lower interest rates) 

for MBSs that are more liquid. In a competitive marketplace, that advantage tends to reduce the rates paid by 

borrowers relative to what rates would be in the absence 

of federal guarantees. (To the extent that Fannie Mae and 

Freddie Mac are able to dominate the market for MBSs, 

the value of greater liquidity may accrue largely to them 

rather than to borrowers.) 

The benefits of the government’s actions to increase 

liquidity in the secondary market by providing credit 

guarantees and purchasing mortgages must be weighed 

against the costs. Those actions expose taxpayers to the 

risk of potentially large losses when the cost of honoring 

guarantees exceeds the value of guarantee fees collected—

or when mortgages held by the government lose value 

because of changes in interest rates or prepayment rates 

(that is, the extent to which borrowers pay mortgages off 

early). Federal guarantees also reduce the incentive for 

mortgage originators to avoid making risky loans in the 

first place.

Besides encouraging a stable supply of financing, another 

objective of federal involvement in the secondary mortgage market is to increase the availability of credit and 

subsidize its costs for people with low or moderate 

income. Broadening access to home ownership could be 

beneficial because owning a home may give people a 

greater stake in their community and thus make communities more stable. Moreover, certain types of housing 

assistance may be provided more effectively through support for the secondary market than through grants or tax 

preferences. For example, some borrowers may have the 

financial means to own a home but have trouble obtaining private credit—a problem known as “credit rationing.” That problem can occur when it is difficult for 

2. Congressional Budget Office, An Overview of Federal Support for 

Housing, Issue Brief (November 2009). Some analysts argue that 

federal housing policy has encouraged unsustainable rates of home 

ownership and overinvestment in housing while reducing investment in sectors of the economy that may be more productive—a 

view reinforced by the disruptions in the housing market that triggered the recent economic crisis. Those broader issues are beyond 

the scope of this analysis, which focuses on federal support for the 

secondary mortgage market.
X FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

CBO

lenders to assess the riskiness of certain borrowers, such as 

those with short credit histories. Lenders cannot address 

that greater risk by charging higher interest rates, because 

such terms tend to attract borrowers who are more likely 

to default. However, the government may decide that the 

value to society from subsidizing certain loans is greater 

than the cost of doing so.

Currently, several federal agencies—including the FHA, 

the Department of Veterans Affairs (VA), and the Government National Mortgage Association (Ginnie Mae)—

provide assistance to low- and moderate-income borrowers through the secondary market, as (to a more limited 

extent) do Fannie Mae and Freddie Mac. The FHA and 

VA increase the flow of credit to such borrowers by 

explicitly insuring mortgages against losses from default, 

and Ginnie Mae guarantees the payment of interest and 

principal on MBSs backed by pools of those mortgages. 

Fannie Mae and Freddie Mac are required to provide support for affordable housing by meeting certain goals set 

by regulators. Those goals specify the percentage of the 

GSEs’ mortgage guarantees and purchases that must 

involve loans used to finance rental housing for, or home 

purchases by, people with low or moderate income. 

Weaknesses of the Precrisis Model

Despite the potential beneficial effects of federal involvement in the secondary mortgage market, the rules and 

market structure under which Fannie Mae and Freddie 

Mac operated before conservatorship—referred to in this 

study as the precrisis model—had numerous weaknesses. 

Those weaknesses included the following: 

 Adverse effects from the implicit federal guarantee of 

the two GSEs (such as a concentration of market 

power, risks to the stability of the larger financial system, incentives for excessive risk taking, and a lack of 

transparency about costs and risks to the government);

 Limited effects on affordable housing;

 Lax regulation; and 

 Tensions in trying to balance competing public and 

private goals.

The implicit federal guarantee concentrated market 

power in Fannie Mae and Freddie Mac by giving them 

lower funding costs than potential competitors in the 

secondary market. As a consequence, the GSEs grew to 

dominate the segments of the market in which they were 

allowed to operate. Because of their size and interconnectedness with other financial institutions, they posed 

substantial systemic risk—the risk that their failure could 

impose very high costs on the financial system and the 

economy. The GSEs’ market power also allowed them to 

use their profits partly to benefit their other stakeholders 

rather than exclusively to benefit mortgage borrowers. 

The implicit guarantee created an incentive for the GSEs 

to take excessive risks: Stakeholders would benefit when 

gambles paid off, but taxpayers would absorb the losses 

when they did not. (Financial institutions that lack the 

benefit of a federal guarantee have less incentive to take 

risks because doing so can increase their financing costs, 

although some still act imprudently at times.) One way 

that Fannie Mae and Freddie Mac increased risk was by 

expanding the volume of mortgages and MBSs held in 

their portfolios, which exposed them to the risk of losses 

from changes in interest or prepayment rates. Over the 

past decade, the two GSEs also increased their exposure 

to default losses by investing in lower-quality mortgages, 

such as subprime and Alt-A loans.3

Because the federal guarantee was implicit rather than 

explicit, the costs and risks to taxpayers did not appear in 

the federal budget. That lack of transparency made it 

more difficult for policymakers to assess and control the 

GSEs’ costs and risks. Lack of transparency also made it 

difficult for policymakers to evaluate whether the GSEs 

were effectively and efficiently meeting their affordablehousing goals; several studies have questioned the effectiveness of the GSEs’ affordable-housing activities.

Weak regulation was a further shortcoming of the precrisis model. For instance, until 2008, the GSEs’ regulators lacked the power to increase capital requirements for 

Fannie Mae and Freddie Mac or to place them in receivership—powers that regulators have long had over banks. 

Finally, as private companies with a public mission and 

implicit public backing, Fannie Mae and Freddie Mac 

faced an intrinsic tension in balancing the objectives of 

3. Subprime and Alt-A mortgages are offered to some borrowers who 

do not meet the qualifications for a prime mortgage (one extended 

to the least risky borrowers) because of such risk factors as a low 

credit rating, insufficient documentation of income, or the ability 

to make only a small down payment. 
SUMMARY FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET XI

CBO

maximizing profits for their shareholders, maintaining 

safety and soundness to minimize potential costs to taxpayers, and supporting affordable housing. For example, 

efforts to help low-income households tend to involve 

targeting loans toward borrowers who generally pose 

more risk than borrowers of traditional conforming 

mortgages do, thereby putting taxpayers at greater risk 

of loss. The affordable-housing goals and the pursuit of 

profit may have encouraged Fannie Mae and Freddie 

Mac to purchase subprime MBSs that were expected to 

generate high returns but that involved excessive risk for 

borrowers and taxpayers alike. 

Alternative Approaches for the 

Future of the Secondary 

Mortgage Market

The weaknesses inherent in the precrisis model may argue 

against returning to that model after the GSEs’ conservatorship ends. A broad array of alternatives are possible for 

the federal government’s future role in the secondary 

mortgage market. Any new approach would need to confront major design issues, such as whether to have federal 

guarantees and, if so, how to structure and price them; 

whether to support affordable housing and, if so, by what 

means; and how to structure and regulate the secondary 

market.

The Congressional Budget Office (CBO) analyzed three 

broad alternatives for structuring the secondary mortgage 

market (see Summary Table 1): 

 Adopting a hybrid public/private approach that would 

involve explicit federal guarantees of some privately 

issued mortgage-backed securities;

 Establishing a fully federal agency that would purchase 

and guarantee qualifying mortgages; or 

 Promoting a fully private secondary market with no 

federal guarantees. 

In examining those broad approaches, CBO looked at a 

number of criteria, including whether a given alternative 

would ensure a stable supply of financing for mortgages, 

how affordable-housing goals would be met, how well 

taxpayers would be protected from risk, whether federal 

guarantees would be priced fairly, and to what extent an 

approach would provide incentives to control risk taking. 

(For a synopsis of the trade-offs between the alternative 

approaches, see Summary Table 2 on page xiv). 

Managing the Transition to a New Approach

Moving from the current operations of Fannie Mae and 

Freddie Mac under conservatorship to any new model 

would involve several transitional issues, including how 

to manage the GSEs’ existing portfolios and guarantee 

obligations and what to do with their operating assets. 

The government faces two basic choices: either retain the 

GSEs’ portfolios and the responsibility for their outstanding guarantees and allow both to run out as mortgages are 

paid off, or pay a private entity to assume the guarantee 

obligations and sell off the portfolios. Whatever model 

for the secondary market is ultimately adopted, the 

expected losses on the GSEs’ existing business will largely 

be borne by taxpayers, because private investors would 

not assume those obligations without compensation. The 

GSEs’ operating assets are valuable; they could be auctioned off to investors (with the proceeds helping to offset some of the losses to taxpayers) or kept for use by a 

federal agency. 

This study does not address those transitional issues in 

depth. Handling them efficiently and without disruption 

to the secondary mortgage market—especially given current conditions in housing and mortgage markets—is 

both important and difficult. However, in CBO’s judgment, those issues have little impact on the relative merits 

of various approaches for the long-term organization of 

the secondary market, which is the focus of this study.

Major Design Issues

Many different models for the secondary mortgage market involve common design issues, such as how to structure and price any federal credit guarantees, whether and 

how to support affordable housing, and how to structure 

and regulate the secondary market. 

Structuring Federal Guarantees. The design of federal 

guarantees is an important issue for both a hybrid public/

private approach and a fully federal approach. A key 

choice involves which mortgages would be considered 

eligible for federal guarantees. Mortgage products that 

qualify for federal backing tend to be popular, and hence 

such backing can be used to encourage best practices by 

lenders. Including a wide range of products in the definition of qualifying mortgages—and setting high dollar 

limits for those loans—would provide benefits to 

more borrowers and could increase the stability of the 
XII FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Summary Table 1.

Key Features of Alternatives for the Secondary Mortgage Market

Source: Congressional Budget Office.

Note: MBSs = mortgage-backed securities.

secondary market. At the same time, a large-scale guarantee program would expose the government to greater risk, 

reduce the incentives for prudent risk taking, and tend 

to crowd out private participation in the market. 

The government could charge guarantee fees that partly 

or fully offset the total expense of its guarantee program, 

including administrative costs, expected losses, and the 

cost of risk. (If fees and other collections were insufficient 

to cover those costs, the government would have to subsidize the program.) Basing guarantee fees on the riskiness 

of a mortgage would weaken the incentive for excessive 

risk taking and reduce the extent to which safer borrowers 

cross-subsidized riskier ones. 

Some proposals envision providing federal guarantees but 

limiting the government’s exposure to risk by sharing risk 

with the private sector. Under such proposals, private 

capital—along with homeowners’ down payments and 

any capital provided by private mortgage insurance—

would be the first line of defense against losses from 

defaults. Transferring risk to the private sector would not 

Hybrid Public/Private Model Fully Federal Agency Fully Private Market

Existing operating assets 

of Fannie Mae and 

Freddie Mac 

Handed over to specialized issuers of 

federally backed MBSs (could be nonprofit, cooperative, or private firms), sold 

to private-label issuers, or liquidated

Used for operations of agency, 

sold to private-label issuers, or 

liquidated

Sold to private-label 

issuers or liquidated

Licenses to issue 

federally guaranteed 

MBSs 

Under “public-utility model,” only a few; 

under “competitive market-maker 

model,” available to any firm meeting 

specified criteria

None; operations undertaken 

by agency

None

Federal guarantees for 

loans or MBSs

Explicit, possibly covering only 

catastrophic risks

Explicit None (Phased out) 

Private capital’s role in 

secondary market

Absorbs most or all losses, except in 

cases of unusually large shocks

None on federally guaranteed 

securities; absorbs all losses 

on private-label securities

Absorbs all losses

Allowable activities for 

federally guaranteed 

securitizers

Under “public-utility model,” restricted 

to issuing MBSs and holding very limited 

portfolios; under “competitive marketmaker model,” restricted only enough to 

limit spillover of risk to government

Issuing guarantees and 

possibly holding portfolios of 

mortgages and MBSs

Not applicable

Support for affordable 

housing 

Could occur through terms on federal 

guarantees, fees on issuers of federally 

backed MBSs, or government agencies

Could occur through agency No special role; could 

occur through government agencies

Role of issuers of privatelabel MBSs Serve borrowers whose mortgages do 

not qualify for federal guarantees

Serve borrowers whose 

mortgages do not qualify for 

federal guarantees

Dominant players in 

secondary market, along 

with other private 

financial institutions
SUMMARY FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET XIII

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only lower the government’s exposure directly but also 

give private entities greater incentives to control risk and 

thereby reduce the government’s exposure further. 

One risk-sharing option that could limit federal losses 

would be for the government to sell catastrophic risk protection on qualifying MBSs. With catastrophic guarantees, payouts to investors might be triggered, for instance, 

only when nationwide default rates exceeded some 

threshold. Smaller losses would be absorbed by private 

capital or insured by private mortgage insurance. Relying 

heavily on the private sector for credit protection would 

have drawbacks, however. Investors would probably perceive securities with very limited federal backing as being 

riskier and less uniform than those currently issued by 

Fannie Mae and Freddie Mac, which would make them 

less liquid. The availability of private capital and private 

mortgage insurance is also susceptible to disruptions in 

the financial markets.

Supporting Affordable Housing. The main design issue 

related to affordable housing is whether to transfer the 

GSEs’ responsibilities in this area to fully federal entities 

(such as the FHA) that are funded with broad-based taxes 

or to pursue affordable-housing goals through taxes or 

mandates on private institutions operating in the secondary mortgage market. Supporting affordable housing generally involves providing subsidies, which are most easily 

controlled and monitored when administered by a federal 

agency. Some observers, however, question whether a federal agency could provide support as effectively or flexibly 

as private entities; in their view, it would be better to have 

such support remain the responsibility of private financial 

institutions. 

In the precrisis model, the GSEs’ affordable-housing 

activities were effectively funded through the financial 

advantage generated by the government’s implicit guarantee. Under alternative approaches with an explicit federal 

guarantee, the fees charged to investors would probably 

either just cover or not entirely cover the government’s 

cost for the guarantee program and so would not generate 

a surplus that could be used to support affordable housing.4

 Thus, the alternatives to fund affordable-housing 

activities would be either to use general revenues or to use 

special taxes or mandates on financial institutions. Broadbased taxes tend to be less distorting and hence preferable 

in terms of economic efficiency, although special assessments on financial institutions might be justified as 

compensation for benefits that those institutions receive 

from the government. 

Structuring and Regulating the Secondary Market. Key 

issues related to the structure of the market include what 

role private-label securitizers would play, how much they 

would be regulated, and whether any of the GSEs’ advantages would be extended to other market participants or 

abolished. For a hybrid public/private approach, another 

critical design issue is how the market would be structured—specifically, the number and types of intermediaries that would exist and the activities they would be 

permitted to engage in. Proposals range from licensing 

a small number of highly regulated private entities to 

package and sell federally guaranteed MBSs (the “publicutility model”) to allowing any private financial institution that met certain regulatory criteria to package and 

sell federally guaranteed MBSs (the “competitive marketmaker model”). 

An argument in favor of the public-utility model is that it 

could create a more level playing field for mortgage originators than a less regulated approach would; the public 

utilities would be required to serve all originators, thereby 

facilitating broad access to the secondary market. In addition, having a small number of intermediaries could 

increase the liquidity of the secondary market by ensuring 

that investors viewed different federally backed MBSs as 

interchangeable. If the intermediaries were structured as 

nonprofit entities, they might also have less incentive to 

take risk than for-profit firms do. 

If the public utilities’ business was limited to creating 

federally backed MBSs, however, they would be more 

exposed to mortgage credit risk than would financial 

institutions with a more diverse set of investments. Concentrating risk exposure would replicate one of the major 

weaknesses of Fannie Mae and Freddie Mac and make the 

new public utilities more susceptible to shocks in the 

housing market than more-diversified institutions would 

be. In addition, having only a few large intermediaries 

that were essential to the functioning of the secondary 

4. Whether the fees would appear to exceed the costs of the guarantees would depend on the accounting approach used to determine 

their budgetary cost. From an economic perspective (which presumes that the government has no intrinsic advantage over large 

private financial institutions because it takes on the same risks), 

the fees collected would be unlikely to exceed the cost of the guarantees. If they did, borrowers could find better guarantee prices in 

the private sector. 
XIV FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Summary Table 2.

Key Factors for Assessing Alternatives for the Secondary Mortgage Market

Continued

Hybrid Public/Private Model Fully Federal Agency Fully Private Market

Supply of financing 

for mortgages

Under normal market conditions, 

the supply of funding for federally 

backed mortgages would be fairly 

stable. During periods of market 

stress, financing could become 

less available, especially under 

versions with narrower federal 

guarantees and more reliance on 

private capital.

The supply of funding for federally 

backed mortgages would be fairly 

stable—both in normal times 

and during periods of market 

stress—because uncertainty 

about the strength of the federal 

guarantee would be minimized.

The market would be more 

susceptible to fluctuations in the 

supply of funding. During periods 

of acute market stress, funding 

could become extremely scarce 

without federal intervention. 

Support for affordable 

housing

Mortgages that satisfied 

affordable-housing goals could be 

subsidized through lower federal 

guarantee fees, with the subsidy 

cost shown in the budget. Or 

responsibility could be 

transferred to a fully federal 

agency, such as the Federal 

Housing Administration.

Subsidies could be delivered by 

the agency and would be shown in 

the federal budget.

Responsibility would be 

transferred to a fully federal 

agency, such as the Federal 

Housing Administration, or 

subsidies would be discontinued. 

Taxpayers’ exposure 

to risk 

Intermediaries in the secondary 

market would bear all credit 

losses until their capital was 

exhausted, limiting the credit risk 

that taxpayers would face. 

If only a few specialized firms 

participated in the market, they 

might receive government 

support if their solvency was 

threatened. 

Taxpayers would bear the entire 

credit risk on guaranteed 

mortgages. 

Private-label issuers seen as 

critical to the functioning of the 

mortgage market might receive 

government support during 

periods of acute market stress.

Taxpayers’ exposure to credit risk 

would be very small under normal 

market conditions. Taxpayers 

could be exposed to greater risk 

through federal deposit insurance 

if banks bore more credit risk.

Firms seen as critical to the 

functioning of the mortgage 

market might receive government 

support during periods of acute 

market stress.

Pricing of federal 

guarantees

The government could have 

trouble fully pricing catastrophic 

risk or setting risk-sensitive 

prices, which would probably shift 

some cost to taxpayers. 

The government probably has 

weaker incentives than private 

guarantors do to charge fees that 

would fully compensate for the 

risks associated with guarantees, 

suggesting that taxpayers would 

probably bear a cost.

No explicit federal guarantees; 

however, any implicit federal 

guarantees that arose would be 

free to the private issuers of 

MBSs and hence would entail a 

cost to taxpayers.
SUMMARY FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET XV

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Summary Table 2. Continued

Key Factors for Assessing Alternatives for the Secondary Mortgage Market

Source: Congressional Budget Office.

market could recreate the “too big to fail” problem, 

even if federal guarantees were limited by law. And nonprofits might have weaker incentives than private-sector 

institutions do to control costs and risks and to innovate. 

Another concern with the public-utility model is “regulatory capture”—that over time, regulators might become 

more responsive to the goals of the regulated entities than 

to the interests of the general public. 

The competitive market-maker model also has strengths 

and weaknesses. On the one hand, spreading mortgage 

credit risk more widely among more-diversified institutions would reduce risks to the overall financial system 

and the economy, compared with both the precrisis 

model and the public-utility model. Having a greater 

number of institutions issue federally backed MBSs 

would also encourage innovation and foster competition—which could help ensure that the benefits of federal 

support went to mortgage borrowers rather than to stakeholders of the financial intermediaries. 

On the other hand, even with a federal guarantee, MBSs 

issued by different institutions might not be viewed as 

completely interchangeable. In that case, the liquidity of 

MBSs would be reduced, and borrowing costs would 

increase. It is also possible that smaller mortgage originators might have trouble gaining access to the secondary 

market if large private institutions were unwilling to buy 

loans from them, although competition among market 

makers would make that outcome unlikely. Another 

Hybrid Public/Private Model Fully Federal Agency Fully Private Market

Incentives to control 

risk taking

The presence of federal 

guarantees would create an 

incentive for excessive risk 

taking. Limiting government 

guarantees and charging riskbased prices for them would 

reduce that incentive. In addition, 

private intermediaries would have 

an incentive to set risk-based 

prices and monitor risk taking. 

Having the government absorb 

all credit losses would create a 

strong incentive for excessive risk 

taking by originators. The government could counter that incentive 

by setting risk-based prices for 

guarantees and by restricting 

eligibility for guarantees to safer 

mortgages. Incentives to limit risk 

taking would probably be weaker 

than if private capital was in the 

position to absorb some losses.

Financial intermediaries would 

have a relatively strong incentive 

to manage risk, but it would be 

weakened if their obligations 

were seen as implicitly 

guaranteed by the government.

Other considerations Depending on the model 

implemented, government control 

over the secondary mortgage 

market could be greater or less 

than under the precrisis model.

Tensions between public and 

private purposes might remain, 

particularly under models with a 

small number of highly regulated 

intermediaries.

Subsidies could tilt the allocation 

of capital in the economy too far 

toward housing and away from 

other uses.

The government would control 

a large segment of the capital 

market.

The market would probably be 

less dynamic, and there would 

be less incentive for product 

innovation.

Tensions between public and 

private purposes would be 

minimized.

Subsidies could tilt the allocation 

of capital in the economy too far 

toward housing and away from 

other uses.

The government would regulate 

the secondary mortgage market 

but otherwise not intervene.

The market would not rely on 

the viability of any one firm or 

business model.

Tensions between public and 

private purposes would be 

minimized.
XVI FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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concern with allowing broad participation by diversified 

firms is that the government could be exposed to greater 

risk because losses from firms’ other lines of business 

could spill over to their activities in the secondary 

mortgage market. 

A Hybrid Public/Private Model

Many proposals for the future of the secondary market 

involve providing federal guarantees of certain mortgages 

or MBSs that would qualify for government backing. 

That approach would preserve many features of how the 

secondary market for conforming mortgages operated 

before Fannie Mae and Freddie Mac were placed in conservatorship. However, a hybrid approach would depart 

from the precrisis model in three main ways: A potentially different set of private intermediaries would be 

established to securitize federally backed mortgages, the 

federal guarantees on those mortgages would be explicit 

rather than implicit, and their subsidy cost would be 

recorded in the federal budget. 

As the preceding discussions about structuring federal 

guarantees and regulating the secondary mortgage market 

illustrate, a hybrid approach could be implemented in 

ways that involved broader or narrower federal guarantees 

and more or less regulation of participants in the market. 

Under a hybrid approach, private capital and possibly private mortgage insurance would absorb credit losses before 

the federal guarantee would be called upon. Fannie Mae 

and Freddie Mac could be privatized and allowed to compete in the secondary market; they could be used to form 

a nonprofit organization that would issue federal guarantees; or they could be liquidated. The government could 

provide additional housing assistance to low- and 

moderate-income families by subsidizing guarantee fees 

for qualifying borrowers or by funding programs of the 

FHA or other federal agencies that target those groups. 

Compared with the approach of establishing a fully 

federal agency, a hybrid public/private approach would 

lessen concerns about putting a large portion of the capital market under government control. It would also limit 

costs and risks to taxpayers by having intermediaries in 

the secondary market bear all credit losses until their capital was exhausted. In addition, putting private capital at 

risk would provide incentives for prudent underwriting 

and pricing of risk. Compared with a fully private secondary market, a hybrid approach would probably 

improve the liquidity of the market, especially during 

times of financial stress. Moreover, providing an explicit 

federal guarantee would avoid the problems of lack of 

transparency and control that an implicit guarantee 

involves.

Relying on explicit government guarantees of qualifying 

mortgages would also have some disadvantages, the 

importance of which would depend partly on the design 

chosen. If competition remained muted, with only a few 

specialized firms participating in the secondary market, 

limiting risk to the overall financial system and avoiding 

regulatory capture could be difficult. Moreover, federal 

guarantees would reduce creditors’ incentive to monitor 

risk. Experience with other federal insurance and credit 

programs suggests that the government would have trouble setting risk-sensitive prices and would most likely end 

up imposing some cost and risk on taxpayers. In addition, a hybrid approach might not eliminate the frictions 

that arise between private and public missions.

A Fully Federal Agency 

An alternative would be to create a government-run 

program that would provide explicit federal guarantees 

promising timely payment of interest and principal on 

qualifying mortgages or MBSs. (Such a program could 

share many features with the current activities of the 

FHA and Ginnie Mae.) The net cost of the federal program would appear in the budget and could be covered 

wholly or partly by charging guarantee fees. Policymakers 

could use the design of the fees to determine the size of 

subsidies to low-income borrowers or providers of lowincome rental housing. Under that fully federal approach, 

some of the existing operations of Fannie Mae and Freddie Mac could become part of a new or existing federal 

agency. 

A federally run program could have some advantages over 

alternatives that relied on the private sector. For example, 

such a program would be more likely to ensure a fairly 

steady flow of funds to the secondary mortgage market—

both in normal times and during periods of financial 

stress—by minimizing uncertainty about the strength 

of the federal guarantee. Compared with the precrisis 

model, this approach would increase transparency by 

replacing an implicit guarantee with an explicit one. 

Moreover, most of the federal subsidies would probably 

flow to mortgage borrowers rather than to private financial institutions. 

At the same time, however, a new federal program would 

permanently increase government control of a large 
SUMMARY FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET XVII

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segment of the capital market. Depending on the size of 

the subsidies, that greater federal presence could tilt the 

allocation of capital in the economy further toward housing and away from other activities. In addition, a federally operated secondary market would probably be less 

dynamic and result in fewer innovations than a market in 

which competing private institutions played a larger role. 

Furthermore, taxpayers, rather than private financial 

institutions, would bear much of the credit risk on guaranteed mortgages. That shift in risk bearing might give 

mortgage originators and other financial intermediaries 

less incentive to control risk—a situation (known as 

moral hazard) that commonly arises with guarantees and 

insurance. 

Depending on the specific budgetary treatment of the 

program, the government could have weaker incentives 

than private parties do to charge guarantee fees that 

would fully compensate for the risks associated with the 

guarantees. Currently, the budgetary treatment of most 

federal credit guarantees follows the guidelines of the 

Federal Credit Reform Act of 1990, which do not include 

a charge for market risk in estimates of federal subsidies.5

As a result, such estimates tend to understate a guarantee’s 

economic cost to taxpayers.

A Fully Private Secondary Mortgage Market

Another approach would be to move to a fully private 

secondary mortgage market and either wind down the 

operations of Fannie Mae and Freddie Mac or sell the 

federal stake in their assets to private investors. Responsibility for carrying out the GSEs’ affordable-housing mission, to the extent it was continued, could be transferred 

to a government housing agency, such as the FHA. Private firms would then form the secondary market—just 

as they did for private-label MBSs before the recent 

financial crisis and as they continue to do for securities 

backed by other types of assets (such as automobile, 

student, commercial real estate, and credit card loans). In 

times of severe distress, the government could still step in 

to promote liquidity. For instance, it could make FHA 

guarantees available to more borrowers, or it could buy 

MBSs (as the Treasury and the Federal Reserve did during 

the financial crisis). Expanding the activities of federal 

agencies, however, generally requires Congressional 

action. 

Privatization might provide the strongest incentive for 

prudent behavior on the part of financial intermediaries 

by removing the moral hazard that federal guarantees 

create. (The enormous losses that have occurred in recent 

years on private-label subprime mortgages, however, offer 

a painful reminder that private markets are not immune 

to aggressive risk taking.) By increasing competition in 

the secondary market, the privatization approach would 

reduce the market’s reliance on the viability of any one 

firm. Private markets may also be best positioned to 

allocate the credit risk and interest rate risk of mortgages 

efficiently, and they would probably be more innovative 

than a secondary market dominated by a fully federal 

agency. Further, privatization would eliminate the tension 

between public and private purposes inherent in the 

traditional GSE model. 

Full privatization could have several drawbacks, however, 

including the risk that it might not prove credible. If the 

private firms operating in the secondary market were seen 

as critical to the functioning of the mortgage market, 

investors might again treat them as implicitly guaranteed 

by the government, weakening market discipline, reducing transparency, and creating moral hazard. In addition, 

without some predictable federal response, the liquidity 

of the private secondary market might dry up during 

periods of acute financial stress. Moreover, privatization 

might not significantly reduce taxpayers’ overall exposure 

to risk if it shifted credit risk on mortgages to banks that 

were covered by federal deposit insurance and if that 

additional risk was not recognized in regulators’ actions 

and in the fees charged for deposit insurance.

Other Mortgage-Financing Approaches 

As an alternative to mortgage-backed securities, the federal government could offer support for other funding 

mechanisms for home loans. One possibility would be to 

encourage greater reliance on covered bonds—bonds collateralized by residential mortgages—which many large 

European banks use to fund the mortgages they hold. 

With covered bonds, banks bear most of the risks of 

mortgage lending: When a mortgage is paid off or goes 

into default, the issuer is contractually obligated to 

replace the collateral with a new mortgage. That allocation of risk has both advantages and disadvantages compared with MBSs, which spread risk more widely among 

financial institutions, investors, and the government. 

5. Market risk is the risk that investors cannot avoid by holding a 

well-diversified portfolio and that they require compensation to 

bear. Mortgages involve market risk because defaults occur most 

frequently in times of economic stress, when losses are most costly.
XVIII FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Other developed countries with high rates of home 

ownership rely less on government-backed MBSs to fund 

mortgages than the United States does. Some observers 

have pointed to Europe’s housing finance systems as 

potential models for this country; those systems have supported rates of home ownership comparable with that in 

the United States while relying less on MBSs. Although 

covered bonds are common in Europe, there is considerable variation in how mortgages are funded and what 

types of mortgages are available. Nevertheless, all developed countries with high rates of home ownership 

depend on some degree of government support to maintain the flow of credit to the mortgage market during 

periods of financial stress.
CHAPTER

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1

Overview of Fannie Mae, Freddie Mac, and the 

Secondary Mortgage Market

The resale market for mortgages and mortgagebacked securities (MBSs) in the United States has 

changed significantly over the years. Key to the evolution 

of that secondary market has been the activities of the 

Federal National Mortgage Association (Fannie Mae) and 

the Federal Home Loan Mortgage Corporation (Freddie 

Mac). 

Four decades ago, Congressional charters set up Fannie 

Mae and Freddie Mac as government-sponsored enterprises (GSEs)—that is, as private corporations with several public missions: 

 To establish an infrastructure for the secondary market 

for residential mortgages, financed by private capital 

to the maximum extent feasible; 

 To provide stability and ongoing assistance to that 

market (including limited subsidies for mortgages on 

housing for low- and moderate-income families); and 

 To promote access to mortgage credit throughout the 

nation by increasing the liquidity of mortgage investments (that is, ensuring they can be readily bought 

and sold) and by improving the distribution of investment capital. 

Fannie Mae and Freddie Mac have carried out those missions mainly by purchasing certain types of mortgages 

from lenders. (Loans that meet the two entities’ criteria 

for purchase are called conforming mortgages.) The 

GSEs either pool those loans to create mortgage-backed 

securities, which they guarantee and sell to investors, 

or they retain the mortgages in their portfolios, along 

with other MBSs that they buy to hold as assets in their 

portfolios.

Backed by their charters and other federal support, 

Fannie Mae and Freddie Mac have long been the largest 

participants in the secondary mortgage market. Other big 

financial institutions came to play a significant role—

particularly in the segments of the market in which the 

GSEs were not allowed to operate—but their role 

diminished sharply during the recent financial crisis.

In September 2008, after falling housing prices and rising 

delinquencies threatened the solvency of Fannie Mae and 

Freddie Mac and their ability to issue debt, the federal 

government assumed control of the two GSEs by placing 

them in conservatorship, and the Treasury guaranteed 

their obligations through 2012. In addition, the Federal 

Reserve supported Fannie Mae and Freddie Mac by purchasing $1.25 trillion of their MBSs and more than $100 

billion of their debt. Those actions—combined with the 

slowness of the private market for issuing MBSs to 

reemerge—reinforced the dominant position of Fannie 

Mae and Freddie Mac in the secondary market and 

diminished the role of the private sector. 

The GSEs’ Roles in the Secondary 

Mortgage Market

The secondary mortgage market channels funds to borrowers by facilitating the resale of mortgages and MBSs. 

In that market, lenders such as banks, thrifts, and mortgage companies obtain funding for the mortgages they 

originate by selling the loans to purchasers such as Fannie 

Mae, Freddie Mac, other financial institutions such as 

banks and insurance companies, or government entities. 

Those purchasers in turn obtain funds through the 

national and international capital markets. 
2 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Activities 

Fannie Mae and Freddie Mac are forbidden by their federal charters from originating loans. Instead, they participate in the mortgage market by guaranteeing and securitizing mortgages (that is, turning them into MBSs) and 

by purchasing and holding mortgages and MBSs in their 

portfolios. 

Fannie Mae and Freddie Mac fund the purchase of mortgages they securitize by selling the resulting MBSs to 

investors in the capital markets. An investor who buys a 

mortgage-backed security guaranteed by one of the GSEs 

will be paid the principal and any interest that is due even 

if borrowers default on the underlying loans.In exchange 

for the guarantee, the GSE receives a periodic guarantee 

fee from the loans’ originators; that fee is effectively 

paid for by mortgage borrowers as part of their interest 

payments. 

The two entities fund the purchase of the mortgages and 

MBSs they hold in their portfolios by issuing debt securities (known as “agency debt”) that are purchased by investors. Fannie Mae and Freddie Mac earn income from the 

difference between the interest they receive on their mortgage and MBS holdings (net of default losses and other 

expenses) and the interest they pay on their agency debt. 

Exposure to Risk

Those various activities expose the GSEs to several types 

of risk. The primary risk associated with their MBS guarantees is credit risk—the obligation to repay MBS holders in full when a borrower defaults. Credit risk is mitigated by the value of the property securing a mortgage, 

the general tendency for housing values to increase over 

time, and the private mortgage insurance that borrowers 

with down payments of less than 20 percent of their 

home’s purchase price are required to buy. 

With the mortgages and MBSs held in their portfolios, 

Fannie Mae and Freddie Mac also face interest rate and 

prepayment risk. Those risks arise when changes in market interest rates affect the value of the GSEs’ mortgage 

holdings differently than the value of the agency debt 

funding those mortgages. An unexpected change in interest rates—whether a large increase or a large decrease—

can cause losses for the two entities. When interest rates 

fall, borrowers tend to prepay their existing mortgages 

and refinance at lower rates. The GSEs lose the relatively 

high interest income from the mortgages that are prepaid, 

but they are still obligated to pay the higher rates on their 

outstanding fixed-rate debt. Conversely, when interest 

rates rise, prepayments slow down. To continue to 

finance their mortgage holdings, Fannie Mae and Freddie 

Mac have to issue additional debt at current market rates, 

which exceed the interest rates on their existing holdings. 

Before the recent financial crisis, most observers considered interest rate and prepayment risk to be the most 

significant types of risk facing the two GSEs.

Such risks for Fannie Mae and Freddie Mac can be lessened in several ways. Before being taken into conservatorship, the GSEs were required by law to maintain a minimum level of capital sufficient to withstand a regulatory 

stress test, although some observers have criticized those 

tests for lack of stringency.1

 (Now, the Treasury provides 

cash infusions to ensure that the two entities maintain a 

minimum level of capital.) In addition, to manage their 

interest rate and prepayment risks, Fannie Mae and Freddie Mac have employed various strategies, including the 

purchase and sale of financial derivatives (securities that 

facilitate the transfer of risk between investors). Prepayment risk can also be offset by issuing callable debt, 

which gives the GSEs the option to buy back their debt at 

a fixed price before it matures. Strategies to mitigate risk 

generally entail costs, however, and Fannie Mae and Freddie Mac balance the risk of loss with the cost of insuring 

against it. 

Structure and Regulation

As government-sponsored enterprises, Fannie Mae and 

Freddie Mac are hybrid organizations that share attributes 

of private companies and government agencies, as set out 

in their charters. Before conservatorship, their shares were 

traded on the New York Stock Exchange, and they operated to the benefit of their shareholders. At the same 

time, they had regulatory and tax benefits not enjoyed by 

other private firms, such as being exempt from state and 

local income taxes and from many of the Securities and 

Exchange Commission’s requirements for registering 

securities. (Under conservatorship, the Treasury now 

1. In a regulatory stress test, a financial institution analyzes its total 

potential losses under various economic scenarios, and regulators 

examine the analyses to evaluate the adequacy of the institution’s 

capital. The Federal Housing Finance Agency, which regulates 

Fannie Mae and Freddie Mac, requires the GSEs to undergo stress 

tests and to maintain enough capital to absorb unusually large 

potential losses (on their portfolio holdings, guarantees, and other 

contingent liabilities) from future interest rate and credit shocks 

and to offset their management and operational risks. 
CHAPTER ONE FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 3

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holds a controlling stake in both entities, and their shares 

have been delisted from the New York Stock Exchange.) 

Another regulatory benefit is that for many purposes, the 

agency debt issued by Fannie Mae and Freddie Mac is 

treated as similar to Treasury securities. For example, it is 

eligible for unlimited investment by banks and thrifts and 

for purchase by the Federal Reserve in open-market operations. In addition, each GSE has the equivalent of a 

$2.25 billion line of credit with the Treasury. 

A federal regulator—since 2008, the Federal Housing 

Finance Agency (FHFA)—supervises Fannie Mae and 

Freddie Mac and issues regulations to control their risk 

taking and oversee their public mission. Like depository 

institutions, the two GSEs are subject to both a minimum overall capital requirement and a minimum riskbased capital requirement, which serve to provide a cushion against losses and to discourage excessive risk taking. 

Regulatory limits on the types of mortgages that Fannie 

Mae and Freddie Mac can buy also reduce potential 

losses. In addition, the FHFA sets goals for the percentage 

of the GSEs’ mortgage guarantees and purchases that 

must support low- and moderate-income housing; the 

GSEs’ charters state that those activities may involve 

lower returns than other activities earn. 

Federal Guarantees 

Although Fannie Mae and Freddie Mac were required to 

include statements on the agency debt and MBSs they 

issued saying that the securities were not federally guaranteed, before conservatorship investors generally assumed 

that those securities carried an implicit federal guarantee 

against losses from default. That assumption was reinforced by the GSEs’ legal status as instrumentalities of the 

federal government, rather than as fully private entities, 

and thus by the inclusion of their securities in the 

“agency” market along with securities that have 

explicit federal backing. (Fannie Mae’s and Freddie 

Mac’s securities continue to trade in that market under 

conservatorship.) 

The perception of a federal guarantee enabled the two 

entities to borrow in the capital markets at significantly 

lower interest rates than could other financial institutions 

that posed comparable risks. It also caused investors to 

place a higher value on MBSs guaranteed by Fannie Mae 

or Freddie Mac than on MBSs guaranteed by private 

mortgage insurers. Those advantages allowed the two 

GSEs to become the dominant players in the secondary 

market for conforming mortgages. 

The benefits of the implied federal guarantee represented 

a subsidy to Fannie Mae and Freddie Mac and a cost to 

taxpayers—who ultimately bore the burden of making 

good on that guarantee when the GSEs’ default losses 

exceeded their capital cushions and the two entities were 

taken into conservatorship. Because those actions effectively made Fannie Mae and Freddie Mac governmental, 

in January 2009 the Congressional Budget Office (CBO) 

began including the net cost of their operations in its 

baseline projections of federal spending (see Box 1-1). 

Changes in the Secondary Mortgage 

Market Through Mid-2008

Fannie Mae and many of the other institutions that support federal housing policy—such as the Federal Housing 

Administration (FHA) and the Federal Home Loan 

Banks—were created during the Great Depression in 

response to a sharp drop in housing prices and skyrocketing foreclosure rates. At that time, mortgage markets in 

many parts of the country were local. The banks and 

thrifts that originated mortgages had limited opportunities to sell their loans (life insurance and mortgage guarantee companies provided only a small secondary mortgage market).2

 As a result, those institutions depended 

largely on deposits for their funding, which restricted the 

amount of mortgage lending they could undertake. 

Mortgages issued by banks generally had maturities of 

10 years or less, and some mortgages required large balloon payments that came due at maturity. With such 

loans, homeowners bore the risk that they would be 

unable to refinance when their mortgage came due. 

The FHA played a key role in changing that situation by 

offering insurance on 30-year amortizing mortgages, in 

which the principal amount was gradually paid down 

over the life of a loan. Those mortgages allowed smaller 

monthly payments and were less susceptible to the risk of 

difficulties with refinancing than mortgages with shorter 

maturities were. (Thirty-year amortizing mortgages are 

now the standard form of federally insured mortgages.) 

2. Kenneth A. Snowden, The Anatomy of a Residential Mortgage 

Crisis: A Look Back to the 1930s, Working Paper 16244 (Cambridge, Mass.: National Bureau of Economic Research, July 

2010), www.nber.org/papers/w16244.
4 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Continued

Fannie Mae was created, in 1938, primarily to purchase 

mortgages guaranteed by the FHA and thereby create 

liquidity for those loans. (For a more detailed history of 

the secondary mortgage market, see Appendix A.)

Emergence of the GSEs

For its first 30 years, Fannie Mae was a fully federal 

agency, although its transactions did not appear in the 

federal budget.3

 Its establishment as a governmentsponsored enterprise occurred in 1968, when the Congress shifted Fannie Mae to private ownership. At the 

same time, lawmakers divided responsibility for the secondary mortgage market by creating the Government 

National Mortgage Association (Ginnie Mae) as an onbudget federal agency within the Department of Housing 

and Urban Development. Ginnie Mae is responsible for 

securitizing mortgages guaranteed by the FHA or the 

Department of Veterans Affairs; the costs of those guarantees are reflected in the federal budget. Two years later, 

in 1970, lawmakers chartered Freddie Mac to increase 

liquidity for mortgages originated by savings and loans.

Box 1-1.

CBO’s Budgetary Treatment of Fannie Mae and Freddie Mac 

In the judgment of the Congressional Budget Office 

(CBO), the federal conservatorship of Fannie Mae 

and Freddie Mac, and their resulting ownership and 

control by the Treasury, make the two entities part 

of the government and imply that their operations 

should be reflected in the federal budget. In its baseline budget projections, CBO treats the mortgages 

guaranteed each year by the two governmentsponsored enterprises (GSEs) as new guarantee obligations of the federal government. For those guarantees, CBO’s projections of budget outlays equal the 

estimated federal subsidies inherent in the commitments at the time they are made.

CBO’s subsidy estimates are constructed on a riskadjusted present-value basis, also known as a fairvalue basis. Those estimates represent the up-front 

payment that a private entity in an orderly market 

would require to assume the federal responsibility for 

the GSEs’ obligations—and, as such, the estimates 

depend on projections of highly uncertain future outcomes.1

 That budgetary treatment is similar to what 

CBO and the Administration’s Office of Management and Budget (OMB) use to record the subsidy 

cost for asset purchases and loans made under the 

Troubled Asset Relief Program.2

 That treatment differs, however, from the way in which OMB accounts 

for the operations of Fannie Mae and Freddie Mac, as 

explained below.3

On a fair-value subsidy basis, CBO estimated in 

August 2009 that the cost of all of the GSEs’ mortgage commitments made before fiscal year 2009 

and new commitments made in 2009 would total 

$291 billion. That figure closely corresponded with 

the GSEs’ own estimates of the deterioration in their 

fair-value net worth: from a combined surplus of 

$7 billion in June 2008 to a deficit of $258 billion in 

June 2009. Since then, CBO has not produced a new 

estimate of the subsidy cost associated with the GSEs’ 

1. For a more detailed description of how CBO accounts for 

Fannie Mae and Freddie Mac and estimates federal subsidies, 

see Congressional Budget Office, CBO’s Budgetary Treatment 

of Fannie Mae and Freddie Mac, Background Paper (January 

2010).

2. Most federal credit programs are accounted for using procedures specified in the Federal Credit Reform Act of 1990 

(FCRA). For a comparison of the costs of Fannie Mae and 

Freddie Mac on a fair-value and a FCRA basis, see Congressional Budget Office, letter to the Honorable Barney Frank 

about the budgetary impact of Fannie Mae and Freddie Mac 

(September 16, 2010).

3. Neither CBO nor OMB incorporates debt securities or 

mortgage-backed securities issued by Fannie Mae or Freddie 

Mac in estimates of federal debt held by the public.

3. The agency’s activities in the secondary mortgage market were 

excluded from the budget on the theory that Fannie Mae obtained 

its funding directly from the financial markets (by selling debt 

securities) rather than from the Treasury.
CHAPTER ONE FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 5

CBO

At that point, Fannie Mae and Freddie Mac were authorized to purchase so-called conventional mortgages (loans 

that did not carry a federal guarantee), and that soon 

became their main business. 

In its early years, Freddie Mac funded its mortgage purchases primarily by creating and selling mortgage-backed 

securities—unlike Fannie Mae, which chose to hold the 

mortgages it bought in its portfolio and fund their 

purchase by issuing agency debt. When interest rates shot 

up in the late 1970s, Fannie Mae was brought close to 

insolvency as its funding costs escalated. Freddie Mac 

fared much better because securitization protected it from 

interest rate risk. In response, Fannie Mae increased its 

use of securitization in the early 1980s (see the top panel 

of Figure 1-1). Although securitization exposed Fannie 

Mae and Freddie Mac to less risk, it was not as profitable 

as portfolio holdings financed with agency debt that bore 

an implicit federal guarantee. Through the 1990s, both 

GSEs gradually increased their portfolio holdings (see the 

bottom panel of Figure 1-1).

Emergence of the Private-Label MBS Market

An important development in the secondary mortgage 

market was the emergence in the late 1970s of “privatelabel” MBSs—securities issued and insured by private 

Box 1-1. Continued

CBO’s Budgetary Treatment of Fannie Mae and Freddie Mac

past commitments—the value of which will change 

over time as repayments and defaults occur and as 

market conditions change. 

For each new set of baseline budget projections, CBO 

estimates the subsidy cost for the GSEs’ new business 

over the next 10 years on a fair-value basis. The average federal subsidy rate on the GSEs’ new business 

has fallen since the peak of the financial crisis, and it 

is expected to decline further in coming years as the 

housing market recovers.4

 The subsidy rate will 

remain positive, however, as long as Fannie Mae and 

Freddie Mac provide capital and guarantees to the 

mortgage market at prices below what private financial institutions can offer. The GSEs are able to do 

that primarily because of their federal backing, which 

ultimately transfers risk from them to taxpayers. 

Unlike CBO, the Administration treats Fannie Mae 

and Freddie Mac as nongovernmental entities for 

budgetary purposes. Instead of recording estimated 

subsidy costs for their new mortgage commitments in 

the budget, it records only cash transfers between the 

Treasury and the two GSEs (such as the Treasury’s 

purchases of their senior preferred stock and the dividends they pay the Treasury on that stock). Because 

CBO considers the GSEs’ activities to be part of the 

federal budget, it classifies those anticipated cash 

transfers as intragovernmental flows. And like all 

transfers from one government account to another, 

those flows do not affect CBO’s estimates of total 

federal spending or revenues.

CBO believes that treating Fannie Mae and Freddie 

Mac as governmental entities for the purposes of the 

federal budget, and accounting for them on a fairvalue basis, accurately reflects their current status. 

That treatment also provides more timely and relevant information to policymakers considering 

options for the future of the GSEs. For instance, if 

legislation required Fannie Mae and Freddie Mac to 

increase subsidies on guarantees to first-time home 

buyers through a new program, the program would 

show an immediate cost under CBO’s budgetary 

treatment. But under a cash treatment that tracked 

inflows and outflows from the Treasury, there would 

be no immediate cost (or possibly a net gain from fees 

collected), because losses would not materialize for 

some months or years. For the same reason, the cost 

of different loan-modification proposals cannot be 

compared meaningfully on a cash basis. 

4. The subsidy rate is the expected federal cost per dollar of new 

credit guaranteed, with the federal cost measured as the difference between the guarantee fees that a private company 

would charge and those levied by Fannie Mae and Freddie 

Mac. 
6 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

CBO

Figure 1-1.

Outstanding Mortgage-Backed 

Securities and Portfolio Holdings as a 

Percentage of the Total Mortgages 

Backed or Held by the GSEs

Source: Congressional Budget Office based on data from the 

Federal Housing Finance Agency, Fannie Mae, and Freddie 

Mac.

Notes: The outstanding mortgage-backed securities in the top 

panel are MBSs guaranteed by Fannie Mae or Freddie Mac 

and then sold to investors in the capital market. The portfolio holdings in the bottom panel include MBSs guaranteed 

by the two government-sponsored enterprises (GSEs) but 

retained as part of their mortgage portfolios, as well as their 

holdings of private-label mortgages; those holdings are 

mostly financed with debt. For each GSE, the percentages 

for MBSs and portfolio holdings add up to 100 percent. 

 Data for 2010 run through September.

companies without government backing. Lacking an 

implicit federal guarantee, private-label issuers could not 

compete effectively with Fannie Mae and Freddie Mac for 

conforming mortgages. Instead, they concentrated on 

nonconforming mortgages—loans that generally were 

not eligible for guarantees by the GSEs because they were 

too large (jumbo mortgages) or too risky (Alt-A or subprime mortgages).4

 By 1997, private-label securities 

accounted for nearly 25 percent of new MBSs issued, and 

by their peak, in 2005 and 2006, they made up 55 percent of new issues (see Figure 1-2). 

The vibrancy of the private-label market is sometimes 

cited as evidence that a purely private secondary mortgage market could be viable. During the recent financial 

crisis, however, liquidity in the private-label market vanished as investors largely stopped buying private-label 

MBSs, and by the end of 2010, that market had not 

recovered. Some observers attribute its lack of recovery to 

investors’ wariness about exposing themselves to the risk 

of a still unsettled housing market. Others point to the 

recovery of other securitization markets as evidence that 

investors are willing to take on risk, but only if they are 

adequately compensated; those observers argue that the 

private-label MBS market cannot compete with the 

favorable pricing of guarantees by the GSEs. It is impossible to know whether the private-label market would have 

recovered more quickly in the absence of Fannie Mae and 

Freddie Mac, but the crisis demonstrated the susceptibility of a fully private secondary market to disruptions 

from large adverse shocks. 

Growth and Decline of the GSEs

Apart from the near insolvency of Fannie Mae in the late 

1970s and early 1980s, and limits on portfolio growth 

1971 1976 1981 1986 1991 1996 2001 2006

0

20

40

60

80

100

1971 1976 1981 1986 1991 1996 2001 2006

0

20

40

60

80

100

Outstanding Mortgage-Backed Securities

Mortgage Portfolio Holdings

Fannie Mae

Freddie Mac

Fannie Mae

Freddie Mac

4. Alt-A and subprime mortgages are available to some borrowers 

who do not meet the qualifications for a prime mortgage (one 

extended to the least risky borrowers) because of one or more risk 

factors, such as a low credit rating, insufficient documentation of 

income, or the ability to make only a small down payment. Typically, Alt-A mortgages may be offered to borrowers who have high 

credit scores but no proof of income, whereas subprime loans may 

be offered to borrowers who have low credit scores, with or without income verification. Some Alt-A loans meet the definition of 

conforming mortgages. 
CHAPTER ONE FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 7

CBO

Figure 1-2.

Mortgage-Backed Securities, by Issuer

Source: Congressional Budget Office based on data from the Securities Industry and Financial Markets Association, Fannie Mae, Freddie 

Mac, the Federal Housing Finance Agency, Ginnie Mae, and the Inside Mortgage Finance mortgage-backed-security database.

that regulators imposed in 2006 after accounting irregularities came to light, the GSEs expanded rapidly in the 

decades leading up to the recent financial crisis (see 

Figure 1-3).5

 That rapid growth was accompanied by very 

high rates of return on equity for their shareholders. The 

high returns were driven largely by increases in the size of 

the GSEs’ retained portfolios, which were financed by 

debt that was relatively inexpensive because of the 

implicit federal guarantee. 

Profitability for Fannie Mae and Freddie Mac came to 

an abrupt end with the sharp decline in housing prices 

that began in mid-2006 (see Figure 1-4). The GSEs had 

previously weathered regional downturns in housing 

markets, but geographic diversification offered little protection against a national downturn accompanied by high 

and rising mortgage default rates. The growth in housing 

prices that preceded the decline also offered relatively 

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

0

500

1,000

1,500

2,000

2,500

3,000

3,500

Fannie Mae and Freddie Mac

Ginnie Mae 

Private Companies (Private-label)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

0

10

20

30

40

50

60

70

80

90

100

Annual Issuances (Billions of 2009 dollars)

Percentage of Annual Issuances

5. For an analysis of accounting irregularities, see Office of Federal 

Housing Enterprise Oversight, Report of the Special Examination of 

Fannie Mae (May 2006), and Report of the Special Examination of 

Freddie Mac (December 2003). The limits on portfolio growth 

were eventually removed when the GSEs finished restating their 

past earnings and were able to resume quarterly financial reporting 

on a regular and timely basis.
8 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

CBO

Figure 1-3.

Growth of the GSEs’ Outstanding 

Mortgage-Backed Securities and Debt

(Billions of 2009 dollars)

Source: Congressional Budget Office based on data from the 

Federal Housing Finance Agency, Fannie Mae, and Freddie 

Mac.

Notes: The amounts shown here are based on the combined par 

value of senior and subordinated debt of any maturity. 

Data for 2010 run through September.

 GSEs = government-sponsored enterprises.

little protection because borrowers had increased their 

debt levels during the housing boom, extracting much of 

their equity through additional borrowing against their 

homes.6

 The steep drop in housing prices meant that 

Fannie Mae and Freddie Mac recovered less when they 

sold homes through the foreclosure process. 

The GSEs’ susceptibility to losses was increased by their 

relaxation of credit standards at the height of the housing 

boom, when they were quickly losing market share to the 

private-label securities market and were looking for new 

sources of profit. In particular, the risky private-label subprime and Alt-A MBSs that they bought for investment 

purposes—as well as nontraditional loan products that 

they bought or guaranteed to help meet their affordablehousing goals—were the source of their initial losses (see 

Figure 1-5).7

 And although those private-label holdings 

and other risky, nontraditional loans accounted for less 

than one-third of Fannie Mae’s business, they were the 

source of more than 70 percent of its recent credit losses.8

The GSEs eventually also suffered large losses on their 

MBS guarantees as housing prices fell further and delinquencies and foreclosures rose for prime borrowers.

Although Fannie Mae and Freddie Mac have experienced 

sizable credit losses, delinquency rates on their portfolio 

holdings and guaranteed MBSs have been lower than 

industry averages. For example, at the end of the second 

quarter of 2010, 4.6 percent of the mortgages held or 

guaranteed by the GSEs were seriously delinquent (at 

least 90 days past due or in foreclosure), compared with 

9.1 percent for the overall mortgage market.9

 Observers 

have attributed the GSEs’ relatively low delinquency 

rates to the fact that their lending standards (even when 

relaxed) were comparatively stringent, which meant that 

many less creditworthy borrowers could only obtain 

mortgages financed through the private-label market. 

6. See Amir E. Khandani, Andrew W. Lo, and Robert C. Merton, 

Systemic Risk and the Refinancing Ratchet Effect, Working Paper 

15362 (Cambridge, Mass.: National Bureau of Economic 

Research, September 2009), www.nber.org/papers/w15362. 

1990 1994 1998 2002 2006 2010

0

500

1,000

1,500

2,000

1990 1994 1998 2002 2006 2010

0

1,000

2,000

3,000

4,000

Outstanding Mortgage-Backed Securities

Outstanding Debt

Fannie

Mae

Freddie Mac

Fannie Mae

Freddie Mac

Total

Total

7. W. Scott Frame, The 2008 Federal Intervention to Stabilize Fannie 

Mae and Freddie Mac, Working Paper 2009-13 (Federal Reserve 

Bank of Atlanta, April 2009), www.frbatlanta.org/pubs/wp/

working_paper_2009-13.cfm. 

8. See Fannie Mae, Fannie Mae 2010 Second Quarter Credit Supplement (August 5, 2010), p. 6. Also see Federal Housing Finance 

Agency, Conservator’s Report on the Enterprises’ Financial Performance: Second Quarter 2010 (August 26, 2010), Figure 4.3, p. 12, 

www.fhfa.gov/webfiles/16591/.

9. The GSEs’ guaranteed loans also performed marginally better 

than the overall prime market. See Federal Housing Finance 

Agency, Foreclosure Prevention & Refinance Report, Second Quarter 

2010 (September 10, 2010), www.fhfa.gov/webfiles/16695/; 

and Department of the Treasury, Office of Comptroller of the 

Currency and Office of Thrift Supervision, OCC and OTS 

Mortgage Metrics Report, Second Quarter 2010 (September 2010), 

www.ots.treas.gov/_files/490019.pdf.
CHAPTER ONE FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 9

CBO

Figure 1-4.

Indexes of Prices for Single-Family 

Homes, January 1991 Through 

September 2010

(Index, 2000 = 100)

Source: Congressional Budget Office based on data from the 

Federal Housing Finance Agency (FHFA) and Standard & 

Poor’s (S&P).

Note: The FHFA price index covers repeat sales of homes financed 

with conforming mortgages; it generally omits subprime and 

jumbo mortgages. The index is unit-weighted, meaning that 

sales of expensive homes have the same weight as sales of 

moderately priced homes. In contrast, the S&P/Case-Shiller 

price index includes all types of mortgages and is weighted 

by homes’ value. Both indexes use 2000 as the base year 

(when the index equals 100).

Operations of Fannie Mae and 

Freddie Mac Under Conservatorship

When housing prices dropped nationwide and foreclosures started to rise, investors began to doubt that the 

GSEs would have enough capital to absorb their losses 

without an infusion of cash from the federal government. 

That perception led to a sharp increase in the two entities’ 

borrowing costs. Consequently, the Secretary of the 

Treasury and the director of the Federal Housing Finance 

Agency—exercising the authority given to them under 

the Housing and Economic Recovery Act of 2008, or 

HERA (Public Law 110-289)—placed Fannie Mae and 

Freddie Mac into federal conservatorship on September 6, 2008. Regulators also replaced the GSEs’ top 

managers. 

The major focus of conservatorship has been to ensure 

the availability of low-cost mortgage credit. To further 

that goal, lawmakers made the federal guarantee on the 

GSEs’ obligations explicit and expanded the authority of 

the GSEs by allowing them to purchase higher-balance 

loans. Separately from the conservatorship, the Federal 

Reserve bought large amounts of agency MBSs, which 

increased the flow of funds to the GSEs. Since 2009, 

Fannie Mae and Freddie Mac have financed or insured 

more than 70 percent of the single-family residential 

mortgages originated in the United States, absorbing 

some of the volume that would normally have gone to the 

private securitization market. In addition, the two entities 

have been given a leading role in attempts to lower the 

number of foreclosures.10

The Treasury’s agreements with the GSEs call for their 

portfolio holdings of mortgages to gradually shrink over 

time to reduce risks to the overall financial system and 

losses to taxpayers. From a level of more than $750 billion each at the end of 2009, the value of their retained 

portfolios is supposed to decline to $250 billion each over 

10 years. 

Federal Financial Support

Under the agreements authorized by HERA, the Treasury 

committed to provide sufficient capital to keep Fannie 

Mae’s and Freddie Mac’s net worth at zero through 2012 

(as measured according to generally accepted accounting 

principles).11 In return, the government received senior 

preferred stock in the GSEs and warrants that give it the 

option to buy nearly 80 percent of the entities’ common 

stock at a price close to zero. (By September 30, 2010, the

1991 1994 1997 2000 2003 2006 2009

0

60

80

100

120

140

160

180

200

FHFA Monthly

House Price Index

S&P/Case-Shiller

Home Price Index

10. The GSEs have also required lenders to repurchase large volumes 

of delinquent loans that breached their guarantee requirements. 

See Richard Ramsden and others, Assessing the Mortgage Morass

(New York: Goldman Sachs, October 15, 2010). 

11. Maintaining nonnegative net worth was necessary to avoid triggering a statutory requirement to put Fannie Mae and Freddie 

Mac into receivership. (The FHFA has suspended the GSEs’ statutory capital requirements.) Initially, the upper bound of the Treasury’s commitment was $100 billion per GSE. Ultimately, that 

limit was raised to $200 billion per GSE, plus cumulative deficits 

in net worth experienced over the 2010–2012 period, minus any 

surplus remaining as of December 31, 2012. Amendments to the 

agreements allow the Treasury to purchase unlimited amounts of 

preferred stock from each GSE through 2012. See Federal Housing Finance Agency, U.S. Treasury Support for Fannie Mae and 

Freddie Mac, Mortgage Market Note 10-1 (January 20, 2010), 

www.fhfa.gov/webfiles/15362/. 
10 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

CBO

Figure 1-5.

The GSEs’ Holdings of Private-Label 

Mortgage-Backed Securities

(Billions of 2009 dollars)

Source: Congressional Budget Office based on data from the 

Federal Housing Finance Agency.

Notes: The amounts shown here are based on the unpaid principal 

balance of mortgages underlying a security. They cover all 

of Fannie Mae and Freddie Mac’s holdings of nonagency 

mortgage-backed securities, including jumbo, subprime, and 

Alt-A securities issued by private institutions. 

 GSEs = government-sponsored enterprises.

government had provided capital infusions of about 

$148 billion to Fannie Mae and Freddie Mac and 

received over $16 billion in dividends on their stock.) 

Although the Treasury backstop strengthened the federal 

guarantee of the two entities’ securities, it did not immediately cause a significant decline in their financing costs. 

The GSEs’ access to long-term debt markets improved 

dramatically after November 25, 2008, when the Federal 

Reserve announced plans to purchase $100 billion in 

agency debt and up to $500 billion in MBSs guaranteed 

by Fannie Mae, Freddie Mac, and Ginnie Mae. Those 

commitments were subsequently raised to $175 billion in 

agency debt and $1.25 trillion in MBSs. By March 31, 

2010, the Federal Reserve had met those goals. Because 

its purchases included some outstanding MBSs, they 

equaled about twice the net volume of MBSs (new supply 

minus prepayments) issued by Fannie Mae and Freddie 

Mac over that period. In addition to the Federal Reserve’s 

purchases, the Treasury bought just over $220 billion of 

the two entities’ MBSs. 

Increasing the Availability of Credit

Nearly all new mortgages originated in the past two years 

were supported by the federal government. Fannie Mae 

and Freddie Mac guaranteed 75 percent of new residential mortgages in 2009, and the FHA and the Department of Veterans Affairs guaranteed most of the rest. 

At the end of 2009, the GSEs held or guaranteed nearly 

$4.8 trillion of residential mortgage debt, or about 

44 percent of the total amount outstanding (see 

Figure 1-6), up from 36 percent in 2006. Their share 

of the market for mortgages on multifamily rental properties has also risen. In 2009, the two GSEs guaranteed a 

total of more than $35 billion, or about 80 percent, of 

new mortgages backing multifamily rental housing. 

In response to disruptions in the market for jumbo mortgages, policymakers raised the cap on conforming loans 

in high-cost areas—to between $417,000 and $729,750, 

depending on local median house prices—to help 

improve the flow of credit and to make those loans more 

affordable. In addition, Fannie Mae and Freddie Mac, in 

coordination with the Treasury, are being used to revive 

the activities of state and local housing finance agencies, 

which declined greatly during the financial crisis. Those 

agencies provide subsidized mortgage financing to lowand moderate-income borrowers (primarily first-time 

home buyers) and to owners of multifamily rental units.

The turmoil in the financial and housing markets has 

affected the GSEs’ ability to meet their requirements for 

the percentage of mortgage guarantees and purchases that 

address the housing needs of low- and moderate-income 

people. Consequently, the FHFA has lowered those percentages.12 In addition, as required under HERA, the 

FHFA has proposed new affordable-housing goals 

intended to better target lower-income households.13

1998 2000 2002 2004 2006 2008

0

50

100

150

200

250

300

350

400

Fannie Mae

Freddie Mac

Total

12. See Federal Housing Finance Agency, “FHFA Sends GSE Housing Goals to Federal Register: Proposed Rule Adjusts Certain Goals 

for Market Conditions; Provides Credit for Loan Modifications” 

(press release, April 28, 2009), www.fhfa.gov/webfiles/2139/. Also 

see Federal Housing Finance Agency, The Housing Goals of Fannie 

Mae and Freddie Mac in the Context of the Mortgage Market: 1996–

2009, Mortgage Market Note 10-2 (February 1, 2010), 

www.fhfa.gov/webfiles/15419/, and Annual Housing Report

(October 2009), www.fhfa.gov/webfiles/15150/.

13. See the remarks by Edward J. DeMarco, Acting Director, Federal 

Housing Finance Agency, given at the Women in Housing and 

Public Policy Luncheon, Washington, D.C., February 18, 2010, 

www.fhfa.gov/webfiles/15411/. 
CHAPTER ONE FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 11

CBO

Figure 1-6.

Outstanding Mortgage Debt

Source: Congressional Budget Office based on data from Haver Analytics and the Federal Reserve.

Notes: These figures apply to mortgages on residences for one to four families.

 Data for Fannie Mae and Freddie Mac reflect their guaranteed mortgage-backed securities (MBSs) and portfolio holdings of whole 

mortgages (but not their holdings of private-label MBSs). Data for Ginnie Mae and private companies reflect the oustanding MBSs they 

issued. Data for major financial institutions (such as commercial banks, savings institutions, and life insurance companies) reflect only 

their holdings of whole mortgages. The “all other” category consists of whole-mortgage holdings by state and local pension plans, the 

Federal Deposit Insurance Corporation, credit unions, mortgage companies, real estate investment trusts, and individuals.

Policymakers have also given Fannie Mae and Freddie 

Mac more flexibility in allowing the refinancing of mortgages they own or guarantee. As interest rates on mortgages have declined in recent years, the number of homeowners who could in principle lower their monthly 

payments through refinancing has grown. However, 

homeowners who are current in their mortgage payments 

but have low or negative equity in their home would have 

difficulty refinancing under the usual rules. To give those 

homeowners more opportunities, the rules governing the 

refinancing of mortgages guaranteed by the GSEs have 

been relaxed: Borrowers with a loan-to-value (LTV) ratio 

as high as 125 percent—meaning that their mortgage balance is up to 25 percent greater than the current value of 

their home—may now qualify for refinancing without 

purchasing private mortgage insurance. By the end of 

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

0

2

4

6

8

10

12

Fannie Mae and

Freddie Mac Ginnie Mae Private Companies(Private-label)

Major Financial

Institutions All Other

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

0

10

20

30

40

50

Fannie Mae and Freddie Mac's Share of Outstanding Mortgage Debt

Outstanding Mortgage Debt, by Guarantor

(Or by holder for nonguaranteed debt)

(Percent)

(Trillions of 2009 dollars)
12 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

CBO

Figure 1-7.

Extent to Which Interest Rates on Freddie Mac’s Ten-Year Debt Exceeded 

Rates on the Treasury’s Ten-Year Debt, January 2007 Through September 2010

(Percentage points)

Source: Congressional Budget Office based on data from Bloomberg. 

Note: This interest rate spread applies to noncallable debt and is based on a weekly, matched series of debt issued by Freddie Mac and the 

Treasury through September 2010.

a. On November 25, 2008, the Federal Reserve announced that it would begin purchasing mortgage-backed securities and agency debt

issued by Fannie Mae and Freddie Mac.

June 2010, more than 950,000 loans had gone through 

the streamlined refinancing process, including nearly 

400,000 with LTV ratios over 80 percent. However, 

many more borrowers have been unable to qualify for 

refinancing because of insufficient income or an LTV 

ratio over 125 percent.

Reducing Mortgage Interest Rates

The policy under conservatorship of continuing to charge 

below-market rates for the GSEs’ credit guarantees contributes to lower interest rates for mortgage borrowers 

(and greater costs to the Treasury). After they entered 

conservatorship, Fannie Mae and Freddie Mac dropped 

plans to increase by 0.25 percentage points the up-front 

fee they charge for insuring mortgages during adverse 

market conditions. Although the GSEs’ average guarantee 

fee appears to have changed little since the financial crisis 

began, fees have risen for riskier borrowers and on riskier 

loan products. In analyzing guarantee fees, the FHFA 

found a pattern of uneven subsidies, with riskier loans 

(those with higher LTV ratios and lower borrowers’ credit 

scores) receiving relatively larger subsidies than safer 

loans.14

The GSEs’ ability to affect market interest rates on the 

MBSs they insure and on the agency debt they issue is 

limited; those rates depend primarily on the perceived 

value of their federal backing and on conditions in financial markets. In November 2008, shortly after conservatorship began, interest rate spreads between the GSEs’ 

agency debt and Treasury securities (that is, the extent to 

which rates on agency debt exceeded those on Treasury 

securities of comparable maturity) shot up by nearly a 

percentage point, reflecting investors’ increasing doubts 

about whether they would be fully protected from losses 

as the financial crisis deepened (see Figure 1-7, which 

shows the interest rate spread for Freddie Mac). Since 

then, actions by the Treasury and the Federal Reserve to 

increase the value of the GSEs’ securities, and general 

2007 2008 2009 2010

0

0.5

1.0

1.5

2.0

Start of Conservatorship Federal Reserve's Policy Announcementa

14. In 2009, the average guarantee fee charged on mortgages declined. 

That change can be attributed to the increased share of loans that 

year with lower LTV ratios and to a rise in the percentage of borrowers with higher credit scores. See Federal Housing Finance 

Agency, Fannie Mae and Freddie Mac Single-Family Guarantee Fees 

in 2007 and 2008 (July 2009), www.fhfa.gov/webfiles/14700/, 

and Fannie Mae and Freddie Mac Single-Family Guarantee Fees in

2008 and 2009 (July 2010), www.fhfa.gov/webfiles/15918/. 
CHAPTER ONE FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 13

CBO

Figure 1-8.

Interest Rates on Jumbo and Conforming Mortgages, January 2007 Through 

September 2010 

(Percent)

Source: Congressional Budget Office based on data from Bloomberg via Bankrate.com.

Note: Conforming mortgages are ones whose size and terms make them eligible to be guaranteed by Fannie Mae and Freddie Mac. Jumbo 

mortgages are ones whose size exceeds the limit for conforming mortgages.

improvement in financial market conditions, have helped 

those spreads fall back below precrisis levels.15 The market prices of MBSs guaranteed by Fannie Mae and Freddie Mac also appear to have returned to precrisis levels. 

Moreover, because of the downward trend in interest 

rates and the reduced spreads, the average rate on 30-year 

fixed-rate conforming mortgages dropped from 6.0 percent at the end of September 2008 to 5.2 percent at the 

same point in 2009, and to 4.5 percent at the end of 

September 2010 (see Figure 1-8), although it has risen 

since then.

Lowering the Number of Mortgage Foreclosures

Fannie Mae and Freddie Mac are key players in the 

Administration’s efforts to reduce mortgage foreclosures 

by modifying loans. Foreclosures, although unavoidable 

in some circumstances, are costly to both lenders and 

borrowers and have negative effects on neighborhoods 

and home prices.16 More than 1 million foreclosures were 

started in 2009 on mortgages guaranteed by Fannie Mae 

or Freddie Mac, and another 1.6 million loans guaranteed by the GSEs were at least 60 days delinquent at the 

end of June 2010. Some loans guaranteed by the GSEs 

are now being modified under the Home Affordable 

Modification Program (HAMP), which began in May 

2009. The Administration committed nearly $50 billion 

to that program through the Troubled Asset Relief Program and another $25 billion through Fannie Mae and 

Freddie Mac; however, only a small portion of HAMP 

funds are likely to be spent, CBO estimates. With the 

2007 2008 2009 2010

0

4

5

6

7

8

Conforming

Jumbo

15. See Congressional Budget Office, The Budgetary Impact and Subsidy Costs of the Federal Reserve’s Actions During the Financial Crisis

(May 2010). The extent to which the Federal Reserve’s actions 

have caused interest rates on mortgages to decline is uncertain, 

and estimates of the effect vary widely. See Joseph Gagnon and 

others, Large-Scale Asset Purchases by the Federal Reserve: Did They 

Work? Staff Report 441 (Federal Reserve Bank of New York, 

March 2010), www.ny.frb.org/research/staff_reports/sr441.pdf; 

Andreas Fuster and Paul S. Willen, $1.25 Trillion Is Still Real 

Money: Some Facts About the Effects of the Federal Reserve’s Mortgage 

Market Investments, Discussion Paper 10-4 (Federal Reserve Bank 

of Boston, November 18, 2010), www.bos.frb.org/economic/

ppdp/2010/ppdp1004.pdf; and Johannes C. Stroebel and John B. 

Taylor, Estimated Impact of the Fed’s Mortgage-Backed Securities 

Purchase Program, Working Paper 15626 (Cambridge, Mass.: 

National Bureau of Economic Research, December 2009), 

www.nber.org/papers/w15626.

16. Christopher L. Foote and others, Reducing Foreclosures, Public Policy Discussion Paper 09-2 (Federal Reserve Bank of Boston, April 

8, 2009), www.bos.frb.org/economic/ppdp/2009/ppdp0902.htm. 
14 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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volume of HAMP modifications declining, the GSEs 

have increased other types of loan modifications. In 

cases where modifying a delinquent loan is not viable, 

the GSEs have increasingly relied on short sales (in 

which a home is sold for less than the amount due on the 

mortgage) and on deeds in lieu of foreclosure (in which 

all interest in a property is immediately transferred 

from a borrower to a lender without going through the 

foreclosure process) to reduce costs and better preserve 

neighborhoods. 

Although modifying loans creates savings for homeowners, it can be costly to Fannie Mae and Freddie Mac 

and ultimately to taxpayers. The GSEs may be adversely 

affected through the value of their portfolio holdings. 

Loan modifications make investors worse off when payments are reduced and a property ends up in foreclosure 

anyway or, conversely, when the borrower would have 

continued to make the higher mortgage payments in any 

event. Evidence suggests that borrowers frequently 

default on modified loans, particularly if they suffer a job 

loss or if further declines in home prices increase their 

negative equity.17 However, loan modifications that 

reduce the odds of default and help stabilize local property values can save money for the GSEs in their role as 

guarantors by lowering their risk of credit losses. Such 

outcomes can also be beneficial for taxpayers, both 

through the gains for the GSEs and through the strengthening of property values and, perhaps, local tax revenues.

17. Default rates on modified GSE loans are about 50 percent after 

nine months, but there are some signs that recent modifications—

which feature deeper reductions in interest and principal and 

declines of more than 20 percent in monthly payments—are performing better. See Department of the Treasury, OCC and OTS 

Mortgage Metrics Report, Second Quarter 2010.
CHAPTER

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2

Possible Rationales for a Federal Role in the 

Secondary Mortgage Market 

Federal policies that affect the secondary mortgage 

market generally have two aims: helping to ensure a stable 

supply of financing for residential mortgages nationwide 

and providing assistance for mortgages on housing for 

low- and moderate-income families. Many of the 

government’s efforts in pursuit of those goals operate by 

increasing the liquidity of mortgages and mortgagebacked securities. Ensuring that mortgage products can 

be readily bought and sold helps to broaden and stabilize 

the base of investors in the secondary market, which in 

turn modestly reduces the interest costs that mortgage 

borrowers face. Those effects are most evident during 

periods of stress in financial markets. However, federal 

support for the secondary mortgage market also entails 

costs—including the transfer of risk from investors to 

taxpayers, a weakening of incentives to control risk, and 

encouragement to overinvest in housing—which must be 

weighed against the potential benefits. 

In the past, the federal government has supported the 

secondary mortgage market in a variety of ways. A key 

structural contribution was creating a legal and regulatory 

framework to facilitate the securitization of conforming 

and nonconforming loans; the cash flows on most MBSs 

are more predictable than those on individual mortgages 

and thus easier for investors to value.1

 Giving federal 

charters to Fannie Mae and Freddie Mac enhanced 

investors’ confidence in the guarantees on MBSs they 

issued. Fannie Mae and Freddie Mac also have added 

liquidity to the mortgage market at times through their 

purchases and sales of the agency MBSs held in their 

portfolios. In addition, the federal government has

increased the flow of credit to low- and moderate-income 

borrowers by explicitly insuring mortgages against losses 

from default (through programs of the Federal Housing 

Administration and the Department of Veterans Affairs, 

or VA) and by guaranteeing timely payment of interest 

and principal on MBSs backed by pools of those 

mortgages (through Ginnie Mae).2

 Most recently, the 

Federal Reserve and the Treasury have increased the 

supply of funding for mortgages through their direct 

purchases of MBSs. 

Under ordinary market conditions, there is probably less 

day-to-day benefit from a federal presence in the secondary mortgage market now than there was four decades 

ago, when Fannie Mae and Freddie Mac were chartered. 

Many financial institutions have developed the capability 

to securitize various types of mortgages that are actively 

traded in secondary markets without the advantage of 

federal guarantees. The investor base for MBSs has 

become larger and more international. Despite those 

changes, however, the recent financial crisis has highlighted the vulnerability of the secondary mortgage 

market to large adverse shocks. At such times, some federal involvement is likely to be necessary if policymakers 

want to ensure an uninterrupted flow of credit to the 

housing market. 

Another goal that is sometimes cited for federal support 

of the mortgage market is to promote home ownership. 

Owning a home may give a household a greater stake in

1. Poorly designed securitizations can have the opposite effect: 

increasing risk and obscuring value.

2. The government provides funding to cover default losses on 

individual mortgages through the FHA and VA. Ginnie Mae 

securitizes those mortgages and administers the guarantee, 

providing investors with assurance of timely payment of the 

amounts owed to them. 
16 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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its community and make the community more stable.3

For example, neighborhoods with higher concentrations 

of homeowners are thought to be better maintained and 

have lower crime rates. The main source of federal subsidies for home ownership, however, is not the secondary 

mortgage market but rather the tax code, which treats 

investments in owner-occupied housing more favorably 

than other investments. Homeowners are eligible for several types of favorable tax treatment: They may be able to 

deduct mortgage interest and property taxes—two significant costs of home ownership—from their taxable 

income without needing to pay taxes on their home’s 

implicit rental value (unlike owners of a rented home, 

who can deduct mortgage interest, property taxes, and 

other expenses but must pay taxes on their net rental 

income). In addition, the threshold that triggers taxes on 

capital gains from houses is high enough that most people 

do not have to pay such taxes when they sell their home.4

Promoting a Stable Supply of 

Mortgage Financing

Banks, thrifts, and mortgage brokers rely on the secondary market to supply funding for the mortgages they originate. Selling mortgages rather than holding them in a 

portfolio lets banks and thrifts avoid the cost of having 

to protect themselves from the risks associated with 

financing long-term mortgages with short-term deposits. 

A broad-based secondary market also tends to equalize 

mortgage interest rates among different regions of the 

country because it reduces reliance on the local availability of deposits to meet the local demand for mortgages.

The effect of federal support for the secondary market is 

most pronounced during periods of turmoil in financial 

markets, when private investors seek the safety of federally guaranteed investments. As funding for risky securities diminishes, mortgage lenders have less ability to 

provide credit to new borrowers or to refinance old loans. 

Interruptions in the supply of credit in turn can hurt the 

market for new home construction, reduce employment, 

and weaken the economy. Lack of liquidity also impedes 

labor mobility by making it harder for people to buy and 

sell homes when they want to move. Such concerns may 

motivate a federal role in the secondary mortgage market.

The Function of Liquidity

Liquidity is an important attribute of a well-functioning 

secondary market. A liquid market is one in which a large 

volume of securities can be readily bought or sold without affecting their price. Market liquidity depends greatly 

on the characteristics of the securities being traded. Securities that are issued in large volumes with short maturities, standardized terms, and little or no risk of default 

(such as Treasury bills) are generally the most liquid. Such 

securities are easiest for investors to evaluate and least susceptible to unexpected changes in value that can make 

them difficult to resell. 

How much federal intervention is necessary to provide 

adequate liquidity to the secondary mortgage market is 

an unsettled question. Proponents of relying more heavily 

on the private sector to provide liquidity point to the 

emergence of an active market for private-label MBSs. 

Advocates of a larger federal role counter that the privatelabel market was considerably less liquid than the market 

for agency MBSs even before the recent financial crisis. 

However, significant differences between the two markets 

make it difficult to pinpoint why the difference in liquidity exists or what might happen if the private sector had a 

larger hand in guaranteeing and securitizing mortgages.

Some of the difference in liquidity between the privatelabel and agency markets is attributable to the fact that 

far fewer private-label MBSs are issued than agency 

MBSs. Another factor is the differing risk of the underlying mortgages—issuers other than Fannie Mae and 

Freddie Mac tend to specialize in the riskier segments of 

the mortgage market, such as subprime and jumbo 

residential loans, where the government-sponsored 

enterprises traditionally were not permitted to operate. 

Probably the main reason that the market for agency 

MBSs has been more liquid, however, has been the 

implicit (and now explicit) federal guarantees, which 

make those securities more homogeneous by nearly eliminating differences in credit quality. The liquidity benefits 

that arise from federal guarantees must be weighed 

against the costs, however. 

3. For a review of the literature on the possible positive social 

benefits associated with housing and arguments for a public role, 

see Edward L. Glaeser and Joseph Gyourko, Rethinking Federal 

Housing Policy: How to Make Housing Plentiful and Affordable 

(Washington, D.C.: American Enterprise Institute, 2008), 

pp. 48–57, www.aei.org/book/971. 

4. As an additional incentive for home ownership, some people 

who bought homes between January 1, 2009, and April 30, 2010, 

were eligible for a temporary tax credit of up to $8,000 to help 

with making down payments. The credit was originally enacted in 

the American Recovery and Reinvestment Act of 2009 (Public 

Law 111-5). 
CHAPTER TWO FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 17

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Enhancing Liquidity with Credit Guarantees 

Credit guarantees—whether provided by private mortgage insurers or by governments—increase a security’s 

liquidity because they attract a broader class of investors, 

who prefer less risky securities, to participate in the market. At the same time, however, by transferring potential 

losses from mortgage lenders to guarantors, guarantees 

tend to reduce the incentive for lenders to control and 

monitor the riskiness of the loans they originate.

The structure of guarantees and investors’ confidence in 

them are critical to maintaining a stable supply of funding through the MBS market. Particularly during periods 

of stress in financial markets, confidence in private guarantees can evaporate when the solvency of private guarantors is no longer assured. A large shock to the economy—

such as the recent nationwide drop in housing prices that 

triggered the subprime mortgage crisis—can increase the 

amount that private mortgage insurance companies must 

pay out for defaults at the same time that their asset holdings are declining in value. Those companies may find 

themselves with insufficient capital to make their insurance credible; downgrades of their credit ratings can 

reinforce the perception of weakness. As a result, mortgage interest rates can rise sharply, and in extreme cases, 

investors may stop buying private-label MBSs. Federal 

intervention could address that inability of the private 

sector to effectively insure against such catastrophic risks.

As with private guarantees, confidence in implicit federal 

guarantees can also wane during times of crisis. Investors’ 

doubts about the ability of Fannie Mae and Freddie Mac 

to cover their obligations in the face of mounting losses—

coupled with concerns about whether and how the 

implicit federal guarantee would be made explicit—were 

factors that led the government to place those entities in 

conservatorship. During normal times, the difference 

between the interest rates that Freddie Mac paid to holders of its agency debt and the interest rates on Treasury 

bonds of similar maturity averaged less than 0.50 percentage points (see Figure 1-7 on page 12). A few months 

before conservatorship, that interest rate spread widened 

to nearly 1 percentage point, an indication that investors 

were no longer sure they would be protected.

Attaching a standing, explicit federal guarantee to certain 

types of mortgages or MBSs could lower the probability 

and severity of disruptions in financing those mortgages. 

Such a guarantee would ensure a more robust market by 

attracting a broader and more stable group of investors. 

At the same time, however, a standing guarantee could 

increase the likelihood and cost of future problems in the 

housing market if it induced risk-taking behavior on the 

part of mortgage originators and securitizers by decreasing the market discipline imposed on them by uninsured 

investors or private mortgage insurance companies. 

During periods of extreme financial distress, even a federally backed guarantee may not be enough to ensure a 

steady stream of relatively low-cost funding to the secondary mortgage market. At such times, the government 

has an additional tool at its disposal: It can step in and 

buy mortgages and MBSs directly, as the Treasury and 

Federal Reserve did during the recent crisis. (The Federal 

Reserve’s purchases entailed no additional credit risk for 

the government because the agency securities it bought 

already carried an effective federal guarantee. If future 

purchases included private-label securities, those purchases would incur credit risk.)

Effects of Federal Guarantees on Borrowing Costs

Investors are willing to pay more for MBSs that are issued 

by Fannie Mae and Freddie Mac or that have other federal backing, which means that the securitizers in turn 

can pay more to buy mortgages from lenders. However, 

most of the potential savings to mortgage borrowers that 

result from investors’ willingness to pay more for federally 

backed securities are offset by guarantee fees (which lenders pay to securitizers), because those fees are factored 

into mortgage interest rates. Under normal market conditions, when guarantee fees are set at fair-market levels, the 

net impact on borrowers’ interest costs tends to be small 

and reflects only the effect of greater liquidity. When 

guarantee fees are subsidized, however, they can significantly lower interest expenses for borrowers. 

Estimates of the savings to borrowers from federal 

guarantees vary widely and depend on the market and 

time period being considered.5

 Before conservatorship, 

various studies tried to estimate how much of the subsidy 

value of the implicit federal guarantee of Fannie Mae 

and Freddie Mac was passed through to mortgage borrowers (as opposed to flowing to the GSEs’ shareholders, 

5. Some evidence suggests that little or no additional savings flowed 

to borrowers when the GSEs purchased agency MBSs to hold in 

their portfolios. See Andreas Lehnert, Wayne Passmore, and Shane 

M. Sherlund, “GSEs, Mortgage Rates, and Secondary Market 

Activities,” Journal of Real Estate Finance and Economics, vol. 36, 

no. 3 (April 2008), pp. 343–363.
18 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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managers, or employees). One way of estimating the benefit to borrowers is comparing the interest rates on mortgages that are eligible for GSE financing with the rates on 

loans that are not eligible (controlling for other differences in the characteristics of borrowers and loans). Evidence from the spread between interest rates on jumbo 

and conforming loans suggests that the implicit federal 

guarantee lowered mortgage interest rates by no more 

than 0.25 percentage points in normal times.6

 During 

the financial crisis, that spread widened to more than 

1 percentage point; at the end of September 2010, it 

remained unusually large (see Figure 1-8 on page 13). 

Another example of the impact of federal guarantees is 

that when Ginnie Mae began creating liquid MBSs 

from government-insured FHA and VA mortgages, the 

liquidity of those mortgages increased.7

 Fannie Mae’s and 

Freddie Mac’s purchases of mortgages on multifamily 

rental housing and of private-label MBSs are also likely

to lower interest costs for borrowers with those types of 

mortgages. 

To the extent that the liquidity created by federal activities in the secondary mortgage market spills over to the 

private-label MBS market, those activities may indirectly 

lower the costs of jumbo loans, subprime loans, and other 

nonconforming mortgages. Such positive spillover can 

occur, for instance, when the expertise that investors gain 

in the agency MBS market makes them more willing to 

participate in the private-label market. However, it is also 

possible that federally supported activities decrease 

liquidity in the private-label market by reducing the 

potential scale at which private-label issuers can operate. 

The size of such effects, whether positive or negative, is 

extremely difficult to quantify, and reliable estimates are 

not available.

Some of the savings to borrowers from lower interest rates 

are likely to be offset by increases in house prices caused 

by the subsidy policies. Interest rate subsidies such as 

those resulting from the GSEs’ purchases and guarantees 

(as well as from the tax deduction for mortgage interest) 

are already reflected in the prices of existing homes and 

land, at least in areas where the supply of housing is constrained. One study found that a 1 percent reduction in 

the after-tax cost of owning a home leads to an increase of 

0.60 percent to 0.85 percent in house prices.8

 That situation is a disadvantage for first-time home buyers, who 

face higher prices for housing because they do not already 

own a home whose price reflects interest rate and other 

subsidies.

Promoting Affordable Housing

Besides encouraging a stable supply of mortgage financing, federal housing policy aims to make homes—both 

owner-occupied and rental—more affordable for lowand moderate-income households. The government 

subsidizes the cost of housing for those groups through its 

support of the secondary mortgage market, through 

several types of rental assistance, and through various 

provisions of the tax code. 

Using the Secondary Mortgage Market to 

Increase Affordability

Government involvement in the secondary mortgage 

market—primarily through the activities of the FHA and 

Ginnie Mae, but also through the affordable-housing 

goals for Fannie Mae and Freddie Mac—increases access 

to mortgage credit for low- and moderate-income 

borrowers and provides interest rate subsidies. In addition, federal support for the secondary market lowers 

financing costs for developers of affordable multifamily 

rental housing. (Expanding the supply of rental housing 

is one way to lower rents.) 

In some cases, assistance for home ownership may be provided at the lowest cost to taxpayers by improving access 

6. That raw spread is not a perfect measure of the value of GSE support because it reflects the higher credit and prepayment risks of 

jumbo mortgages, which are heavily concentrated in California’s 

volatile housing market. See Congressional Budget Office, Interest 

Rate Differentials Between Jumbo and Conforming Mortgages, 

1995–2000 (May 2001); Joseph A. McKenzie, “A Reconsideration of the Jumbo/Non-Jumbo Mortgage Rate Differential,” Journal of Real Estate Finance and Economics, vol. 25, no. 2/3 (2002), 

pp. 197–213; Wayne Passmore, Roger Sparks, and Jamie Ingpen, 

“GSEs, Mortgage Rates, and the Long-Run Effects of Mortgage 

Securitization,” Journal of Real Estate Finance and Economics, 

vol. 25, no. 2/3 (2002), pp. 215–242; and Wayne Passmore, 

Shane Sherlund, and Gillian Burgess, “The Effect of Housing 

Government-Sponsored Enterprises on Mortgage Rates,” Real 

Estate Economics, vol. 33, no. 3 (September 2005), pp. 427–463. 

7. Susan Woodward and Robert Hall, “What to Do About Fannie 

Mae and Freddie Mac” (blog post, January 28, 2009), http://

woodwardhall.wordpress.com/?s=%22What+to+Do+About+

Fannie+Mae+and+Freddie+mac%22.

8. Christopher Mayer and R. Glenn Hubbard, “House Prices, Interest Rates, and the Mortgage Market Meltdown” (draft, Columbia 

Business School, New York, October 2008), www4.gsb.

columbia.edu/null?&exclusive=filemgr.download&file_id=3549. 
CHAPTER TWO FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 19

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to mortgage credit. Low- and moderate-income households can face significant barriers to getting a home loan 

if information about their creditworthiness is difficult or 

costly to obtain. For example, because many of those borrowers have short or no credit histories, lenders may not 

be able to distinguish good credit risks from bad ones. 

Lack of information gives rise to problems of adverse 

selection: If lenders tried to protect themselves from 

losses by demanding higher interest rates, they would 

tend to attract only the riskiest borrowers. (Many lowerrisk borrowers would probably not take out a loan at the 

higher rates because it would be so expensive.) Knowing 

that, lenders might be unwilling to offer credit on any 

terms—a situation known as credit rationing.9

 Although 

credit rationing has probably declined over time with 

lenders’ increased use of borrowers’ credit scores, lack of 

information remains a barrier to lending in some cases. 

When credit rationing occurs in the mortgage market, 

the government may be able to improve economic efficiency and the welfare of consumers by intervening to 

make credit more available. One way to do that is 

through the secondary market, by being willing to purchase and guarantee mortgages that meet less stringent 

criteria than private lenders would require on their own. 

Such interventions generally involve a subsidy (which 

flows through lenders to borrowers) because the government is offering terms that are more favorable than what 

a competitive private lender would offer. Those interventions may not always improve efficiency, however, 

because credit subsidies can encourage some households 

to borrow more than is financially sensible.10

The federal government has also tried to improve access 

to mortgage financing through annual targets for the 

percentage of mortgages bought by Fannie Mae and Freddie Mac that were made to low- and moderate-income 

borrowers. (Those targets are described in more detail in 

the next chapter.) In addition, the Community Reinvestment Act of 1977 encourages banks and savings and loan 

institutions to make loans to borrowers in all parts of 

their local communities, including low- and moderateincome neighborhoods.

Other Federal Efforts to Make Housing 

More Affordable

Qualifying individuals and families can receive rental 

assistance in the form of subsidized units in public housing complexes and some privately owned buildings, a 

type of aid known as unit-based assistance. Alternatively, 

they can receive housing vouchers that can be used to 

cover part of their rental costs in the private market. With 

vouchers, poorer families tend to move to safer neighborhoods (which translates into improved mental and physical health) at a subsidy cost similar to that of unit-based 

assistance.11

The tax code also supports home ownership through the 

deductibility of mortgage interest and property taxes and 

through the favorable treatment of capital gains on residential properties. Such benefits may be fairly small for 

low- and moderate-income families, however, because 

those families often claim the standard deduction on 

their tax returns rather than itemizing deductions and 

generally face low marginal income tax rates.

9. See Joseph E. Stiglitz and Andrew Weiss, “Credit Rationing in 

Markets with Imperfect Information,” American Economic Review, 

vol. 71, no. 3 (June 1981), pp. 393–410. 

10. See Deborah Lucas and Marvin Phaup, “The Cost of Risk to the 

Government and Its Implications for Federal Budgeting,” in 

Lucas, ed., Measuring and Managing Federal Financial Risk

(Chicago: University of Chicago Press, 2010), pp. 29–54. 

11. See Jeffrey R. Kling, Jeffrey B. Liebman, and Lawrence F. Katz, 

“Experimental Analysis of Neighborhood Effects,” Econometrica, 

vol. 75, no. 1 (January 2007), pp. 83–119. 

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3

Weaknesses of the Precrisis Model for 

Fannie Mae and Freddie Mac

The activities of Fannie Mae and Freddie Mac have 

been a fairly effective but costly means of creating a stable 

supply of financing for residential mortgages, which in 

turn has helped to support the nation’s high rate of home 

ownership. Nevertheless, the model under which the two 

government-sponsored enterprises operated before federal 

conservatorship—referred to here as the “precrisis 

model”—had major structural weaknesses. Those weaknesses included an implicit federal guarantee that led to a 

concentration of market power in the two GSEs, risks to 

the stability of the larger financial system, and a lack of 

openness about costs and risks to the government. Weak 

regulation and goals for financing affordable housing 

allowed greater risk taking and may have contributed to 

those shortcomings. Furthermore, the policies directed at 

making housing more affordable appear to have provided 

only limited benefits to borrowers. Finally, an intrinsic 

tension existed in charging private companies with a public mission; the GSEs, their regulators, and policymakers 

struggled to find a balance among the competing goals of 

maximizing profits for shareholders, maintaining the 

entities’ safety and soundness, and fulfilling the entities’ 

public mission. 

Adverse Consequences of the Implicit 

Federal Guarantee 

The federal government’s implicit guarantee of the debt 

and other obligations of Fannie Mae and Freddie Mac 

was at the root of several weaknesses of the precrisis 

model: The GSEs were able to acquire a substantial 

degree of market power, which in turn increased risk to 

the overall financial system (systemic risk); the entities 

had an incentive to take excessive risks; and the costs and 

risks to taxpayers and the economy were not apparent in 

the federal budget. (The implicit federal guarantee was 

made explicit when the government took over the two 

GSEs in 2008.)

Market Power 

Fannie Mae’s and Freddie Mac’s charters gave the GSEs 

advantages over other participants in the secondary market for conforming mortgages, including the perception 

of an implied federal guarantee on their obligations. 

Those advantages furnished the GSEs with market 

power—meaning that they could charge somewhat more 

for their guarantees than it cost to provide them, while 

still charging less than potential competitors that lacked 

those advantages. The GSEs’ most important advantage 

was the financial value of the implicit federal guarantee; 

that value has often been equated to a federal subsidy 

because it represents the cost to taxpayers of providing 

the guarantee. The subsidy lowered the cost to the GSEs 

of issuing debt and increased the value to investors of 

their guarantees on mortgage-backed securities. 

Precisely measuring the value of the federal subsidy—

or how it has been divided among shareholders, managers, and employees of the GSEs; mortgage borrowers; and 

other parties—is not possible. Nevertheless, studies by 

the Congressional Budget Office (CBO) and others 

have concluded that before conservatorship, the GSEs 

received significant federal subsidies, which grew over 

time and were not fully passed on to borrowers.1

 For 

example, CBO previously estimated that the annual federal subsidy of Fannie Mae and Freddie Mac totaled 

1. See Congressional Budget Office, Federal Subsidies and the Housing GSEs (May 2001); Wayne Passmore, “The GSE Implicit Subsidy and the Value of Government Ambiguity,” Real Estate 

Economics, vol. 33, no. 3 (2005), pp. 465–486; and Deborah 

Lucas and Robert McDonald, “An Options-Based Approach to 

Evaluating the Risk of Fannie Mae and Freddie Mac,” Journal of 

Monetary Economics, vol. 53 (January 2006), pp. 155–176. 
22 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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nearly $20 billion in 2003, about double the estimated 

subsidy in 2000. Of that $20 billion, just over $13 billion 

went to borrowers of conforming mortgages (in the form 

of slightly lower mortgage interest rates); the rest was 

retained by the GSEs’ shareholders, managers, and 

employees.2

 Using a different valuation approach (and 

based on the economic conditions prevailing in 2005), an 

academic study concluded that the government would 

have to have charged Fannie Mae and Freddie Mac an 

annual insurance premium of 0.2 to 0.3 percentage 

points to cover the federal cost of the implicit guarantee.3

That implicit guarantee allowed the GSEs to issue a large 

volume of unsecured debt securities. It also led investors 

to pay more for those securities, and for the GSEs’ credit 

guarantees on MBSs, than they would have for similar 

obligations that lacked federal support. Investors in the 

secondary market require greater capital backing in order 

for fully private guarantees to be perceived as safe, and 

putting that capital at risk is costly to private firms. Free 

of that need, Fannie Mae and Freddie Mac were able to 

charge fees in excess of their guarantee costs but below 

those of their competitors. That advantage allowed them 

to become the dominant players in the secondary market 

for conforming mortgages and to grow rapidly in other 

areas where they gained regulatory permission to operate, 

such as the markets for subprime and Alt-A securities.

Systemic Risk

Fannie Mae and Freddie Mac are restricted by law in the 

types of investments they can make for their portfolios 

and the types of mortgages they can guarantee. Although 

such restrictions limit their exposure to risk by controlling their growth and activities, the restrictions also 

limit their ability to reduce risk through diversification. 

(Fannie Mae and Freddie Mac could also try to reduce 

risk through the use of derivatives and other risk-sharing 

contracts, but they have chosen not to do so for the risk 

associated with their guarantees.) 

The GSEs’ lack of diversification, coupled with low levels 

of capital reserves prior to conservatorship, left them 

highly exposed to large, sudden changes in housing prices 

or prepayment rates. That exposure posed a risk to the 

larger financial system because the consequences of letting Fannie Mae or Freddie Mac fail could have been 

extremely damaging to the mortgage and housing markets—and, to a lesser extent, to investors in agency debt 

and MBSs.4

 Those investors include numerous U.S. 

banks and foreign central banks. Although banks are normally restricted in the amount of credit exposure to a 

given company they can take on (at least on their balance 

sheets), such limits do not apply to agency debt. If Fannie 

Mae or Freddie Mac defaulted on its obligations, the 

solvency of other financial institutions would be threatened. Moreover, the willingness of some other nations’ 

central banks to hold Treasury securities might suffer if 

they saw such a default as a signal of greater risk in Treasury obligations.

Incentives for Risk Taking

Fannie Mae and Freddie Mac were rewarded for taking 

risks because the riskiness of their operations had little 

effect on their credit costs and their access to the market. 

When times were good, the GSEs’ stakeholders received 

the gains in the form of higher profits on riskier investments, but when times were bad, taxpayers were left with 

the losses. 

That divergence was most apparent with the GSEs’ large 

portfolio holdings, which historically were highly profitable but also risky.5

 (In addition to credit risk, the mortgages held in their portfolios carried substantial interest 

2. Congressional Budget Office, Updated Estimates of the Subsidies to 

the Housing GSEs, attachment to a letter to the Honorable Richard 

C. Shelby (April 8, 2004). 

3. The fair premium rate rises with the GSEs’ ratio of debt to equity, 

which suggests that fair premiums would have been much higher 

after the decline in mortgage values that started in late 2007. See 

Deborah Lucas and Robert McDonald, “Valuing Government 

Guarantees: Fannie and Freddie Revisited,” in Lucas, ed., Measuring and Managing Federal Financial Risk (Chicago: University of 

Chicago Press, 2010), pp. 131–154. 

4. Gary H. Stern and Ron J. Feldman, Too Big to Fail: The Hazards of 

Bank Bailouts (Washington, D.C.: Brookings Institution, 2004). 

5. See the statement of Alan Greenspan, Chairman of the Federal 

Reserve Board, before the Senate Committee on Banking, Housing, and Urban Affairs, Government-Sponsored Enterprises (February 24, 2004), www.federalreserve.gov/boarddocs/testimony/

2004/20040224/default.htm; and Ben. S. Bernanke, Chairman 

of the Federal Reserve Board, “GSE Portfolios, Systemic Risk, 

and Affordable Housing” (remarks by satellite presented to the 

Independent Community Bankers of America Annual Convention and Techworld, Honolulu, Hawaii, March 6, 2007), 

www.federalreserve.gov/newsevents/speech/bernanke20070306a. 

htm. Also see Robert A. Eisenbeis, W. Scott Frame, and Larry D. 

Wall, “An Analysis of the Systemic Risks Posed by Fannie Mae and 

Freddie Mac and An Evaluation of the Policy Options for Reducing Those Risks,” Journal of Financial Services Research, vol. 31, 

no. 2 (April 2007), pp. 75–99. 
CHAPTER THREE FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 23

CBO

rate and prepayment risks that were only partially mitigated by hedging.)6

 Specifically, the implicit federal guarantee allowed Fannie Mae and Freddie Mac to finance 

their portfolio holdings by borrowing (issuing agency 

debt) at interest rates only slightly higher than those on 

Treasury securities. The GSEs realized earnings from the 

difference between the higher average returns on the 

mortgages they owned and the interest rate they paid on 

the agency debt they issued. Without a federal guarantee, 

increasing their portfolio risk would not have been profitable because the costs of new borrowing would presumably have risen commensurately with the increase in 

expected returns on their assets: Investors in agency debt 

would have required higher interest rates as Fannie Mae 

and Freddie Mac became riskier. 

Several factors made risk taking by the GSEs less likely to 

be detected and harder to evaluate. The implicit guarantee greatly reduced incentives for prospective investors in 

agency debt to monitor and discipline the GSEs’ risk taking and growth. In addition, the ability of investors and 

regulators to evaluate the riskiness of Fannie Mae and 

Freddie Mac was hindered because the GSEs were exempt 

from the Securities and Exchange Commission’s reporting requirements and more generally because their financial reporting was opaque. The GSEs’ extensive use of 

derivatives to manage interest rate and prepayment risk 

made it complicated to determine their risk exposure. 

The lack of transparency in their accounting for those 

activities, in particular, was a major reason that Fannie 

Mae and Freddie Mac had to restate their income and 

balance sheet positions in the mid-2000s. Such problems 

were not unique to the GSEs, however. The risk exposure 

of other large financial institutions also was not obvious 

to regulators or investors. 

Lack of Transparency in the Federal Budget

Because the federal subsidy arising from the implicit 

guarantee was not reflected in the federal budget, the size 

of the subsidy was less apparent to policymakers and the 

public. That omission also weakened the discipline of the 

budget process, which is designed to identify the costs of 

pursuing different policy goals.7

 As a result, carrying out 

housing policy goals through Fannie Mae and Freddie 

Mac appeared to be free, whereas providing similar assistance through on-budget programs could entail a cost. 

Even if the implicit guarantee had been accounted for in 

the budget, the reported subsidy might not have been a 

comprehensive measure of the guarantee’s cost to taxpayers. The Federal Credit Reform Act of 1990 (FCRA) stipulates that the cost shown in the budget for a federal loan 

guarantee be the discounted present value of the future 

stream of net payments projected to stem from that guarantee. FCRA specifies that interest rates on Treasury securities be used as discount rates in estimating present 

value, but use of those risk-free rates neglects the cost of 

market risk (the risk that defaults will occur most frequently in times of economic stress, when losses are most 

costly). Under FCRA, estimates of the budgetary impact 

of loans and loan guarantees are systematically lower than 

the fair value, or market value, of those loans and loan 

guarantees, which has the effect of making such federal 

support for housing appear cheaper than noncredit forms 

of support. (CBO projects the costs of Fannie Mae and 

Freddie Mac under conservatorship on a fair-value basis 

that includes the cost of market risk; for more details, see 

Box 1-1 on page 4.)8

Limited Effects on Affordable Housing

Their charters require Fannie Mae and Freddie Mac to 

provide ongoing assistance to the secondary mortgage 

market and to promote access to mortgage credit 

throughout the nation, including for low- and moderateincome families and residents of central cities. Subsequent legislation, the 1992 Federal Housing Enterprises 

and Financial Safety and Soundness Act, required the 

Department of Housing and Urban Development 

(HUD) to establish affordable-housing goals expressed in 

percentages of total housing units financed by Fannie 

Mae and Freddie Mac. 

6. Dwight Jaffee, “The Interest Rate Risk of Fannie Mae and Freddie 

Mac,” Journal of Financial Services Research, vol. 24, no. 1 (August 

2003), pp. 5–29, and “On Limiting the Retained Mortgage Portfolios of Fannie Mae and Freddie Mac” (paper prepared for the 

American Enterprise Institute conference “Should Fannie Mae’s 

and Freddie Mac’s Mortgage and MBS Portfolios Be Capped, 

Reduced, or Eliminated?” Washington, D.C., April 26, 2005), 

www.aei.org/docLib/20050426_Jaffeepaper.pdf.

7. For an analysis of how implied guarantees could be treated in the 

budget, see Marvin Phaup, “Federal Use of Implied Guarantees: 

Some Preliminary Lessons from the Current Financial Distress,” 

Public Administration Review (July/August 2009), pp. 651–659. 

8. Congressional Budget Office, letter to the Honorable Barney 

Frank about the budgetary impact of Fannie Mae and Freddie 

Mac (September 16, 2010). 
24 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

CBO

Since then, regulators have set annual targets for all mortgages and, beginning in 2005, separate goals for home 

purchases (as opposed to refinanced loans). Those goals 

apply to low- and moderate-income families (defined as 

those with income at or below an area’s median income), 

families who have very low income (no more than 60 percent of the area median), and underserved areas (generally 

census tracts with large percentages of low-income people 

or minorities). Since 2001, slightly more than half of the 

loans purchased or guaranteed by the GSEs have counted 

toward those goals. Regulators have also set targets for 

mortgages on affordable multifamily rental housing, 

expressed in fixed dollar volumes for low-income renters 

overall and for low-income renters living in poor neighborhoods. In pursuit of those targets, Fannie Mae and 

Freddie Mac purchase mortgages on multifamily rental 

properties—which account for about 10 percent of the 

housing units they finance—and issue multifamilyhousing MBSs. 

Although the GSEs have usually met or exceeded the 

affordable-housing goals set by regulators, it is unclear 

whether those goals are the most effective or efficient way 

to support housing for low- and moderate-income families.9

 The current approach has two principal drawbacks: 

 Mortgage purchases by the GSEs may not significantly 

increase home-ownership rates for low-income 

families. Mortgage purchases that satisfy the goals for 

low- and moderate-income borrowers help those borrowers by reducing the interest rates they pay and by 

making credit more available than it would be otherwise. But small reductions in interest rates have only 

marginal effects on rates of home ownership, in part 

because down payments appear to be a bigger obstacle 

for first-time buyers. Some research suggests that the 

GSEs have satisfied their affordable-housing goals 

without having any significant impact on home ownership among lower-income families.10 Assistance provided through the Federal Housing Administration 

and the Department of Veterans Affairs, which insure 

loans that have lower down-payment requirements, is 

likely to be more effective at increasing home 

ownership. 

 Mortgages for lower-income borrowers are generally 

riskier than those for higher-income borrowers. 

Because the larger federal subsidy implicit in buying 

riskier mortgages is not accounted for in the budget, it 

is not possible to assess whether the benefits of supporting such mortgages justifies the subsidy costs or 

the added risks to taxpayers and the financial system. 

Weak Regulation 

Since their inception, Fannie Mae and Freddie Mac have 

been regulated separately from other federally insured 

financial institutions. Their regulators—first HUD and 

later the Office of Federal Housing Enterprise Oversight—were equipped with relatively weak tools for controlling risk taking. Capital requirements for the two 

GSEs were set in statute rather than by regulation, and 

according to some measures, those requirements were 

more lax than for depository institutions. Moreover, regulators lacked the ability to put the GSEs into receivership, 

which is the mechanism that bank regulators use to begin 

to resolve failed institutions. The need for Congressional 

action in the event of insolvency reinforced the perception that the government stood behind Fannie Mae and 

Freddie Mac.11

The Housing and Economic Recovery Act of 2008 

strengthened the power of the GSEs’ regulator. It created 

the Federal Housing Finance Agency to oversee Fannie 

Mae, Freddie Mac, and the Federal Home Loan Banks. 

The agency was given the power to set requirements for 

minimum leverage and risk-based capital, receivership 

powers, and budgetary resources independent of the 

Congressional appropriation process. However, the 

incentives for prudent regulation may still be weakened 

by the agency’s dual responsibility to set and enforce 

affordable-housing goals.

Tensions Between Public and 

Private Purposes 

Before conservatorship, Fannie Mae and Freddie Mac had 

a responsibility as private companies to operate in the 

9. Federal Housing Finance Agency, The Housing Goals of Fannie 

Mae and Freddie Mac in the Context of the Mortgage Market: 

1996–2009, Mortgage Market Note 10-2 (February 1, 2010), 

www.fhfa.gov/webfiles/15419/.

10. Ron Feldman, “Mortgage Rates, Homeownership Rates, and 

Government-Sponsored Enterprises,” The Region, Federal Reserve 

Bank of Minneapolis, vol. 16, no. 1 (2002), pp. 4–24.

11. Richard Scott Carnell, “Handling the Failure of a GovernmentSponsored Enterprise,” Washington Law Review, vol. 80 (August 

2005), pp. 565–642. 
CHAPTER THREE FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 25

CBO

interest of their shareholders. At the same time, they were 

obligated to fulfill their public mission in return for the 

benefits conferred by their charters. The GSEs faced 

inherent tensions between those private and public objectives. Most notably, the implicit federal guarantee gave 

them an incentive to take excessive risk because it 

increased the expected returns to their shareholders at the 

expense of taxpayers. Tensions also arose between the 

need for prudent risk management and the affordablehousing goals set by regulators. Because those goals targeted lending toward borrowers who generally pose more 

risk than borrowers of traditional conforming mortgages 

do, they tended to work at cross-purposes with the safety 

and soundness goals of regulators.12

How the GSEs weighed those conflicting public and private purposes is unclear. For example, the affordablehousing goals could largely be satisfied by purchasing and 

guaranteeing mortgages of middle-income families, suggesting that those investments probably required little 

sacrifice of profits.13 However, recent research has found 

that loans that counted toward the housing goals had 

higher delinquency rates than loans that did not meet any 

of the goals, which implies that the GSEs accepted more 

risk in the process of meeting those goals.14 As another 

example, some analysts have attributed the GSEs’ 

purchases of subprime mortgages (and their subsequent 

losses) to the affordable-housing goals, but those purchases may also have been motivated by the desire for 

profits.15 In particular, subprime private-label MBSs generally contained a relatively high concentration of loans 

that met the affordable-housing criteria; however, such 

purchases by the GSEs were made on the same terms as 

those offered to other investors, so the GSEs did not 

expect to sacrifice profits when they made those 

purchases. 

To avoid encouraging excessive risk taking, the Federal 

Housing Finance Agency has proposed new rules that 

would not allow the GSEs to count purchases of privatelabel MBSs toward their housing goals. In addition, as 

required under HERA, the agency has proposed new 

housing goals that are designed to better target lowerincome households.16 More generally, some observers 

argue that it would be advantageous to separate policies 

designed to support liquidity in the broader secondary 

market from policies aimed at subsidizing the cost of 

mortgage financing for low- and moderate-income borrowers. One way to do that would be to expand FHA 

programs, whose subsidies are more visible because they 

appear in the budget.17

12. Some observers have argued that regulatory pressure to meet the 

affordable-housing goals exposed Fannie Mae and Freddie Mac to 

excessive credit risk that ultimately contributed to their large 

losses. More generally, those observers assert that the goals may 

have helped fuel the housing bubble by accommodating the 

increasing demand for housing. See, for example, Ross Levine, An 

Autopsy of the U.S. Financial System, Working Paper 15956 (Cambridge, Mass.: National Bureau of Economic Research, April 

2010), www.nber.org/papers/w15956. 

13. Neil Bhutta, GSE Activity and Mortgage Supply in Lower-Income 

and Minority Neighborhoods: The Effect of the Affordable Housing 

Goals (unpublished paper, 2009), which revised Bhutta, Regression 

Discontinuity Estimates of the Effects of the GSE Act of 1992, 

Finance and Economics Discussion Series Paper 2009-03 (Federal 

Reserve Board, November 2008). 

14. Robert S. Seiler Jr., “Affordable Housing Goals and the Performance of Single-Family Mortgages Acquired by Fannie Mae and 

Freddie Mac, 2004–2008” (presentation given at the FDIC/

Federal Reserve System symposium “Mortgages and the Future of 

Housing Finance,” Arlington, Va., October 25–26, 2010).

15. For a summary of the opposing views on that issue, see Peter J. 

Wallison and Charles W. Calomiris, The Last Trillion-Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac, Financial Services Outlook (Washington, D.C.: American Enterprise 

Institute, September 2008), www.aei.org/outlook/28704; and the 

statement of Franklin D. Raines, former Chairman and Chief 

Executive Officer of Fannie Mae, before the House Committee on 

Oversight and Government Reform, December 9, 2008. 

16. See the remarks by Edward J. DeMarco, Acting Director, Federal 

Housing Finance Agency, given at the Women in Housing and 

Public Policy Luncheon, Washington, D.C., February 18, 2010, 

www.fhfa.gov/webfiles/15411/.

17. See Dwight M. Jaffee and John M. Quigley, “Housing Subsidies 

and Homeowners: What Role for Government-Sponsored Enterprises?” in Gary Burtless and Janet Rothenberg Pack, eds., Brookings-Wharton Papers on Urban Affairs: 2007 (Washington, D.C.: 

Brookings Institution Press, 2007), pp. 103–149.

CHAPTER

CBO

4

Alternative Approaches for the Future of the

Secondary Mortgage Market

The cost to taxpayers of assisting Fannie Mae and 

Freddie Mac and continuing their operations under conservatorship—and the structural weaknesses that contributed to their financial problems—have prompted policymakers to consider various alternatives for the future 

federal role in the secondary mortgage market. Possible 

approaches vary widely in the degree of federal involvement in that market, ranging from a government-run 

program that would guarantee and securitize qualifying 

mortgages to a fully private secondary mortgage market. 

Any new approach would involve transitional issues, such 

as what to do with the operations, existing portfolios, and 

outstanding guarantee obligations of Fannie Mae and 

Freddie Mac. Although transitional issues are challenging 

and important, they are discussed only briefly in this 

study because their resolution is unlikely to affect the relative merits of the various approaches for the long-term 

organization of the secondary mortgage market.

In choosing policies for the future of the market, policymakers face a number of major design issues. Some 

approaches would involve federal credit guarantees. For 

those alternatives, design issues include how the guarantees would be structured (what types of borrowers, properties, and mortgage products would qualify for them); 

how the guarantees would be priced; and how much private capital would be required in order to limit the federal 

government’s exposure to risk. In addition, with any 

approach, policymakers would face the issue of how 

much, and by what means, federal intervention in the 

secondary market would be used to support affordable 

housing. Another broad issue is how the secondary market would be structured and regulated. For instance, if 

private entities securitized federally backed mortgages, 

would those entities consist of a small number of specialized and heavily regulated institutions, or would most 

large financial institutions be allowed to participate? 

For this analysis, the Congressional Budget Office examined three broad approaches to structuring the secondary 

mortgage market.1

 The first alternative was a hybrid 

public/private approach that would involve explicit 

federal guarantees of certain privately issued mortgagebacked securities. The second approach was the establishment of a fully federal agency that would purchase and 

guarantee qualifying mortgages. The third alternative was 

the promotion of a fully private secondary market with 

no federal guarantees. (For a summary of the main features of those approaches, see Table 4-1, which is the 

same as Summary Table 1.) To understand the relative 

strengths and weaknesses of those three broad options, 

CBO evaluated them against various criteria:

 How well would an approach promote a stable supply 

of financing for residential mortgages nationwide? 

 How effectively would it address affordable-housing 

goals?

 How well would taxpayers be protected from risk? 

 Would federal guarantees be fairly priced? 

 Would there be adequate incentives to control risk 

taking?

1. For other analyses of proposals for the future of that market, see 

Government Accountability Office, Fannie Mae and Freddie Mac: 

Analysis of Options for Revising the Housing Enterprises’ Long-Term 

Structures, GAO-09-782 (September 2009), www.gao.gov/

products/GAO-09-782; N. Eric Weiss, Options to Restructure 

Fannie Mae and Freddie Mac, CRS Report for Congress R40800 

(Congressional Research Service, September 17, 2009); and Ingrid 

Gould Ellen, John Napier Type, and Mark A. Willis, Improving 

U.S. Housing Finance Through Reform of Fannie Mae and Freddie 

Mac: Assessing the Options (New York: New York University, 

Furman Center for Real Estate and Urban Policy, May 2010), 

www.urban.org/publications/1001382.html.
28 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

CBO

Table 4-1. 

Key Features of Alternatives for the Secondary Mortgage Market

Source: Congressional Budget Office.

Note: MBSs = mortgage-backed securities.

CBO’s evaluation of the different approaches according 

to those criteria is summarized in Table 4-2 on page 30 

(which is the same as Summary Table 2). 

As a further alternative to those approaches, the government could encourage greater reliance on funding mechanisms that serve as partial substitutes for securitization, 

such as covered bonds (bonds collateralized by residential 

mortgages). Greater use of covered bonds is one of 

numerous ways in which mortgage financing in many 

other countries differs from that in the United States. 

This study discusses covered bonds briefly but does not 

examine that alternative in depth.

Managing the Transition to a 

New Approach

Any new model for the secondary mortgage market 

would necessitate a transition from the current operations 

of Fannie Mae and Freddie Mac under conservatorship, 

requiring decisions about how to manage the government-sponsored enterprises’ retained portfolios and 

Hybrid Public/Private Model Fully Federal Agency Fully Private Market

Existing operating assets 

of Fannie Mae and 

Freddie Mac 

Handed over to specialized issuers of 

federally backed MBSs (could be nonprofit, cooperative, or private firms), sold 

to private-label issuers, or liquidated

Used for operations of agency, 

sold to private-label issuers, or 

liquidated

Sold to private-label 

issuers or liquidated

Licenses to issue 

federally guaranteed 

MBSs 

Under “public-utility model,” only a few; 

under “competitive market-maker 

model,” available to any firm meeting 

specified criteria

None; operations undertaken 

by agency

None

Federal guarantees for 

loans or MBSs

Explicit, possibly covering only 

catastrophic risks

Explicit None (Phased out) 

Private capital’s role in 

secondary market

Absorbs most or all losses, except in 

cases of unusually large shocks

None on federally guaranteed 

securities; absorbs all losses 

on private-label securities

Absorbs all losses

Allowable activities for 

federally guaranteed 

securitizers

Under “public-utility model,” restricted 

to issuing MBSs and holding very limited 

portfolios; under “competitive marketmaker model,” restricted only enough to 

limit spillover of risk to government

Issuing guarantees and 

possibly holding portfolios of 

mortgages and MBSs

Not applicable

Support for affordable 

housing 

Could occur through terms on federal 

guarantees, fees on issuers of federally 

backed MBSs, or government agencies

Could occur through agency No special role; could 

occur through government agencies

Role of issuers of privatelabel MBSs Serve borrowers whose mortgages do 

not qualify for federal guarantees

Serve borrowers whose 

mortgages do not qualify for 

federal guarantees

Dominant players in 

secondary market, along 

with other private 

financial institutions
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 29

CBO

existing obligations and what to do with their operating 

assets. Those transitional issues are important to execute 

efficiently and without disruption to the secondary market, particularly because the housing market remains 

extremely weak and the private-label mortgage market 

has only barely reemerged. Nevertheless, how those issues 

are resolved would probably have little impact on the 

relative merits of the broad approaches for the long-term 

future of the secondary market discussed in this chapter.

At the end of September 2010, Fannie Mae and Freddie 

Mac had a total of $1.6 trillion of outstanding debt—

which (together with equity) financed the more than 

$1.5 trillion of mortgages, agency mortgage-backed securities, and private-label MBSs in their portfolios. In all, 

$3.9 trillion of MBSs guaranteed by the two entities were 

outstanding at the end of September. Their assets and 

obligations also include financial contracts entered into 

to reduce interest rate and prepayment risk. 

The GSEs expect sizable future losses on their guarantees 

and portfolio holdings in addition to the losses already 

recorded (as indicated by the negative fair value they 

report for equity in their financial statements). Whatever 

model is ultimately adopted for the future of the secondary mortgage market, those losses will largely be borne by 

taxpayers, because private investors would be unwilling to 

assume the GSEs’ liabilities without being compensated 

for the expected losses and for the uncertainty about the 

size of those losses. The government could pay a private 

entity to assume the GSEs’ guarantee obligations and sell 

off their portfolios, or it could choose to keep the existing 

portfolios and responsibility for the outstanding guarantees and allow both to run out as mortgages are paid off.

Liquidating the GSEs’ retained mortgage portfolios 

within a few years would probably not improve the government’s financial position and might well worsen it. 

Selling a large share of assets in a short period could 

drive down their prices significantly. Even liquidating the 

portfolios over a long period could involve considerable 

transaction costs. Hence, the strategy of holding most of 

the assets to maturity and managing the GSEs’ agency 

debt to minimize costs could involve the least expense for 

taxpayers. That strategy could be implemented, for 

instance, by keeping on the current employees of Fannie 

Mae and Freddie Mac to handle those responsibilities. 

Under such a strategy, as the mortgages in the GSEs’ 

portfolios were paid off, the government could retire 

an equal amount of agency debt; and as agency debt 

matured, it could be replaced with lower-cost Treasury 

securities as needed. (Another alternative would be to 

repurchase outstanding agency debt in the open market 

and replace it with Treasury issues. However, the government would probably have to pay a premium to repurchase a large portion of the agency debt, which could 

offset the potential savings from slightly lower interest 

rates on the Treasury securities.) Retaining rather than 

selling the $1.5 trillion of mortgage assets held in the 

GSEs’ portfolios would avoid depressing market prices 

for MBSs and avoid the transaction costs associated with 

complicated sales.

If the government instead wanted to actively reduce the 

GSEs’ portfolio holdings, how could it do so at the lowest 

cost to taxpayers and with the least disruption to financial 

markets? One alternative would be a so-called “good 

bank/bad bank” approach: The government would place 

assets that were high-risk, nonperforming, or hard to 

value (mainly private-label securities) into a “bad bank,” 

which the government would continue to own and control. At the same time, it would put the GSEs’ good assets 

(mainly MBSs guaranteed by the GSEs themselves) into a 

new and legally separate “good bank,” which could raise 

private capital more easily. Another option would be for 

the government to rely on public/private investment partnerships, in which the government would effectively 

retain most of the default risk in order to attract private 

capital. Those approaches bear some resemblance to the 

way in which the Federal Deposit Insurance Corporation 

resolves most bank failures: absorbing the losses on a 

failed bank’s nonperforming assets and finding a buyer 

(usually another bank) to acquire and operate the viable 

parts of the failed bank’s business. 

Beyond their portfolios and guarantee obligations, Fannie 

Mae and Freddie Mac have valuable operating assets, 

including origination and information systems and the 

specialized expertise of their employees. If the government decided to liquidate the GSEs, it could sell their 

systems to other financial institutions or incorporate 

those systems into a new federal agency. Alternatively, if 

the government pursued a fully private or hybrid public/

private approach to the secondary mortgage market, it 

could recapitalize Fannie Mae and Freddie Mac and sell 

them to investors as going concerns. 
30 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

CBO

Table 4-2. 

Key Factors for Assessing Alternatives for the Secondary Mortgage Market

Continued

Hybrid Public/Private Model Fully Federal Agency Fully Private Market

Supply of financing 

for mortgages

Under normal market conditions, 

the supply of funding for federally 

backed mortgages would be fairly 

stable. During periods of market 

stress, financing could become 

less available, especially under 

versions with narrower federal 

guarantees and more reliance on 

private capital.

The supply of funding for federally 

backed mortgages would be fairly 

stable—both in normal times 

and during periods of market 

stress—because uncertainty 

about the strength of the federal 

guarantee would be minimized.

The market would be more 

susceptible to fluctuations in the 

supply of funding. During periods 

of acute market stress, funding 

could become extremely scarce 

without federal intervention. 

Support for affordable 

housing

Mortgages that satisfied 

affordable-housing goals could be 

subsidized through lower federal 

guarantee fees, with the subsidy 

cost shown in the budget. Or 

responsibility could be 

transferred to a fully federal 

agency, such as the Federal 

Housing Administration.

Subsidies could be delivered by 

the agency and would be shown in 

the federal budget.

Responsibility would be 

transferred to a fully federal 

agency, such as the Federal 

Housing Administration, or 

subsidies would be discontinued. 

Taxpayers’ exposure 

to risk 

Intermediaries in the secondary 

market would bear all credit 

losses until their capital was 

exhausted, limiting the credit risk 

that taxpayers would face. 

If only a few specialized firms 

participated in the market, they 

might receive government 

support if their solvency was 

threatened. 

Taxpayers would bear the entire 

credit risk on guaranteed 

mortgages. 

Private-label issuers seen as 

critical to the functioning of the 

mortgage market might receive 

government support during 

periods of acute market stress.

Taxpayers’ exposure to credit risk 

would be very small under normal 

market conditions. Taxpayers 

could be exposed to greater risk 

through federal deposit insurance 

if banks bore more credit risk.

Firms seen as critical to the 

functioning of the mortgage 

market might receive government 

support during periods of acute 

market stress.

Pricing of federal 

guarantees

The government could have 

trouble fully pricing catastrophic 

risk or setting risk-sensitive 

prices, which would probably shift 

some cost to taxpayers. 

The government probably has 

weaker incentives than private 

guarantors do to charge fees that 

would fully compensate for the 

risks associated with guarantees, 

suggesting that taxpayers would 

probably bear a cost.

No explicit federal guarantees; 

however, any implicit federal 

guarantees that arose would be 

free to the private issuers of 

MBSs and hence would entail a 

cost to taxpayers.
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 31

CBO

Table 4-2. Continued

Key Factors for Assessing Alternatives for the Secondary Mortgage Market

Source: Congressional Budget Office.

Major Design Issues

Design choices that would arise under various approaches 

for the future of the secondary mortgage market include 

three major issues:

 How to structure and price any federal guarantees; 

 Whether to support affordable housing and, if so, by 

what means; and 

 How to structure and regulate the secondary market. 

The disruptions that occurred in the secondary market 

during the recent financial crisis suggest that some type of 

federal support may be necessary to ensure an uninterrupted flow of mortgage credit during times of acute 

financial stress. Federal intervention is costly, however. 

The costs and other effects of proposals that include federal guarantees depend critically on the design of those 

guarantees.

In terms of supporting housing for people with low or 

moderate income, the main design issues involve what to 

do about the GSEs’ current affordable-housing goals. 

Should the government maintain such goals? If so, should 

responsibility for pursuing them be transferred to some 

fully federal entity, such as the Federal Housing Administration, and funded with broad-based taxes? Or should 

Hybrid Public/Private Model Fully Federal Agency Fully Private Market

Incentives to control 

risk taking

The presence of federal 

guarantees would create an 

incentive for excessive risk 

taking. Limiting government 

guarantees and charging riskbased prices for them would 

reduce that incentive. In addition, 

private intermediaries would have 

an incentive to set risk-based 

prices and monitor risk taking. 

Having the government absorb 

all credit losses would create a 

strong incentive for excessive risk 

taking by originators. The government could counter that incentive 

by setting risk-based prices for 

guarantees and by restricting 

eligibility for guarantees to safer 

mortgages. Incentives to limit risk 

taking would probably be weaker 

than if private capital was in the 

position to absorb some losses.

Financial intermediaries would 

have a relatively strong incentive 

to manage risk, but it would be 

weakened if their obligations 

were seen as implicitly 

guaranteed by the government.

Other considerations Depending on the model 

implemented, government control 

over the secondary mortgage 

market could be greater or less 

than under the precrisis model.

Tensions between public and 

private purposes might remain, 

particularly under models with a 

small number of highly regulated 

intermediaries.

Subsidies could tilt the allocation 

of capital in the economy too far 

toward housing and away from 

other uses.

The government would control 

a large segment of the capital 

market.

The market would probably be 

less dynamic, and there would 

be less incentive for product 

innovation.

Tensions between public and 

private purposes would be 

minimized.

Subsidies could tilt the allocation 

of capital in the economy too far 

toward housing and away from 

other uses.

The government would regulate 

the secondary mortgage market 

but otherwise not intervene.

The market would not rely on 

the viability of any one firm or 

business model.

Tensions between public and 

private purposes would be 

minimized.
32 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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efforts to promote affordable housing be supported 

through taxes or mandates on institutions operating in 

the secondary market? 

Key issues related to the competitive structure of the market include what role private-label securitization would 

play and how it would be regulated; whether various regulatory advantages that the GSEs enjoy, such as access to 

the “To Be Announced” market (which lets mortgage 

originators lock in interest rates in advance), should be 

extended to other market participants or abolished; and, 

under a hybrid public/private approach, how many and 

what types of private entities would be allowed to create 

federally backed MBSs. 

Structuring Federal Guarantees

Explicit federal guarantees are one way to ensure a fairly 

stable supply of funding for the secondary mortgage 

market, and several of the proposals that CBO examined 

would rely on them. Federal guarantees could be attached 

to individual mortgages, to MBSs, or to other types of 

claims secured by mortgages that qualified for federal 

support. Unlike the implicit guarantees of the precrisis 

model, the subsidy cost of those explicit federal 

guarantees would be reported in the budget. Critical 

issues in designing federal guarantees include which 

mortgages (or other types of transactions) would qualify 

for a federal guarantee and how the price of the guarantee 

would be determined. For approaches that include a role 

for the private sector, another key issue is to what extent 

private capital would absorb losses. One way to proceed is 

to leave much of the credit risk with the private sector 

while having the federal government explicitly bear only 

the risk of catastrophic credit losses.

The Scope of Qualifying Mortgages. Mortgage products 

that qualified for a federal guarantee would tend to be 

more popular than ones that did not qualify; hence, the 

guarantee could be targeted in such a way as to encourage 

best practices by lenders. Some proposals involve limiting 

federal guarantees to fixed-rate mortgages of standard 

maturities and perhaps to certain types of adjustable-rate 

mortgages (ARMs). Other proposals would permit a 

wider range of products to be covered and new products 

to be introduced. Which types of mortgages are best for 

consumers is not obvious, however; a particular product 

may suit certain borrowers but not others. 

For instance, a 30-year fixed-rate mortgage offers borrowers who plan to stay in their current residence for many 

years the prospect of predictable payments and the 

opportunity to refinance if interest rates fall. However, 

those same features expose investors to considerable interest rate and prepayment risk. As a result, such mortgages 

are likely to bear higher interest rates and to be more susceptible to disruptions in supply than mortgages that are 

easier for investors to evaluate and price. Thus, for home 

buyers who expect to move in a few years (perhaps 

because of a new job or a shift to a different home), taking out a 30-year fixed-rate mortgage involves paying 

(through a higher interest rate) for protection against possible future rate increases that is not needed or desired. 

Certain adjustable-rate mortgages, which amortize over 

30 years but have an interest rate that is fixed for a shorter 

period, avoid some of those risks while also giving borrowers significant protection against changes in interest 

rates.2

A federal guarantee could cover a broad range of mortgages or be limited to a narrower set of products, property 

types, and borrowers in order to achieve specific goals. 

Stricter eligibility requirements for a federal guarantee 

would further the goals of limiting the government’s 

exposure to risk and focusing subsidies more narrowly on 

targeted groups. Such requirements would also give the 

private market a larger role in financing mortgages that 

did not qualify for a federal guarantee. (Ginnie Mae, the 

Federal Housing Administration, and the Department 

of Veterans Affairs could continue to play their current 

roles in assisting certain groups of borrowers.) For those 

reasons, some proposals call for limiting guarantees to a 

narrower range of mortgages than those now securitized 

by Fannie Mae and Freddie Mac. For instance, once the 

financial crisis is over, federal guarantees for high-balance 

loans could gradually be eliminated to give more scope 

to private markets and avoid providing subsidies to 

upper-income home buyers.3

 The government’s risk 

exposure could be reduced by tightening the definition 

2. One common example of such a product is a 5-1 ARM, which 

carries a fixed interest rate for the first 5 years and a floating rate 

for the next 25 years. Rate caps and floors limit the annual and 

lifetime changes in the interest rate. The fixed-rate period provides 

borrowers with predictable payments over a 5-year planning horizon, during which many of them plan to sell or refinance their 

home. 

3. The Housing and Economic Recovery Act of 2008 (Public Law 

110-289) allows the GSEs to guarantee loans that formerly would 

have been classified as jumbo mortgages and thus would have 

been ineligible for such guarantees.
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 33

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of conforming fixed- and adjustable-rate mortgages to 

exclude Alt-A loans, option ARMs (which give borrowers 

the right to decide how much principal and interest to 

repay), and other nontraditional mortgage products. 

Conversely, proponents of less stringent eligibility 

requirements worry that liquidity would be compromised 

if federal guarantees were limited to a narrow segment of 

the mortgage market. Some of those proponents want 

greater reliance on federal guarantees in order to establish 

consumer protections that apply as broadly as possible or 

to provide the benefits of such guarantees to a larger 

number of borrowers on a wider variety of products. 

The federal government could also guarantee other types 

of securities that financial institutions sell to fund mortgages, such as covered bonds. Although securities other 

than MBSs are widely used in other countries, they are 

much less common in the United States. CBO did not 

analyze such alternatives in depth, but covered bonds and 

other ways in which foreign countries support housing 

finance are discussed briefly at the end of this chapter. 

Pricing of Federal Guarantees. The government could 

cover some or all of its costs for a guarantee program by 

assessing fees on issuers or purchasers of MBSs that 

carried a federal guarantee. Those fees (like current 

guarantee fees) would be passed on to mortgage borrowers in the form of higher interest rates or up-front 

charges.

Government guarantee fees could be based on risk, with a 

higher premium attached to riskier mortgages. For example, fees might be lower for pools of fixed-rate mortgages 

and higher for pools containing ARMs, which historically 

have had higher default rates. Risk-based guarantee fees 

would provide an incentive for lenders to steer borrowers 

toward safer products. They would also minimize the 

extent to which safer borrowers would cross-subsidize 

riskier ones. In addition, the fee structure could be used 

to subsidize certain types of borrowers or mortgages to 

achieve affordable-housing goals. 

Experience with other federal guarantee and insurance 

programs suggests that the government seldom finely tailors premiums to risks.4

 Part of the reason is that the government has less incentive than private firms do to ensure 

that premiums cover costs because those costs are not 

fully reflected in the budget. The budgetary treatment of 

federal loans and loan guarantees, which is governed by 

the Federal Credit Reform Act of 1990, does not include 

the cost of market risk.5

 That budgetary treatment makes 

it difficult to identify and charge the full price of risk. 

(Exceptions to that treatment have been made in some 

cases, such as for the obligations that the government 

incurred under the Troubled Asset Relief Program.)6

 If 

market risk was incorporated into budgetary costs, the 

government might have a greater incentive to pass the 

cost of risk along to the beneficiaries of its guarantees, 

except in cases in which it explicitly chose to offer a credit 

subsidy. 

One way to have budget estimates incorporate the cost of 

the risk associated with government guarantees would be 

to report the fair-value cost of those guarantees. The fair 

value of a liability, such as a loan guarantee, usually corresponds to its market value. That value is defined as the 

price that would have to be paid to induce a participant 

in a well-functioning market to assume the liability. 

Thus, fair-value estimates include the cost of market risk. 

The prices of transactions in the private-label mortgage 

market—and the rates charged for private mortgage 

insurance—offer information about the value of mortgage guarantees that the government could use to infer 

the cost of providing federal guarantees.7

Risk Sharing Between the Public and Private Sectors.

When guarantees are made at the level of individual 

mortgages or on pools of mortgages, the government’s 

exposure to risk depends on the characteristics of the 

underlying loans (such as the maximum allowable loanto-value ratio). It also depends on the extent to which 

losses would first be absorbed by a layer of private capital 

or private mortgage insurance. 

4. See Congressional Budget Office, Federal Reinsurance for Disasters

(September 2002).

5. Market risk is the common component of risk that investors 

cannot protect themselves against by diversifying their portfolios. 

Investors require compensation for market risk because investments exposed to such risk are more likely to have low returns 

when the economy as a whole is weak and resources are highly 

valued.

6. Congressional Budget Office, Report on the Troubled Asset Relief 

Program—November 2010 (November 2010).

7. Other mechanisms that might help to provide price information 

include auctioning off the guarantees or buying private reinsurance for a portion of the government’s risk exposure.
34 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Providing federal credit guarantees fosters a more liquid 

secondary market, but it puts taxpayers at risk and weakens the incentive for intermediaries in the market to prudently control and price risk. To balance the objectives of 

protecting investors and promoting liquidity on the one 

hand, and of protecting taxpayers and strengthening 

incentives to manage risk on the other hand, most proposals for a hybrid public/private approach call for having 

private or nonprofit intermediaries retain a portion of the 

credit risk on federally guaranteed mortgages. In those 

proposals, most losses would be absorbed by private capital before the federal guarantee would be invoked. In 

addition, to accommodate borrowers who could not 

afford the down payment required to obtain a federal 

guarantee, some proposals would allow certain borrowers 

to buy private mortgage insurance.

In those cases, the capital held by financial institutions 

and the private mortgage insurance obtained by borrowers (together with borrowers’ down payments) could be 

the first lines of defense for the government against losses. 

Capital requirements could be based on risk, so that more 

capital would automatically be required when an institution took on greater risk. In addition, riskier mortgages 

could be required to carry higher amounts of private 

insurance. Although higher requirements for capital and 

mortgage insurance would reduce the probability of 

losses to the government, they would tend to increase 

mortgage interest rates. Setting those requirements would 

require policymakers to determine the appropriate balance of private costs and government risks. Under a wide 

range of alternatives, however, the government would be 

protected against small and moderate losses but would 

remain exposed to losses in the event of a large negative 

shock to housing prices nationwide.

Catastrophic Guarantees. Proposals that would leave 

much more credit risk with the private sector—but 

would stop short of relying on a purely private secondary 

mortgage market—would involve having the federal 

government explicitly bear only the systemic or catastrophic credit risk of the secondary market.8

 Some such 

proposals would attach insurance to pools of mortgages 

and have the government absorb losses only if many of 

the mortgages became delinquent. An alternative would 

be for the government to offer protection to investors in 

qualifying mortgages or MBSs only if total losses on such 

securities exceeded a threshold level or if housing prices 

nationally fell by more than a fixed percentage. The government uses the catastrophic-risk approach to reinsure 

commercial properties against the risk of terrorism, and 

similar proposals have been made for federal reinsurance 

against the risk of natural disasters.9

 Nevertheless, some 

investors might be willing to purchase only securities that 

were guaranteed against all credit losses. To meet the 

demand for safe securities, private mortgage insurance 

and other private guarantees would be expected to absorb 

any noncatastrophic losses. 

Limiting government insurance to catastrophic risk 

would address a specific problem—that the private secondary mortgage market has trouble providing liquidity 

during periods of acute financial stress. A narrow guarantee would avoid exposing taxpayers to losses from isolated 

defaults caused by poor risk management or fraud. One 

rationale for having an explicit federal guarantee of catastrophic losses is that, otherwise, investors might assume 

that an implicit guarantee existed, even if the secondary 

mortgage market was completely privatized. Making a 

catastrophic guarantee explicit and charging for it could 

give the government a smaller role than in the past. An 

explicit guarantee with risk-based pricing would also 

reduce the moral hazard associated with implicit guarantees by making the cost of debt financing sensitive to the 

riskiness of a mortgage.10

A drawback of coverage for catastrophic risk is that if it 

applied only to very large and unlikely events, investors 

might not believe that the government would be able to 

avoid bailouts for smaller events. In other words, they 

might believe that an implicit guarantee remained under 

certain noncatastrophic circumstances. At the same 

time, the lack of an explicit guarantee would make the 

mortgage market less liquid during normal times than if a 

8. Statement of James B. Lockhart III, Director, Federal Housing 

Finance Agency, The Present Condition and Future Status of Fannie 

Mae and Freddie Mac, before the Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises of the 

House Committee on Financial Services, June 3, 2009. 

9. Kent Smetters and David Torregrosa, Financing Losses from 

Catastrophic Risks, Hamilton Project Discussion Paper 2008-03 

(Washington, D.C.: Brookings Institution, June 2008), 

www.brookings.edu/papers/2008/06_risks_smetters.aspx. 

10. Moral hazard is the incentive for parties that are insured, whether 

implicitly or explicitly, to take greater risks because they no longer 

bear the full costs of their actions. See Joseph E. Stiglitz, “Risk, 

Incentives, and Insurance: The Pure Theory of Moral Hazard,” 

Geneva Papers on Risk and Insurance, vol. 8, no. 26 (January 

1983), pp. 4–33. 
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 35

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broader explicit guarantee existed. In particular, MBSs 

would be harder to value because they would become 

more diverse in terms of their risk: If the government’s 

guarantees were triggered by total losses for all residential 

loans or by national declines in housing prices, an investor’s losses on any particular mortgage instrument would 

depend mainly on the strength of the protection provided 

by private institutions. As a consequence, less sophisticated investors might find the risk exposure too difficult 

to assess and leave the MBS market. 

Support for Affordable Housing 

A variety of proposals exist for the future role that institutions in the secondary mortgage market would play in 

supporting low- and moderate-income housing. Under 

approaches that include a significant role for the private 

sector, a fundamental question is whether to continue 

relying on targets set for firms by regulators, as under the 

precrisis model, or whether to transfer responsibility to 

fully federal entities, such as the FHA. A related issue is 

whether support for affordable housing would be paid for 

through general revenues, fees charged to institutions 

securitizing federally guaranteed mortgages, or mandates 

on those institutions to force them to cross-subsidize 

mortgage guarantees.

Proponents of transferring the affordable-housing responsibilities of Fannie Mae and Freddie Mac to a federal 

agency such as the FHA assert that such an approach 

would lead to greater transparency and government control of subsidies. However, opponents argue that federal 

agencies do not have expertise in certain areas of the market where the GSEs play an important role—particularly 

the market for rental housing—and that a federal agency 

would probably be less flexible and less able to serve borrowers’ evolving needs. Their preference would be to have 

those functions remain at least partly the responsibility of 

private financial institutions.

Under a hybrid public/private approach with explicit federal guarantees, an alternative to transferring responsibility for affordable-housing activities to a federal agency 

would be for the government to target assistance toward 

affordable housing by subsidizing guarantees in certain 

circumstances or by setting the eligibility criteria for guarantees in particular ways. For example, guarantee fees 

could be subsidized for mortgages on multifamily rental 

housing. Alternatively, if giving additional support to 

first-time home buyers was a policy objective, it could be 

accomplished by lowering guarantee fees or decreasing 

down-payment requirements for such borrowers. Or the 

government could allow institutions that issued federally 

insured MBSs to buy mortgages made to low- and 

moderate-income borrowers that might not otherwise 

meet their criteria. 

If subsidies for affordable housing were delivered through 

explicit federal guarantees, the subsidy costs would 

appear in the budget and would have to be funded 

through higher revenues, reductions in other spending, 

or federal borrowing. (In contrast, under the precrisis 

model, the GSEs’ affordable-housing activities were effectively funded through the financial advantage generated 

by the government’s implicit guarantees—whose costs 

were not included initially in the federal budget but have 

become apparent in the past few years.) Higher revenues 

could come from increases in general tax revenues or, 

alternatively, from fees assessed on financial intermediaries.11 Broad-based taxes tend to be less distorting and 

hence preferable in terms of economic efficiency, 

although special assessments on financial institutions 

might be justified as compensation for benefits received 

from the government. 

Structure and Regulation of the 

Secondary Market 

Under any of the approaches discussed in this chapter, 

private intermediaries would continue to play an important role in the secondary mortgage market. Even if Fannie Mae and Freddie Mac were replaced by a federal 

agency, the private-label MBS market would most likely 

remain an important source of funding for mortgages 

that were ineligible for federal support. The recent financial crisis exposed various weaknesses of the private-label 

market, which suggests that changes in the regulation of 

that market might be appropriate to improve liquidity, 

stability, and transparency. (For a description of the 

private-label market, see Box 4-1.) 

Approaches that would replace Fannie Mae and Freddie 

Mac with private intermediaries would also have to 

address whether and how to preserve or replace the “To 

Be Announced” market. A related issue would be whether 

to make other regulatory benefits of the agency MBS 

market available to private intermediaries. (For more 

information about those issues, see Box 4-2 on page 38.)

11. The Housing and Economic Recovery Act of 2008 included a 

similar approach, but regulators stopped charging the fees when 

Fannie Mae and Freddie Mac experienced losses. 
36 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Continued

For a hybrid public/private approach, critical design 

issues involving the structure of the secondary mortgage 

market include how many and what types of intermediaries would exist and what activities they would be permitted to engage in. Proposals range from licensing a small 

number of highly regulated private entities to package 

and sell federally guaranteed MBSs (known as the publicutility model) to letting any private financial institution 

that met certain regulatory restrictions create and sell federally guaranteed MBSs (the competitive market-maker 

model). Each of those market structures would have 

distinct benefits and drawbacks.

Public Utilities Versus Competitive Market Makers Under 

a Hybrid Approach. In the public-utility model, the creation of federally insured MBSs would be carried out by 

one or a small number of specialized, possibly nonprofit, 

institutions. The MBS operations of Fannie Mae and 

Freddie Mac could be transferred to those new entities. 

The federal government would be protected from default 

losses by the entities’ capital and possibly by private mortgage insurance. Other financial institutions would operate the private-label MBS market; they would securitize 

products, such as jumbo mortgages, that did not carry 

federal backing, subject to some government regulation. 

Box 4-1.

The Market for Private-Label Mortgage-Backed Securities 

Before the recent financial crisis, many mortgage 

originators relied on the private-label market to provide funding for certain mortgages—such as jumbo, 

subprime, and Alt-A loans—that are nonconforming, 

or ineligible for purchase by a government-backed 

entity. At its peak, the private-label market represented about 20 percent of outstanding mortgage 

credit and nearly 40 percent of new originations. 

During the financial crisis, however, concerns were 

raised about certain products and practices, and 

investors shied away from private-label mortgagebacked securities (MBSs); as a result, origination 

activity in that market ceased. Many observers believe 

that the private-label MBS is likely to reemerge as an 

important means of financing mortgages that do not 

qualify for federal backing. 

Protecting most investors from credit risk is generally 

considered necessary to maintain a highly liquid securitization market. Besides credit protection, other features that are probably essential in order for securitization to provide a stable source of private capital 

include transparent information about the structure 

of an MBS and its underlying mortgages, and the 

ability of investors who are left holding the risk to 

properly assess and manage it.1

 Because MBS issuers 

may be able to profit when they have information 

about the underlying mortgages that potential buyers 

do not, regulations that promote adequate disclosures 

by issuers can also improve the functioning of the 

market.

Traditionally, credit protection has been achieved in 

the private-label MBS market by using a “multiclass,” 

or “subordination,” structure in which credit risk is 

concentrated in securities held by a group of investors 

who are willing to assume that risk in exchange for 

higher expected returns. More generally, each class of 

securities (known as a tranche) has a different priority 

claim to the cash flows on the underlying pool of 

mortgages. The safest securities are paid off first and 

usually qualify for top credit ratings. (Private mortgage insurance or other third-party guarantees may 

be used to reduce risk and obtain higher ratings.) The 

riskiest tranches are the subordinated securities that 

are exposed to losses from missed payments of principal and interest. MBS issuers frequently retain the 

riskiest tranches of multiclass securities, which gives 

them an incentive to understand and properly price 

the risk associated with the mortgage pool. The 

1. Ben S. Bernanke, “The Future of Mortgage Finance in the 

United States” (speech given at the University of California 

symposium “The Mortgage Meltdown, the Economy, and 

Public Policy,” Berkeley, Calif., October 31, 2008), 

www.federalreserve.gov/newsevents/speech/

bernanke20081031a.htm.
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 37

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Some proposals call for implementing the public-utility 

model by setting up cooperatives—owned by banks and 

other mortgage originators—that could act as conduits to 

the capital markets, securitizing federally guaranteed 

mortgages purchased from member institutions.12 That 

approach shares some features with the Federal Home 

Loan Bank system, but it differs critically in that federal 

guarantees would be explicit rather than implicit and

capital would be raised through securitization rather than 

collateralized advances. (For more about the mortgage 

activities of the Federal Home Loan Banks, see 

Appendix B.) 

Under the public-utility model, the activities of the small 

number of institutions dealing in federally backed 

mortgages or MBSs would be regulated fairly tightly. 

Regulators would oversee the structure and pricing of any 

private mortgage insurance, approve new mortgage products, establish capital requirements, and possibly set a target rate of return on equity. Under most proposals of this 

type, the institutions would not hold and manage large 

Box 4-1. Continued

The Market for Private-Label Mortgage-Backed Securities 

benefit of such complex structures is that the securities in each tranche can be tailored to match the risk 

preferences of different types of investors, lowering 

the overall cost of mortgage financing. Complexity 

has drawbacks, however: It reduces transparency, 

complicates the renegotiation of contracts, and can 

distort incentives for prudent risk management.

Changes in the market may be necessary in order for 

private-label securitization to reemerge strongly and 

for investors to regain confidence in the market.The 

American Securitization Forum, which represents 

market participants, has launched an initiative to 

improve the standardization and transparency of disclosures about the characteristics of the individual 

loans in mortgage pools. It is also focusing on 

improving the accuracy and reliability of the representations and warranties on loan originations, which 

are critical to the assurances provided to investors 

about underwriting practices.2

 Moreover, the recently 

enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203) contains 

provisions that will require most securitizers to retain 

5 percent of the credit risk on an MBS. That requirement will improve incentives for strong credit underwriting, but it could discourage participation in the 

private-label market. Separately, some observers attribute the slow reemergence of that market in part to 

the fact that regulators have increased the size limits 

for loans that Fannie Mae and Freddie Mac are 

allowed to purchase. Restoring lower loan limits 

could encourage more private-label activity. 

Analysts have also suggested changing the contractual 

structure of private-label MBSs because the complexity of those structures made some securities hard to 

value and difficult to compare with other MBSs. No 

consensus exists on that point, however.3

 Less complex structures—in the form of fewer but larger 

tranches—could also have the benefit of improving 

liquidity. Whether such changes will occur and be 

maintained on their own or whether additional regulation would be desirable to create a more stable market is an open question that is beyond the scope of 

this study. 

2. Statement of George P. Miller, Executive Director, American 

Securitization Forum, before the Subcommittee on Securities, Insurance, and Investment of the Senate Committee on 

Banking, Housing, and Urban Affairs, October 7, 2009. 

3. Randall S. Kroszner, “Improving the Infrastructure for NonAgency Mortgage-Backed Securities” (speech given at the 

Federal Reserve System Conference on Housing and Mortgage Markets, Washington, D.C., December 4, 2008), 

www.federalreserve.gov/newsevents/speech/

kroszner20081204a.htm.

12. Toni Dechario and others, A Private Lender Cooperative Model for 

Residential Mortgage Finance, Staff Report 466 (Federal Reserve 

Bank of New York, August 2010), www.ny.frb.org/research/

staff_reports/sr466.pdf. 
38 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Box 4-2.

Preserving the TBA Market and Other Regulatory Features of the 

Status Quo

Most mortgage-backed securities (MBSs) guaranteed 

by Fannie Mae and Freddie Mac are initially sold in 

the “To Be Announced” (TBA) market, which is currently not subject to regulation by the Securities and 

Exchange Commission (SEC). The TBA market is a 

“forward” market in which lenders promise to deliver 

in the future—generally, in 30, 60, or 90 days—a 

package of loans with preset interest rates that qualify 

for an agency guarantee (one by a government entity 

such as Fannie Mae, Freddie Mac, or Ginnie Mae). 

The TBA market enables lenders to lock in interest 

rates for mortgage borrowers in advance at a relatively 

low cost. That ability encourages participation in the 

agency MBS market and thus enhances liquidity.1

Under current law, the TBA market appears to exist 

only because Fannie Mae and Freddie Mac are 

exempt from the SEC’s regulations and disclosure 

requirements. Other participants in the secondary 

mortgage market must register their MBSs. Such 

private-label securities are not eligible to be traded in 

the TBA market; doing so would most likely violate 

the SEC’s Regulation AB, which requires that information about the assets underlying an asset-backed 

security be available to investors at the time of purchase. In the TBA market, loan pools have not yet 

been assembled, and the underlying loans may not 

have been originated, which would make it difficult 

or impossible to meet those disclosure requirements. 

Consequently, if policymakers wanted to preserve the 

TBA market in the absence of Fannie Mae and Freddie Mac, the SEC might need to reduce disclosure 

requirements for privately issued MBSs that carried 

qualifying government guarantees. A rationale for the 

two entities’ exemption from those requirements is 

that agency securities are extremely homogeneous in 

terms of credit risk, and hence no disclosures about 

specific mortgages are necessary.2

 Mortgages that 

were fully guaranteed by the federal government 

would probably be similarly homogeneous, which 

could justify relaxing disclosure requirements.3

As an alternative to the TBA market, mortgage 

originators could use interest rate futures markets to 

reduce their exposure to changes in interest rates 

when they lock in rates for potential borrowers, 

although that option would be more expensive and 

riskier for originators. Currently, the most active 

interest rate futures markets are for Treasury bonds. 

Such markets provide only partial protection to 

mortgage originators because Treasury rates and 

mortgage rates are closely related but do not move in 

lock step. It is possible, however, that in the absence 

of the TBA market, new futures markets would 

develop that would better meet the needs of originators to hedge against changes in interest rates. 

MBSs guaranteed by Fannie Mae, Freddie Mac, and 

Ginnie Mae enjoy a number of other regulatory 

advantages. They are eligible to be purchased by the 

Federal Reserve in its open-market operations and to 

serve as collateral for Federal Reserve Bank discount 

loans. In addition, most banks and thrifts can hold 

unlimited amounts of such securities. Those benefits 

help broaden the market for agency MBSs and 

increase their liquidity. Under any future approach 

that included federal guarantees, policymakers might 

wish to retain some of those advantages for securities 

backed by federally guaranteed mortgages. 

1. James Vickery and Joshua Wright, TBA Trading and Liquidity in the Agency MBS Market, Staff Report 468 (Federal 

Reserve Bank of New York, August 2010), www.ny.frb.org/

research/staff_reports/sr468.pdf. 

2. Toni Dechario and others, A Private Lender Cooperative 

Model for Residential Mortgage Finance, Staff Report 466 

(Federal Reserve Bank of New York, August 2010), pp. 4–7, 

www.ny.frb.org/research/staff_reports/sr466.pdf. For an analysis of issues involving Fannie Mae, Freddie Mac, and SEC 

regulation, see Congressional Budget Office, Effects of Repealing Fannie Mae’s and Freddie Mac’s SEC Exemptions (May 

2003), p. 13. 

3. However, some observers argue that the disclosure requirements on Fannie Mae and Freddie Mac are inadequate 

because the quality of their MBSs varies considerably, and the 

lack of disclosure has allowed them to profit by retaining the 

more desirable securities in their portfolios and selling the 

less profitable ones to investors. 
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 39

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portfolios of mortgages. They would, however, be 

allowed to hold a small number of mortgages to support 

their securitization activities—to form pools of mortgages 

for securitization, to manage losses through foreclosure or 

loan modification, and possibly to let investors observe a 

short payment history on mortgages before the entities 

issued securities backed by those loans. With limited 

portfolios, the new entities would have much less need to 

issue debt and manage interest rate and prepayment 

risk—and taxpayers’ potential risk exposure would be 

lower—than under the precrisis model. 

The competitive market-maker model, by contrast, 

would allow a larger number of private financial institutions to form the backbone of the secondary market. 

Those private institutions would issue federally insured 

MBSs as well as operating in the private-label MBS market. This model differs from the public-utility model in 

two main ways. First, more types and greater numbers 

of financial institutions would be eligible to participate. 

Second, competitive forces rather than regulation would 

be the major determinant of structure and pricing in the 

secondary market. 

The competitive market-maker model would permit any 

financial institution that met specific regulatory criteria, 

such as capital requirements and restrictions on certain 

activities, to issue and administer federally guaranteed 

MBSs. Likely participants would include the large commercial and investment banks that already have expertise 

in securitizing mortgages in the private-label and commercial real estate markets. Under this model, Fannie 

Mae and Freddie Mac could be reprivatized (with the 

government retaining liability for losses on their existing 

business) and then could compete on a level playing field 

with other intermediaries in the market to issue MBSs. As 

in the public-utility model, the capital of the intermediaries and possibly private mortgage insurance would absorb 

most credit losses; the federal guarantee would be called 

on only in the event of unusually large losses. (For further 

discussion of the shared and contrasting features of those 

two models, see Box 4-3.)

Evaluating the Trade-offs of Different Competitive 

Structures. Both the public-utility and the competitive 

market-maker models have certain benefits and drawbacks. An argument offered in favor of a public-utility 

model is that a nonprofit intermediary could create a 

more level playing field for mortgage originators, facilitating broad access to the secondary market. Guarantees 

would be more homogeneous than with a large number 

of intermediaries, which would increase the liquidity of 

MBSs. Nonprofit entities might also have less incentive 

to take risk than for-profit firms do. Limiting intermediaries to a few core activities would make them relatively 

transparent and straightforward to regulate. 

The public-utility model also has some drawbacks 

compared with the competitive market-maker model. 

Secondary-market entities whose only business was securitizing federally backed mortgages would have an undiversified exposure to mortgage credit risk. That exposure 

would leave them more susceptible to moderate-sized 

shocks in the housing market than they would be if they 

could diversify into non-housing-related assets. In addition, having only a few large intermediaries that were 

essential to the functioning of the secondary market 

could recreate the “too big to fail” problem of Fannie Mae 

and Freddie Mac, even if federal guarantees were limited 

by law. 

Moreover, under the public-utility model, stakeholders in 

the cooperative or nonprofit entities serving as utilities 

might have conflicting interests that would make governance more difficult than for private firms. For instance, 

in a cooperative, the interests of large and small members 

can diverge. Nonprofits (like government agencies) may 

have weaker incentives than private-sector institutions do 

to control costs and risks and to innovate. Another concern is “regulatory capture”—over time, regulators may 

become more responsive to the goals of the regulated 

firms than to the interests of the general public.13 That 

situation can occur if firms successfully use their political 

influence to have friendly regulators appointed or if the 

regulators need to rely heavily on the technical expertise 

of the regulated firms. 

Conversely, investors might not believe they would be 

allowed to earn a sufficiently high rate of return on their 

capital, in which case intermediaries operating under the 

public-utility model might have difficulty attracting 

enough private capital. The outcome would depend 

partly on the capital requirements and other rules 

governing the new entities’ activities and rates of return, 

which in turn would depend on a new and untested regulatory structure. Finally, if the new entities were allowed 

13. George Stigler, “The Theory of Economic Regulation,” Bell 

Journal of Economics and Management Science, vol. 2 (Spring 

1971), pp. 3–21. 
40 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Continued

Box 4-3.

Comparing the Public-Utility Model with the Competitive 

Market-Maker Model

Hybrid public/private models for the future of the 

secondary mortgage market include having a limited 

number of specialized firms issue federally guaranteed 

mortgage-backed securities (the so-called publicutility model) or having a larger number of morediversified financial institutions issue such securities 

(the competitive market-maker model). Although the 

specifics of individual proposals vary significantly, in 

general those two models take a similar approach to 

several issues: the design of federal credit guarantees, 

support for affordable housing, and the future roles 

of Fannie Mae and Freddie Mac. In addition, under 

both models, private firms would continue to provide 

financing for mortgages that were ineligible for federal guarantees through the private-label market or 

other means. Significant differences between the two 

models involve the organization of the industry: the 

number of firms operating in the secondary market, 

permissible lines of business, and the role of regulation relative to competition.

Shared Features

Both the public-utility model and the competitive 

market-maker model represent a mix of public and 

private elements. In each case, private firms would 

securitize mortgages that qualify for a federal 

guarantee. 

Guarantees. Under both models, the federal government would provide an explicit guarantee for qualifying mortgage-backed securities (MBSs) issued by 

private firms. In return, it would receive a guarantee 

fee that could depend on the risk characteristics of 

the mortgages. To protect the government against 

most losses, and to create appropriate incentives to 

control risk, private institutions would provide 

backing through private capital, private mortgage 

insurance, and some amount of risk retention by loan 

originators. The federal guarantee could be attached 

to MBSs or to individual loans. Alternatively, federal 

guarantees could be limited to protecting investors 

against catastrophic losses, in which case federal payouts would occur only if total default rates exceeded 

some threshold. In either case, the guarantees would 

not apply to the issuer’s corporate debt or equity. 

Affordable Housing. The main ways in which the 

government would support affordable housing 

through the secondary mortgage market would be via 

choices about the types of mortgages that would be 

eligible for a federal guarantee and the size of federal 

guarantee fees that would be charged. Secondarymarket firms could be encouraged to purchase certain 

types of mortgages by subsidizing federal guarantees, 

such as on MBSs composed of mortgages on multifamily rental housing; those subsidies would appear 

in the federal budget. Alternatively, guarantee fees 

could be set to cover the full cost of the guarantees, 

and responsibility for affordable housing could be 

assigned to a fully federal agency, such as the Federal 

Housing Administration. 

Roles of Fannie Mae and Freddie Mac. At least initially, hybrid models envision that Fannie Mae and 

Freddie Mac would continue, either separately or as a 

single entity, to administer federal guarantees and 

securitize federally guaranteed mortgages. The presence of those government-sponsored enterprises 

(GSEs) would reduce concerns about the transition 

to a new approach and possibly reassure global investors. Eventually, either the GSEs’ operations would 

be folded into a new entity (under the public-utility 

model) or the GSEs would be restructured as private 

financial institutions that would compete on a level 

playing field in the secondary market (under the 

competitive market-maker model). 
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 41

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to maintain sizable mortgage portfolios funded by issuing 

debt (which many observers recommend against), and 

if either an explicit or implicit federal guarantee applied 

to that debt, the entities would face less pressure from 

investors to limit their risk taking. 

An argument in favor of the competitive market-maker 

model is that increasing the number of participating 

financial institutions, and relying primarily on private 

ones, would most likely reduce systemic risk relative to 

both the precrisis model and the public-utility model by 

spreading mortgage credit risk more widely among morediversified institutions. That approach would also foster 

competition, which could help ensure that the benefits of 

federal support went to mortgage borrowers rather than 

to shareholders or employees of financial intermediaries. 

Box 4-3. Continued

Comparing the Public-Utility Model with the Competitive 

Market-Maker Model

Contrasting Features 

The public-utility model would retain much of the 

structure under which Fannie Mae and Freddie Mac 

operated before the recent financial crisis, whereas the 

competitive market-maker model would allow for 

broader participation of financial institutions and 

generally feature less government regulation. 

Number of Secondary-Market Firms. Under the 

public-utility model, the government would charter a 

very limited number of firms to securitize qualifying 

mortgages, whereas under the competitive marketmaker model, a potentially unlimited number of 

firms would be allowed to compete for that business. 

The main barrier to participation under the competitive market-maker model is that firms would have to 

meet capitalization standards and other restrictions 

set by regulators. In theory, most large commercial 

and investment banks and some medium-sized banks 

could issue federally backed MBSs.

Permissible Lines of Business. The public-utility 

model would create firms whose sole business would 

be to securitize qualifying mortgages. The competitive market-maker model would allow diversified 

financial firms to participate in the market. 

Firms that specialize in residential mortgages are 

more vulnerable to shocks to the housing market 

than more-diversified financial institutions are. The 

public-utility model would attempt to lessen vulnerability to fluctuations in the housing market through 

tougher capital standards and strict limits on the 

mortgage portfolios retained by the new entities. 

Essentially, the entities would hold mortgages mainly 

for warehousing purposes while they assembled mortgage pools. (Limited holdings of mortgages on multifamily housing could also be permitted.) 

In contrast, the competitive market-maker model 

would allow diversified financial firms to create subsidiaries that would issue federally guaranteed MBSs. 

It would also permit (but not encourage) those institutions to hold mortgages in their portfolios. Greater 

diversification would mean that those firms would be 

less vulnerable to shocks to the housing market. At 

the same time, however, losses on business by other 

parts of a firm might spill over and pose risks to taxpayers by absorbing some or all of the capital set aside 

in case of losses on the firm’s mortgage business. 

Regulation. Under both models, the government 

would set regulations for the safety and soundness of 

participating firms and the types of mortgages eligible 

for a federal guarantee, but the public-utility model 

generally envisions greater regulatory oversight. 

Additional regulation would be necessary under that 

model because, otherwise, the limited number of 

charters would allow the secondary-market entities to 

capture a large share of the benefits and price guarantees above a fair-market value. The public-utility 

model would have regulators set guarantee fees and 

the target profit levels. The competitive marketmaker model, in contrast, would rely on the market 

to set guarantee prices and limit profits to competitive levels. 
42 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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In addition, the greater competitive pressure could 

increase the likelihood of reliance on risk-based pricing 

and encourage innovation. Finally, liquidity in the 

broader mortgage market could be improved if the competitive market-maker model led to greater integration 

between the markets for private-label and federally 

backed MBSs.

The competitive market-maker model also has disadvantages relative to the public-utility model. Some observers 

have raised concerns that smaller originators might have 

trouble gaining access to the secondary market if large 

private intermediaries were unwilling to buy mortgages 

from them, although competitive pressures would tend to 

mitigate such problems. Depending on how MBSs were 

structured, securities issued by different institutions 

might not be viewed as interchangeable, even with a federal guarantee, in which case liquidity advantages would 

be reduced and mortgage borrowers’ costs would rise. 

Allowing broad participation in the secondary market 

might also increase taxpayers’ exposure to risk. Even if 

participants in the market were subject to capital requirements designed to absorb most of the risk of mortgage 

guarantees, spillovers from their other lines of business 

could pose additional risks to taxpayers.

A Hybrid Public/Private Model

Many proposals for the secondary mortgage market 

involve a hybrid approach with a combination of private 

for-profit or nonprofit entities and federal guarantees on 

qualifying MBSs. At its core, the hybrid public/private 

approach would preserve many features of the way in 

which Fannie Mae and Freddie Mac have operated, with 

federal guarantees (combined with private capital and 

private mortgage insurance) protecting investors against 

credit risk on qualifying mortgages. However, most 

hybrid proposals would differ from the precrisis operations of Fannie Mae and Freddie Mac in several important ways: A possibly different set of private intermediaries would participate in securitizing mortgages backed by 

federal credit guarantees, the guarantees would be explicit 

rather than implicit, and their subsidy cost would be 

recorded in the federal budget.14 As the public-utility and 

competitive market-maker models illustrate, a hybrid 

approach could be implemented in a way that involved 

more or less federal regulation of participants in the secondary market and a smaller or larger number of competitors in that market. (For a summary of the main features 

of this and the other broad approaches discussed in this 

report, see Table 4-1 on page 28.) 

Advantages of a Hybrid Approach

Regardless of its exact design, a hybrid model with 

explicit federal backing for qualifying privately issued 

MBSs would have several advantages over the precrisis 

model, as well as over either a fully federal agency or 

complete privatization (approaches that are discussed 

below). An explicit federal guarantee would help maintain liquidity in the secondary mortgage market, in normal times and particularly in times of stress, and could 

retain the standardization of products offered to investors 

that Fannie Mae and Freddie Mac bring to that market. 

Compared with the precrisis model, imposing guarantee 

fees would ensure that taxpayers received some compensation for the risks they were assuming. 

Compared with a fully federal agency, a hybrid approach 

would lessen the problem of putting a large portion of the 

capital market under government control, encourage the 

inflow of private capital to the secondary market, and 

limit the costs and risks to taxpayers by having private 

capital absorb some or most losses. Putting private capital 

at risk would also provide incentives for prudent management and pricing of risk. 

Compared with a fully private market, hybrid proposals 

would give the government more ongoing influence over 

the secondary market and an explicit liability in the case 

of large mortgage losses that would be reflected in the 

14. Numerous proposals have been made along those lines. See, for 

example, Mortgage Bankers Association, MBA’s Recommendations 

for the Future Government Role in the Core Secondary Mortgage 

Market (Washington, D.C.: MBA, August 2009); Donald Marron 

and Phillip Swagel, Whither Fannie and Freddie? A Proposal for 

Reforming the Housing GSEs (Washington, D.C.: e21-Economic 

Policies for the 21st Century, May 24, 2010), www.economics21.

org/commentary; Mortgage Finance Working Group, A Responsible Market for Housing Finance: Draft White Paper on the Future of 

the U.S. Secondary Market for Residential Mortgages (Washington, 

D.C.: Center for American Progress, December 2009), www.

americanprogress.org/issues/2009/12/pdf/housing_finance.pdf; 

and the statement of Anthony T. Reed, Vice President for Capital 

Markets, SunTrust Mortgage, on behalf of the Housing Policy 

Council of the Financial Services Roundtable, Housing Finance—

What Should the New System Be Able to Do? Part II: Government 

and Stakeholder Perspectives, before the House Committee on 

Financial Services, April 14, 2010, http://financialservices.house.

gov/media/file/hearings/111/reed_4.14.10.pdf. 
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 43

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budget. That arrangement might have the advantage of 

leading to a more orderly handling of crisis situations. 

Disadvantages of a Hybrid Approach

Relative to other approaches, a public/private model has a 

number of potential drawbacks, the importance of which 

differs depending in part on the specific design chosen. 

Experience with other federal insurance and credit programs suggests that the government would have trouble 

setting risk-sensitive prices for guarantees and probably 

would shift some risks to taxpayers. A hybrid approach 

also might not eliminate the tensions that exist—with 

regard to risk management and pursuit of affordablehousing goals—between serving private shareholders and 

carrying out public missions. 

Another concern is that over time, the secondary-market 

entities might push for broader guarantees of their product lines and attempt to reestablish themselves as too-bigto-fail institutions backed by implicit federal guarantees. 

Consequently, regulators would need to be vigilant to 

control risks to the financial system and avoid regulatory 

capture, while also being open to market innovations. 

(For a summary of how this and the other broad 

approaches that CBO examined would meet various 

policy criteria, see Table 4-2 on page 30.) 

A Fully Federal Agency 

As an alternative to relying on private institutions, the 

federal government could follow the FHA/Ginnie Mae 

model by creating a government-run program to guarantee and securitize qualifying mortgages. That program 

would provide explicit protection against default risk to 

investors in agency-backed MBSs.15 The cost of the program could be covered in whole or in part by charging 

guarantee fees, and the net cost would be recorded in the 

federal budget. Under that approach, elements of the current operations of Fannie Mae and Freddie Mac could be 

merged into a new or existing federal agency.

Specific Design Issues for a Fully Federal Agency

A critical policy issue is whether a federal agency would 

retain and manage a large portfolio of mortgages. Holding a mortgage portfolio would expose taxpayers to 

potentially large losses from prepayment and interest rate 

risk. In principle, buying mortgages when investors’ 

demand for MBSs is low and selling mortgages when 

their demand is high can help stabilize mortgage interest 

rates. However, influencing interest rates to stabilize the 

financial system and the economy is generally seen as the 

responsibility of the Federal Reserve. Moreover, large 

federal holdings of mortgages or MBSs are probably not 

necessary for the secondary market to operate efficiently; 

issuing guaranteed MBSs can largely achieve that outcome.16 For example, Ginnie Mae, which guarantees 

timely payment of interest and principal on MBSs that 

are backed by loans insured by the FHA and VA, provides 

liquidity for those mortgages without having a retained 

portfolio. 

If the government opted to retain a sizable mortgage 

portfolio, another question would be whether to finance 

it by issuing more Treasury securities or by continuing to 

issue separate agency securities, as Fannie Mae and Freddie Mac do now. Funding such a portfolio with securities 

issued by a new agency would entail somewhat higher 

interest costs than funding that portfolio with additional 

Treasury securities, because the agency debt would be less 

attractive to investors on account of its lesser liquidity. At 

the same time, funding such a portfolio with Treasury 

debt would raise the total amount of federal debt held by 

the public and require a higher statutory debt ceiling—

which in turn could adversely affect public perceptions of 

15. See Dwight Jaffee and John M. Quigley, The Government Sponsored Enterprises: Recovering from a Failed Experiment, Working 

Paper W09-001 (Berkeley, Calif.: University of California, Institute of Business and Economic Research, Program on Housing 

and Urban Policy, February 2009), http://urbanpolicy.berkeley. 

edu/pdf/JQ_GSEs_Failed_Experiment_031109.pdf; Dwight 

Jaffee, “Reforming Fannie and Freddie,” Regulation, vol. 31, no. 4 

(Winter 2008–2009), pp. 2–7; Thomas H. Stanton, “The Failure 

of Fannie Mae and Freddie Mac and the Future of Government 

Support for the Housing Finance System,” Journal of Law and 

Policy, Brooklyn Law School, vol. 18, no. 1 (2009), pp. 217–261; 

and Thomas H. Stanton, “Lessons from Public Administration: 

Recommendations for the Future of Fannie Mae and Freddie Mac 

and Other Aspects of Government’s Response to the Financial 

Debacle” (paper presented at the Federal Reserve Bank of Chicago’s 45th Annual Conference on Bank Structure and Competition, Chicago, May 6–8, 2009), www.thomas-stanton.com/pubs/

grfd/GRFD-Lessons_from_Public_Administration.pdf. 

16. See the statement of Douglas Holtz-Eakin, Director, Congressional Budget Office, Aligning the Costs and Benefits of the Housing 

Government-Sponsored Enterprises, before the Senate Committee 

on Banking, Housing, and Urban Affairs, April 21, 2005; and the 

statement of Alan Greenspan, Chairman, Federal Reserve Board, 

Government-Sponsored Enterprises, before the Senate Committee 

on Banking, Housing, and Urban Affairs, February 24, 2004, 

www.federalreserve.gov/boarddocs/testimony/2004/20040224/

default.htm. 
44 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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the government’s financial condition and thereby increase 

interest rates on Treasury securities.

Regardless of whether a large federal mortgage portfolio 

was funded by issuing agency securities or Treasury securities, the credit market obligations of the federal government would be significantly larger than they would be 

without such portfolio holdings. However, payments on 

the additional debt would be mostly offset by income 

from the mortgages held, so issuing such debt would 

probably not require significant future reductions in federal spending or increases in taxes. Moreover, that debt 

would largely substitute in private portfolios for the 

MBSs that private investors would otherwise be holding. 

Therefore, the additional borrowing by the federal government to fund a mortgage portfolio would probably 

not crowd out more-efficient investment activity by the 

private sector. 

Advantages of a Federal Agency

A federal agency would ensure a constant flow of funds to 

the secondary mortgage market during both normal 

times and times of stress by minimizing any uncertainty 

about the strength of the federal guarantee. Compared 

with the traditional operations of Fannie Mae and Freddie Mac, this approach would increase transparency by 

replacing an implicit guarantee with an explicit one, 

whose cost would be reported in the budget. Moreover, 

no subsidies would flow to the shareholders of Fannie 

Mae and Freddie Mac or successor private entities. In 

addition, establishing a federal agency would eliminate 

the conflicts that arise when a government-sponsored 

enterprise must serve both private and public purposes. 

Direct control over the secondary market for qualifying 

mortgages would also make it easier for the government 

to encourage better consumer protections, such as simplifying mortgage disclosure forms or limiting guarantees to 

mortgage products that are considered safer for consumers.17 Guarantee fees could be adjusted to control the size 

of any interest rate subsidies to low-income borrowers or 

providers of low-income rental housing, or targeted 

groups could be allowed to qualify for federal guarantees 

with lower down payments or other concessions on loan 

terms. However, policymakers could also impose consumer protections and control subsidies under any of the 

other approaches that CBO examined. 

Disadvantages of a Federal Agency

Establishing a federal agency to securitize mortgages 

would place a large and important segment of the capital 

market under direct government control. Government 

entities often have weaker incentives to control costs and 

risks than the private sector does. Historically, the government has been less likely to set risk-based prices, and it 

rarely charges the full market price of the risks it assumes. 

The underpricing of risk could tilt the allocation of capital in the economy too far toward housing and away from 

other activities. The government’s tendency to underprice 

risk may occur partly because the budgetary treatment of 

credit obligations does not include a charge for market 

risk. If a fair-value accounting approach was adopted—

under which loans and loan guarantees were valued on 

the basis of comparable market prices—the incentive to 

charge risk-based prices would probably be stronger than 

under current rules for budget accounting. 

A federally run program would mean that taxpayers, 

rather than private financial institutions, would bear 

almost all of the credit risk in the secondary market for 

qualifying mortgages. (Some of the risk on those mortgages might still be borne by private mortgage insurers on 

loans with low down payments.)18 That shifting of risk 

would create moral hazard; for instance, mortgage originators might have less reason to verify the truthfulness of 

information provided on mortgage applications. The fact 

that the FHA’s condition worsened after the financial crisis—the serious delinquency rate on FHA-insured mortgages rose from 5.6 percent in the first quarter of 2008 to 

8.5 percent in the second quarter of 2010—is a reminder 

17. For a sample disclosure form, see Alex J. Pollock, “The Basic Facts 

About Your Mortgage Loan” (American Enterprise Institute, 

2007), www.aei.org/docLib/20070913_20070515_Pollock

Prototype.pdf. For a behavioral finance analysis of framing mortgage choices, see Michael S. Barr, Sendhil Mullainathan, and 

Eldar Shafir, An Opt-Out Home Mortgage System, Hamilton 

Project Discussion Paper 2008-14 (Washington, D.C.: Brookings 

Institution, September 2008), www.brookings.edu/papers/2008/

09_mortgage_system_barr.aspx. 

18. Joseph E. Stiglitz, “Panel Discussion: What Is the Appropriate 

Role of the Federal Government in the Private Markets for Credit 

and Insurance? What Is the Outlook?” Review, Federal Reserve 

Bank of St. Louis, vol. 88, no. 4 (July/August 2006), pp. 391–

395. Also see Deborah Lucas and Marvin Phaup, “The Cost of 

Risk to the Government and Its Implications for Federal Budgeting” in Lucas, ed. Measuring and Managing Federal Financial Risk

(Chicago: University of Chicago Press, 2010), pp. 29–54.
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 45

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that government-run programs do not eliminate credit 

risk and may in fact exacerbate it.19

The secondary market would probably also be less 

dynamic under federal control than under approaches 

with a larger role for the private sector. More-restrictive 

government standards might curtail innovations in the 

mortgage market, and government agencies generally 

have less incentive to innovate than private entities do.20

For example, the FHA was slow to innovate in its product 

offerings and late to introduce automatic underwriting. It 

remains somewhat slower at processing applications than 

private mortgage originators whose loans are often subsequently guaranteed by Fannie Mae and Freddie Mac

A Fully Private Secondary 

Mortgage Market

Some observers have called for completely privatizing the 

secondary market for mortgages. Under that approach, 

there would be no federal charters or explicit federal guarantees of MBSs or debt securities. The federal government could wind down the operations of Fannie Mae and 

Freddie Mac, sell their assets in pieces to private investors, 

or sell the entities as a whole to private investors (in 

which case those successor entities could compete with 

other financial institutions to originate MBSs in the secondary market). 

Private securitization markets function smoothly in most 

circumstances, and when they do, they may produce a 

more efficient allocation of capital in the economy and 

better incentives to properly price and manage risk than 

alternatives with a larger government role.21 When Fannie 

Mae and Freddie Mac were chartered, the private-label 

market for MBSs was negligible; however, that market 

grew rapidly from the 1990s through 2006. Moreover, 

markets for the securitization of other types of consumer 

credit, such as credit card and auto loans, have also grown 

rapidly. Although the private-label MBS market all but 

disappeared during the financial crisis, there are signs that 

it may slowly be starting to return.22 Indeed, its reemergence may be hindered by the GSEs’ participation in new 

areas—such as the market for jumbo mortgages—where 

private firms cannot compete as long as low-cost federal 

guarantees are available. In other words, the private-label 

market might have rebounded more quickly in the 

absence of Fannie Mae and Freddie Mac. 

Even if the government no longer provided standing 

guarantees, it could affect liquidity in the mortgage market through various means. Policymakers could regulate 

certain aspects of the market—for instance, setting disclosure and capital requirements and supporting efforts 

to maintain standardization. In times of severe distress, 

such as the recent crisis, the government could provide 

additional liquidity and support for the mortgage market 

by having the Treasury or the Federal Reserve purchase 

private-label MBSs. Alternatively, the FHA and Ginnie 

Mae could increase the volume of mortgages they guarantee, as they have in the past few years. (Expanding the 

activities of federal agencies, however, generally requires 

Congressional action.)

Specific Design Issues for a Fully Private Market

To avoid disruptions to the mortgage market, privatization would probably require a gradual transition from the 

status quo, particularly because Fannie Mae and Freddie 

Mac now play an even more dominant role in the mortgage market than they did before the financial crisis. One 19. See Diego Aragon and others, Reassessing FHA Risk, Working 

Paper 15802 (Cambridge, Mass.: National Bureau of Economic 

Research, March 2010), www.nber.org/papers/w15802. 

20. See Robert E. Litan, In Defense of Much, But Not All, Financial 

Innovation (Washington, D.C.: Brookings Institution, February 

2010), www.brookings.edu/experts/litanr.aspx; Kristopher 

Gerardi, Harvey Rosen, and Paul S. Willen, “The Impact of 

Deregulation and Financial Innovation on Consumers: The Case 

of the Mortgage Market,” Journal of Finance, vol. 65, no. 1 (February 2010), pp. 333–360; and Raghuram G. Rajan, “Has Financial Development Made the World Riskier?” (speech given at the 

Federal Reserve Bank of Kansas City’s symposium “The Greenspan Era: Lessons for the Future,” Jackson Hole, Wyo., August 

25–27, 2005), www.kansascityfed.org/publicat/sympos/2005/pdf/

rajan2005.pdf. 

21. See the statement of Peter J. Wallison, American Enterprise Institute, On the Future of the Mortgage Market and the Housing Enterprises, before the Senate Committee on Banking, Housing, and 

Urban Affairs, October 8, 2009; and the statement of Lawrence J. 

White, Stern School of Business, New York University, before the 

Subcommittee on Capital Markets, Insurance, and Government 

Sponsored Enterprises of the House Committee on Financial 

Services, June 3, 2009. 

22. See Marc Hochstein and Sara Lepro, “Redwood Trust Launches 

First ‘New’ Private-Label MBS Since ’08,” American Banker (April 

22, 2010). Also see Laurie Goodman and others, “Stages in the 

Restart of Private Label Residential Mortgage Securitization,” 

Amherst Mortgage Insight (May 20, 2010). 
46 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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way to phase out the expectation of government backing 

would be to gradually reduce the dollar limit for conforming mortgages.23

A competitive private secondary market might emerge 

more quickly if Fannie Mae and Freddie Mac were broken up or liquidated. If they no longer had the advantage 

of federal backing, those entities probably would not continue to dominate other large financial institutions in the 

securitization market. Whatever their fate, the two GSEs 

have a valuable investment in infrastructure and data for 

securitizing mortgages and in the skills of their employees 

and their relationships with servicers and lenders. As long 

as securitization continued, the GSEs’ systems could be 

sold, their data could be made public or sold, and most of 

the personnel now at Fannie Mae and Freddie Mac could 

find jobs at the reorganized or privatized institutions. 

Private firms operating in the secondary market would 

probably not provide special assistance to low- and 

moderate-income borrowers in the absence of federal 

subsidies or mandates (beyond what is already required 

under the Community Reinvestment Act). Without federal backing of the secondary market, there would be less 

justification for assessing fees on those intermediaries to 

support affordable-housing activities rather than relying 

on a broader tax base. Assistance that is now channeled 

through Fannie Mae and Freddie Mac could instead be 

provided through expanded FHA or other programs. 

Advantages of a Private Market

Privatization might provide the best incentive—market 

discipline—for prudent behavior on the part of intermediaries in the secondary mortgage market. (The magnitude of recent problems in the subprime and Alt-A 

markets, however, shows that purely private firms also 

take too much risk at times.) Increasing competition in 

the secondary market would reduce the market’s reliance 

on the viability of any one firm, which could lessen the 

systemic risk borne by taxpayers. In addition, privatization would eliminate the tension inherent in the traditional GSE model between public and private missions, 

and it could reduce the incentive that would exist under a 

hybrid model for firms to shift risk to the government.24

A private secondary market would also ensure that incentives to invest in housing were not distorted by having the 

government channel credit toward housing—although 

those incentives would still be affected by many other 

aspects of government policy, especially the tax treatment 

of housing. Private markets may be best positioned to 

dynamically allocate the credit and interest rate risk of 

mortgages among willing parties. In addition, with a fully 

private market, interest rates on mortgages would be 

more likely to be tailored to the risk of particular borrowers, resulting in smaller cross-subsidies. For example, 

mortgage rates might be tied more closely to down payments, credit scores, and price volatility in local housing 

markets. 

Privatization might also provide a market test of whether 

securitizing mortgages was the most efficient way to raise 

funds in the secondary market or whether an alternative, 

such as covered bonds, would be a preferable means of 

financing. (Covered bonds are discussed below.)

Disadvantages of a Private Market

Full privatization of the secondary mortgage market 

would pose two major risks. First, the government might 

not credibly be able to distance itself from an implied federal guarantee, particularly given the number of times it 

has intervened to save creditors of too-big-to-fail institutions during financial crises.25 Second, privatization 

might not ensure a stable supply of credit to the mortgage 

market during periods of financial stress. As the Chairman of the Federal Reserve Board has noted, the near 

absence of private securitization in the mortgage market 

under the stressed conditions that prevailed in 2009 

and early 2010 begs the question of whether mortgage 

23. Peter J. Wallison, The Dead Shall Be Raised: The Future of Fannie 

and Freddie, Financial Services Outlook (Washington, D.C.: 

American Enterprise Institute, February 2010), www.aei.org/

outlook/100938.

24. Dwight M. Jaffee, “The Future Role of Fannie Mae and Freddie 

Mac in the U.S. Mortgage Market” (paper prepared for the American Economic Association session “The Future of the GSEs,” 

Atlanta, Ga., January 3, 2010). 

25. The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203) gave the Federal 

Deposit Insurance Corporation authority for the orderly liquidation of systemically important financial companies. How much 

that authority will reduce the too-big-to-fail problem is difficult to 

predict. The intent is for orderly liquidation to impose most losses 

on companies’ shareholders and creditors rather than taxpayers.
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 47

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securitization would continue to occur in times of future 

stress without some federal support.26

The risk to the nation’s financial system from a deep 

recession or downturn in housing markets is difficult for 

private insurance markets to price or to credibly protect 

against with capital reserves.27 Consequently, even with 

full privatization, taxpayers could again be called on to 

rescue firms that were considered too big to fail and 

whose obligations were thus implicitly guaranteed by the 

government. If investors came to expect such federal bailouts, financial institutions operating in the secondary 

mortgage market might continue to take excessive risks. 

Even apart from that possibility, taxpayers would retain 

some exposure to risk because, with privatization, some 

of the credit risk on mortgages would be shifted to banks 

that had federal deposit insurance. 

The Federal Reserve and the Treasury might address 

those risks by being prepared to purchase or guarantee 

privately issued mortgages and MBSs during times of 

severe financial stress, as they did in 2009 and early 2010 

with the debt and MBSs of Fannie Mae and Freddie Mac. 

However, such interventions might be implemented with 

a lag, in which case the mortgage market could fail to 

function normally for a while. 

Other Mortgage-Financing Approaches

All of the approaches discussed above would continue to 

rely on the MBS market as the main source of funding 

for residential mortgages. The federal government could, 

however, support other funding mechanisms in addition 

to, or instead of, securitization. A proposal that has 

received considerable attention would be to provide federal support for covered bonds—a type of borrowing that 

many large European banks use to fund the mortgages 

held on their balance sheets.

Other developed countries with high rates of home ownership rely less on government-backed MBSs to fund 

mortgages than the United States does. Among those 

countries, there is considerable variation in how mortgages are financed and in what types of mortgages are 

available. All developed countries, however, seem to 

depend on some degree of government support to maintain the flow of credit to the mortgage market during 

periods of heightened financial stress. 

Covered Bonds

Covered bonds are a form of collateralized borrowing that 

banks can use to fund loans retained on their balance 

sheets. Such bonds have rarely been used in the United 

States, although they are a major source of funding in 

Europe.28 Some analysts believe that covered bonds have 

the potential to gain wider use in this country and that 

any explicit federal guarantees of qualified MBSs should 

also be extended to covered bonds, with the goal of promoting competition in mortgage financing.29 Other analysts argue that covered bonds are unlikely to become a 

popular means of financing in the United States because 

banks have alternatives that are less costly and that may 

allocate risk more efficiently among financial institutions, 

investors, and the government. 

Commercial banks have shown some interest in issuing 

more covered bonds in the United States. Recently, legislation was introduced in the Congress to change the regulatory treatment of covered bonds and reduce some of the 

existing barriers to growth in that market.30 In addition, 

to remove possible administrative impediments, the 

26. Ben S. Bernanke, “The Future of Mortgage Finance in the United 

States” (speech given at the University of California symposium 

“The Mortgage Meltdown, the Economy, and Public Policy,” 

Berkeley, Calif., October 31, 2008), www.federalreserve.gov/

newsevents/speech/bernanke20081031a.htm. 

27. Dwight M. Jaffee, “Monoline Regulations to Control the 

Systemic Risk Created by Investment Banks and GSEs,” B.E. 

Journal of Economic Analysis & Policy, vol. 9, no. 3 (March 2009), 

www.bepress.com/bejeap/vol9/iss3/art17/. 

28. See O. Emre Ergungor, “Covered Bonds: A New Way to Fund 

Residential Mortgages,” Economic Commentary (Federal Reserve 

Bank of Cleveland, July 15, 2008), www.clevelandfed.org/

research/commentary/2008/0708.cfm; and Richard J. Rosen, 

“What Are Covered Bonds?” Chicago Fed Letter, no. 257 (Federal 

Reserve Bank of Chicago, December 2008).

29. For an analysis, see Diana Hancock and Wayne Passmore, “Retail 

Investor Runs, Asset Securitization, and An Analysis of Government Secured Bond Insurance” (preliminary draft prepared for the 

American Economic Association annual meetings, Atlanta, Ga., 

January 2010); and Diana Hancock and Wayne Passmore, “Three 

Initiatives Enhancing the Mortgage Market and Promoting Financial Stability,” B.E. Journal of Economic Analysis & Policy, vol. 9, 

no. 3 (March 2009), www.bepress.com/bejeap/vol9/iss3/art16. 

30. Congressional Budget Office, cost estimate for H.R. 5823, United 

States Covered Bond Act of 2010 (October 1, 2010). 
48 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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Federal Deposit Insurance Corporation (FDIC) and the 

Treasury issued new policy statements and best-practices 

statements in 2008 to lessen some of the uncertainty surrounding the regulatory treatment of covered bonds.31

None of those changes have yet led to a significant expansion of the covered-bond market in this country. 

Allocation of Risk. Covered bonds are often compared 

with MBSs because they are backed by pools of mortgages, but they differ fundamentally in the way that risk 

is shared among banks, other investors, and the government. With covered bonds, the bank that originates a 

mortgage retains most of the credit and prepayment risk 

of that mortgage on its balance sheet. Investors in covered 

bonds are protected from that risk because, when a 

mortgage is paid off or goes into default, the issuer is 

contractually obligated to replace the collateral with a 

new mortgage. Because of those risk-sharing arrangements, covered bonds more closely resemble collateralized 

advances, which banks use extensively to borrow at relatively low cost from the Federal Home Loan Banks 

(FHLBanks), as described in Appendix B. 

The federal government bears a portion of the default risk 

associated with covered bonds because the bonds have 

legal priority over the FDIC; in the event that the issuing 

bank becomes insolvent, investors have first claim on the 

mortgages serving as collateral for covered bonds. If 

banks use covered bonds to increase their lending or 

replace uninsured deposits, the risk to the FDIC rises. (In 

general, costs incurred by the FDIC are financed by fees 

imposed on insured financial institutions.) Partly for that 

reason, regulators effectively limit covered bonds to 4 percent of a bank’s total liabilities. 

The extent to which greater use of covered bonds would 

affect overall costs to the federal government, however, 

would depend on what the bonds were replacing or augmenting and on how capital requirements were adjusted. 

For example, if covered bonds simply substituted for similar collateralized advances made by FHLBanks, which 

also have a priority claim over the FDIC, the agency’s 

exposure to losses would be little changed. But if banks 

decided to fund riskier mortgages (and possibly other 

assets) through covered bonds, the FDIC’s exposure 

could rise. 

Advantages. Covered bonds may provide a useful supplement to private-label and agency MBSs as a tool for 

financing mortgages, particularly in light of the slow 

recovery of the private-label market. Proponents say covered bonds offer the potential for a stable source of mortgage funding, even in times of stress. During the recent 

financial crisis, such bonds performed relatively well in 

Europe, although government support of banks may have 

contributed to investors’ continuing confidence in those 

securities.32

Because banks retain most of the risk on the mortgages 

they make when they issue covered bonds, their incentive 

for prudent risk management is stronger than when the 

risk is transferred to investors through securitization. 

Another potential advantage is that impediments to loan 

modifications may be lower than with securitization 

because mortgages financed with covered bonds are 

controlled by a single bank. 

Disadvantages. From the perspective of banks, using covered bonds to finance mortgage holdings appears to have 

a number of drawbacks compared with securitization and 

FHLBank advances. Banks face higher capital requirements on mortgages funded with covered bonds than on 

MBSs held as investments: Because banks retain the 

credit risk, they must hold the same percentage of capital 

against mortgages that serve as collateral for covered 

bonds as against individual residential mortgages—4 percent—compared with just 1.6 percent if mortgages are 

held in the form of highly rated private-label or agency 

MBSs. Moreover, MBSs—especially those guaranteed by 

the government—offer greater liquidity to banks. In 

addition, banks may not want to retain the prepayment 

risk on the mortgages backing covered bonds—a risk that 

investors may be more willing and able to bear. The disadvantages of covered bonds are likely to be greatest for 

smaller banks, which would not be able to issue enough 

bonds to be liquid and would lose the benefits from 

diversification that securitization provides.

Banks can borrow relatively inexpensively against their 

mortgage holdings by taking out FHLBank advances. 

The FHLBanks have an advantage over private financial 

institutions in funding costs because, like Fannie Mae 

and Freddie Mac before conservatorship, they have an 

31. Department of the Treasury, Best Practices for Residential Covered 

Bonds (July 2008). 

32. Bernanke, “The Future of Mortgage Finance in the United 

States”; and Hancock and Passmore, “Three Initiatives Enhancing 

the Mortgage Market and Promoting Financial Stability.”
CHAPTER FOUR FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 49

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implicit federal guarantee. As long as the FHLBanks 

retain that advantage, many analysts question the 

viability of a covered-bond market in the United States. 

FHLBank advances also have the benefit of more-flexible 

collateral requirements because more types of assets can 

be used as collateral on them. (However, advances generally require higher amounts of collateral than covered 

bonds do.) 

For investors, covered bonds currently have two drawbacks. First, they are illiquid in the United States and are 

likely to remain so if the FDIC does not lift its limits on 

the sizes of bond issues as a percentage of banks’ total liabilities.33 Second, in the absence of a covered-bond statute, investors face some legal uncertainty about the priority of their claims to collateral if a bond issuer becomes 

insolvent.34 Legislation like the recently introduced 

Covered Bond Act of 2010 (H.R. 5823) would address 

those concerns, but at the cost of increasing the FDIC’s 

exposure to losses. 

Covered bonds may also benefit from various forms of 

government assistance even in the absence of formal guarantees. European nations have opted to provide assistance 

to some issuers of covered bonds, raising the question of 

whether an implicit guarantee exists on such bonds. 

Moreover, the market for new issues of covered bonds 

experienced stress after the failure of Lehman Brothers 

in September 2008 until the European Central Bank 

announced a special purchase program.35

International Approaches to Mortgage Financing

Many developed countries, particularly in Western 

Europe, have rates of home ownership comparable with 

those in the United States but rely less on securitizing 

mortgages and providing formal government guarantees.36 Instead, mortgages in those nations are financed 

with deposit-based funding and with covered bonds. 

Differences in the way that governments support and regulate their financial systems, and in the laws governing 

mortgage products, help explain why institutions and 

products differ among countries. Banks play a bigger role 

in mortgage financing in Europe, whereas Fannie Mae, 

Freddie Mac, Ginnie Mae, and (to a lesser extent) the 

Federal Home Loan Banks play a more dominant role in 

the United States. Government support for European 

banks takes many forms—including deposit insurance, 

state ownership, and capital injections for weak institutions—and varies among nations. In terms of mortgage 

products, federal support for the secondary mortgage 

market in the United States has encouraged the issuance 

of 30-year fixed-rate mortgages, which are much less 

common in Europe; there, home loans are more likely to 

be adjustable-rate mortgages or some form of hybrid 

ARM (with interest rates that are fixed for a period and 

then float). Penalties for prepaying home loans are also 

common in Europe, whereas they are not permitted in 

the United States on conforming mortgages. (Allowing 

penalties for prepayment reduces mortgage interest rates 

but gives borrowers less flexibility.) Another difference is 

that in Europe lenders have recourse to borrowers’ nonhousing wealth in the case of default, but in many U.S. 

states they do not. Overall, default rates on mortgages 

have been lower in Europe than in the United States. 

Some observers have pointed to Denmark’s housing 

finance system as a potential model for the United States. 

In Denmark, 30-year fixed-rate mortgages have been 

common (at least until recently, when borrowers switched 

to loans with shorter maturities to take advantage of the 

prevailing low rates on those mortgages). Under the 

“principal of balance” approach, mortgage originators 

33. Joseph A McKenzie, “Covered Bonds” (presentation given at the 

Congressional Research Service seminar “Covered Bonds: Issues 

for Congress,” Washington, D.C., July 16, 2010). 

34. See the statement of Bert Ely, Principal, Ely & Company, Covered 

Bonds: Prospects for a U.S. Market Going Forward, before the 

House Committee on Financial Services, December 15, 2009; 

also see Edward V. Murphy, Covered Bonds: Issues in the 111th 

Congress, CRS Report for Congress R41322 (Congressional 

Research Service, July 15, 2010). 

35. Michael Lea, “Alternative Forms of Mortgage Finance: What Can 

We Learn from Other Countries?” (paper presented at a conference of the Joint Center for Housing Studies of Harvard University, “Moving Forward: The Future of Consumer Credit and 

Mortgage Finance—A National Symposium,” Cambridge, Mass., 

February 19, 2010), www-rohan.sdsu.edu/~realest/images/

Harvard-Lea.pdf. 

36. Exceptions exist: Japan has entities roughly similar to Fannie Mae 

and Freddie Mac, and the Canadian Mortgage and Housing Corporation provides full guarantees on certain mortgages as well as 

securitizing those mortgages and backing them with explicit guarantees similar to those provided by Ginnie Mae. The Netherlands 

has government-backed mortgage insurance. See Michael Lea, 

International Comparison of Mortgage Product Offerings (Washington, D.C.: Research Institute for Housing America and the Mortgage Bankers Association, September 2010), www.housing

america.org/PublishedReports; and Lea, “Alternative Forms of 

Mortgage Finance.”
50 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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fund an individual mortgage by issuing a matching bond. 

Danish mortgages have a unique feature that allows borrowers to benefit from unexpected increases or decreases 

in interest rates. When rates rise, borrowers can repurchase their mortgages for less than the amount of the outstanding principal balance and thus reduce the risk of 

negative equity.37 When rates fall, the borrowers can take 

advantage of refinancing opportunities. In the Danish 

system—as in other systems that provide borrowers with 

options that are costly to lenders—borrowers ultimately 

pay for those features in the form of higher interest rates 

or fees up front. 

As in the United States, many housing markets in Europe 

experienced unsustainably rapid rates of price growth in 

the past decade, culminating in sharp declines in housing 

prices and skyrocketing default losses.38 European governments took a variety of steps to restore stability to 

their mortgage markets, including guaranteeing bank 

debt, nationalizing or recapitalizing weak banks, and 

supporting the consolidation of banks.39 In some countries, the government bailed out issuers of covered bonds, 

and in early 2009, the European Central Bank launched a 

€65 billion ($84.5 billion) program to purchase covered 

bonds in an effort to restore liquidity to that market. The 

U.K., Dutch, and German governments, among others, 

also provided large direct injections of capital to banks. In 

Spain and Germany, the federal government guaranteed 

more than €300 billion ($390 billion) worth of bonds by 

big mortgage lenders, including savings banks owned by 

state governments. In the United Kingdom, where securitization plays a larger role in mortgage finance, the central bank took the unusual step of accepting MBSs as collateral for loans (much as the Federal Reserve did in the 

United States). 

37. Allen Frankel and others, “The Danish Mortgage Market,” BIS 

Quarterly Review, Bank for International Settlements (March 

2004), pp. 95–109, www.bis.org/publ/qtrpdf/r_qt0403h.pdf. 

38. Michael Ball, “Overcoming the Crisis in European Housing Markets,” in European Mortgage Federation, Hypostat 2008: A Review 

of Europe’s Mortgage and Housing Markets (Brussels: European 

Mortgage Federation, November 2009), pp. 16–18, 

www.hypo.org/Content/default.asp?pageId=578.

39. Walter W. Eubanks, The European Union’s Response to the 2007–

2009 Financial Crisis, CRS Report for Congress R41367 (Congressional Research Service, August 13, 2010). 
APPENDIX

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A

History of the Secondary Mortgage Market

The market for buying and selling residential mortgages in the United States—and the federal government’s 

role in that market—has evolved over the years in 

response to changes in economic conditions, regulations, 

and wider financial markets. The 20th century saw the 

expansion of the secondary market nationwide; its gradual dominance by investor-owned government-sponsored 

enterprises (GSEs); the increasing use of securitization, 

whereby pools of mortgages are converted into mortgagebacked securities (MBSs); and the emergence of a vibrant 

private-sector market for certain types of MBSs. That 

evolution created the setting for the policy choices that 

lawmakers face today.

Promotion of a National Market

Many federal housing programs and institutions, including the Federal National Mortgage Association (Fannie 

Mae), were established in response to the Great Depression, when incomes and housing prices fell sharply and 

foreclosure rates skyrocketed. Structural features of the 

mortgage market at that time made it highly susceptible 

to disruptions in the flow of funding. The market was 

largely local: Banks and other lenders relied heavily on 

local deposits to fund mortgages. As a result, if savings 

in an area were too low to meet the local demand for 

mortgages, borrowers faced higher interest rates than in 

markets with a surplus of savings. And although a strong 

secondary market existed for commercial mortgages in 

the 1920s, the secondary market for residential mortgages 

was limited. Life insurance companies purchased some 

loans from mortgage banks, and mortgage guarantee 

companies insured mortgages and sold some residential 

MBSs.1

 But in general, the banks and thrift institutions 

(such as savings and loans) that originated most mortgages kept the loans and funded them with locally 

obtained deposits. 

Because of banks’ reliance on short-term deposits, regulators restricted their mortgages to relatively short terms 

(usually three to five years). Borrowers had to refinance 

large balances fairly frequently when bank loans came 

due, and if new financing was not available, the alternative was often default. The situation was somewhat 

different at thrift institutions, which had about 40 percent of the market for residential mortgages in 1929. 

Thrift institutions offered fixed-rate mortgages whose 

principal and interest payments were large enough to pay 

off a loan when it reached maturity.

With the steep declines in incomes and housing prices 

during the Depression, mortgage delinquencies and foreclosures surged. By 1934, roughly half of home mortgages in urban areas were delinquent, and the annual 

foreclosure rate was over 13 percent.2

Lawmakers took several steps during the Depression to 

reduce the reliance on local funding and promote a 

national mortgage market: 

 In 1932, the Federal Home Loan Bank (FHLBank) 

System was established to provide credit to savings and 

loans and other thrifts that, at the time, specialized in 

making home loans (see Appendix B). 

1. Private-sector securitization of mortgages largely disappeared for 

several decades after the Depression. See Sarah Lehman Quinn, 

“Government Policy, Housing, and the Origins of Securitization, 

1780–1968” (Ph.D. dissertation, University of California, Berkeley, Fall 2010); and William N. Goetzmann and Frank Newman, 

Securitization in the 1920s, Working Paper 15650 (Cambridge, 

Mass.: National Bureau of Economic Research, January 2010), 

www.nber.org/papers/w15650. 

2. David C. Wheelock, Government Response to Home Mortgage 

Distress: Lessons from the Great Depression, Working Paper 2008-

038A (Federal Reserve Bank of St. Louis, October 2008), 

http://research.stlouisfed.org/wp/2008/2008-038.pdf. 
52 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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 In 1933, a federal agency named the Home Owners’ 

Loan Corporation (HOLC) was created to refinance 

existing residential mortgages as a stopgap measure. 

Between August 1933 and June 1936, the HOLC 

refinanced about 1 million loans—or roughly 20 percent of the outstanding mortgages on nonfarm, 

owner-occupied properties.3

 At its height, in 1934, 

the HOLC accounted for about 70 percent of new 

mortgages originated. 

 In 1934, another federal agency, the Federal Housing 

Administration (FHA), was established to provide 

mortgage insurance against defaults. The FHA was 

instrumental in making long-term, fixed-rate mortgages with low down payments a standard mortgage 

product. FHA borrowers amortized their mortgages; 

that is, their scheduled monthly principal and interest 

payments were sufficient to pay off the loans at maturity (generally after 30 years). That self-liquidating 

feature removed the instability that some borrowers 

had faced by having a large balance due at maturity.

 In 1938, lawmakers established Fannie Mae as a government agency to support the nascent secondary 

mortgage market. Initially, it bought and sold mortgages that were insured by the FHA and originated 

primarily by mortgage bankers. Lenders were more 

willing to make FHA-insured loans knowing that they 

could sell the mortgages to Fannie Mae. Fannie Mae 

financed its purchases by selling debt securities to 

the Treasury and the public. For the next 30 years, 

Fannie Mae remained a government agency, and its 

secondary-market activities were limited to buying 

and selling federally insured mortgages.4

 (In 1948, 

it was authorized to also purchase mortgages insured 

by the Veterans Administration, or VA, now the 

Department of Veterans Affairs.) 

Transition to Investor-Owned GSEs

In 1954, the Congress began the process of shifting 

Fannie Mae to private ownership. Each lender selling 

mortgages to the agency was required to make a capital 

contribution to purchase nonvoting common stock in 

Fannie Mae, which would gradually help retire the preferred stock held by the Treasury. The transition was 

completed by the 1968 Charter Act, which chartered 

Fannie Mae as a government-sponsored enterprise and 

provided for its sale to private shareholders.5

The Charter Act also split off the Government National 

Mortgage Association (Ginnie Mae) from Fannie Mae. 

Ginnie Mae is an on-budget federal agency whose role is 

to securitize loans insured by the FHA and VA. In creating Ginnie Mae, the government largely kept the secondary market for federally insured mortgages in federal 

hands (although Fannie Mae continued to purchase most 

FHA and VA loans through 1970).

Two years after Fannie Mae was converted into a 

government-sponsored enterprise, the Emergency Home 

Finance Act of 1970 created a new GSE, the Federal 

Home Loan Mortgage Corporation (Freddie Mac). That 

institution was intended to complement the FHLBank 

system and to deepen the secondary market. Freddie Mac 

was initially owned by the member institutions of the 

FHLBanks, which were primarily thrifts. In 1989, the 

Financial Institutions Reform, Recovery, and Enforcement Act authorized thrifts to sell their shares in Freddie 

Mac to the public as a way of injecting more capital into 

the thrift industry during the savings and loan crisis.6

Shares in Fannie Mae and Freddie Mac became more 

attractive for investors when lawmakers increased the 

opportunity for the GSEs to grow. The 1970 law that 

3. C. Lowell Harriss, History and Policies of the Home Owners’ Loan 

Corporation (New York: National Bureau of Economic Research, 

Financial Research Program, 1951), www.nber.org/books/

harr51-1. 

4. Those activities were not included in the federal budget, partly on 

the theory that Fannie Mae obtained its financing directly from 

the financial markets rather than from the Treasury.

5. That sale mitigated the pressure that lawmakers had been under to 

include Fannie Mae in the budget; in addition, the money raised 

from the sale lowered the budget deficit at the time. See President’s Commission on Budget Concepts, Report of the President’s 

Commission on Budget Concepts (October 1967), pp. 59–60. Also 

see Department of Housing and Urban Development, 1986 

Report to Congress on the Federal National Mortgage Association 

(June 29, 1987), p. 27; and Thomas H. Stanton, GovernmentSponsored Enterprises: Mercantilist Companies in the Modern World

(Washington, D.C.: American Enterprise Institute, March 2002), 

p. 87, www.aei.org/book/307. 

6. In accordance with generally accepted accounting principles, the 

member institutions carried their stock in Freddie Mac on their 

balance sheets at well below market value. Selling that stock 

allowed the thrifts to record the gains on their balance sheets 

and thus increase the amount of capital they had relative to the 

minimum required by regulators. 
APPENDIX A FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 53

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created Freddie Mac authorized both GSEs to purchase 

conventional, conforming mortgages (loans that satisfy 

certain requirements in terms of size and leverage and 

that are not insured by the federal government). Conventional mortgages quickly became the GSEs’ major source 

of new business, while Ginnie Mae dominated the secondary market for FHA and VA loans. The GSEs’ expansion was aided by the development of markets for private 

mortgage insurance on conventional loans and by periodic amendments to the GSEs’ charters that increased the 

size limit for conforming mortgages.

The Shift Toward Securitization 

Initially, Fannie Mae and Freddie Mac pursued different 

strategies with regard to creating mortgage-backed securities. Although the 1968 Charter Act gave Fannie Mae the 

power to securitize loans, the GSE was slow to adopt that 

practice, preferring to buy mortgages to hold in its portfolio. In the late 1970s and early 1980s, Fannie Mae 

suffered a series of deeply unprofitable years that put its 

viability in doubt. Much like the savings and loan industry, it had financed its mortgage investments by issuing 

shorter-term debt, seeking to take advantage of lower 

short-term interest rates. That strategy exposed Fannie 

Mae to interest rate risk—when interest rates rose, its 

borrowing costs increased commensurately, while its 

income from existing mortgages remained fixed. The 

Department of Housing and Urban Development estimated that between 1978 and 1984, Fannie Mae had a 

negative net worth on a mark-to-market basis.7

 Despite 

its very weak financial condition, Fannie Mae was able to 

continue issuing debt because of the implicit federal guarantee on that debt. After 1984, as interest rates declined 

and Fannie Mae did a better job matching the duration of 

its assets and liabilities, it returned to profitability.

Freddie Mac, in contrast, initially adopted Ginnie Mae’s 

approach and concentrated on securitizing conforming 

mortgages rather than assembling a large portfolio. 

Because securitization effectively transfers both interest 

rate and prepayment risk to the holders of MBSs, Freddie 

Mac was able to remain profitable throughout the early 

1980s.

After that period, the two GSEs’ business strategies began 

to converge. Partly in response to its losses, Fannie Mae 

started securitizing mortgages in 1981. By 1986, the 

value of its outstanding MBSs exceeded that of its portfolio holdings. Freddie Mac, conversely, steadily increased 

its holdings of mortgages in the early 1990s. (Until the 

recent financial crisis, portfolio holdings were generally 

much more profitable for the GSEs than their guarantee 

business because those holdings took advantage of the 

lower borrowing costs that the GSEs enjoyed as a result of 

the implicit federal guarantee.) By 2001, the operations 

of the two GSEs looked virtually the same (see Figure 1-1 

on page 6). 

Emergence of the Private-Label Market

A private secondary market for various types of nonconforming mortgages reemerged in the late 1970s and grew 

rapidly over the next several decades. That market 

involved so-called private-label, or nonagency, mortgagebacked securities that were not guaranteed by Fannie 

Mae, Freddie Mac, or Ginnie Mae. Bank of America 

issued the first private-label jumbo MBS—backed by 

prime loans above the conforming limit—in 1977. 

In the 1980s, the federal government took several actions 

to support the market for private-label MBSs, such as 

clarifying and relaxing the Securities and Exchange Commission’s requirements for registering bonds and removing the unfavorable tax treatment of multiclass MBSs.8

The government also created the real estate mortgage 

investment conduit (REMIC), an organizational status 

7. Accounting on a mark-to-market basis means recording the market value of all assets and liabilities. When interest rates peaked in 

1981, Fannie Mae’s negative worth was nearly $11 billion, or 

more than 20 percent of the mark-to-market value of its assets; see 

Department of Housing and Urban Development, 1986 Report to 

Congress on the Federal National Mortgage Association, pp. 99–101. 

Nevertheless, Fannie Mae’s balance sheet, which followed generally accepted accounting principles (reflecting a mix of historical 

and mark-to-market valuations), continued to show a small 

positive net worth throughout the period.

8. Issuers of private-label MBSs manage credit and prepayment risks 

by structuring the securities with different classes (or tranches) 

that have different priority claims on the underlying cash flows of 

the mortgages. The senior tranches have the highest claim on payments, whereas the subordinated classes, which usually carry lower 

credit ratings, absorb the initial credit losses. See Robert Van 

Order, On the Economics of Securitization: A Framework and Some 

Lessons from U.S. Experience, Working Paper 1082 (Ann Arbor: 

University of Michigan, Stephen M. Ross School of Business, May 

2007), http://deepblue.lib.umich.edu/handle/2027.42/55302; 

and Joshua D. Coval, Jakub Jurek, and Erik Stafford, “The Economics of Structured Finance,” Journal of Economic Perspectives, 

vol. 23, no. 1 (Winter 2009), pp. 3–25. 
54 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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open to issuers of MBSs in which the credit rating for a 

security came to depend on the credit quality of the 

underlying mortgages serving as collateral and on the priority of the claims on the cash flows of those mortgages, 

not on the rating of the MBS issuer. The introduction of 

REMIC status spurred growth in the number of firms 

issuing private-label MBSs.

By 1997, more than $100 billion in private-label MBSs 

were being issued each year, and those securities made up 

nearly a quarter of new MBSs issued (see Figure 1-2 on 

page 7).9

 A total of more than $1 trillion in private-label 

MBSs were outstanding by 2004, and rapid growth in 

issues backed by subprime and Alt-A loans pushed that 

total above $2 trillion in just two years (see Figure 1-6 on 

page 11).10 At its peak in the first quarter of 2006, the 

private-label market represented about 20 percent of outstanding mortgage credit and 55 percent of new issues.11

In the following years, private-label securitization collapsed during the financial crisis.12 Private-label securities 

accounted for just 3 percent of new MBSs issued in 2009 

and remained a negligible share through much of 2010. 

Even at the peak of private-label issuance, Fannie Mae 

and Freddie Mac were able to remain dominant in the 

secondary market for conforming mortgages because of 

their regulatory advantages and implicit federal guarantee. Private-label issuers instead focused on markets where 

the GSEs could participate only to a limited extent, such 

as most of the subprime market. Because the GSEs and 

private issuers operated largely in different markets, experience does not provide enough information to assess how 

liquid the secondary market would be if more reliance 

was placed on private-label issuance (for instance, if regulators lowered the size limit for conforming mortgages). 

9. Inside Mortgage Finance, The 2009 Mortgage Market Statistical 

Annual—Volume II: The Secondary Market (Bethesda, Md.: Inside 

Mortgage Finance Publications, 2009), p. 9.

10. Subprime and Alt-A loans are offered to some borrowers who do 

not meet the qualifications for a prime mortgage (one extended to 

the least risky borrowers) because of such risk factors as a low 

credit rating, insufficient documentation of income, or the ability 

to make only a small down payment.

11. John Krainer, Recent Developments in Mortgage Finance, Economic 

Letter 2009-33 (Federal Reserve Bank of San Francisco, October 

26, 2009), www.frbsf.org/publications/economics/letter/2009/

el2009-33.html. 

12. Shane M. Sherlund, The Past, Present, and Future of Subprime 

Mortgages, Finance and Economics Discussion Series Paper 2008-

63 (Federal Reserve Board, November 2008), www.federalreserve.

gov/pubs/feds/2008/200863/200863pap.pdf.
APPENDIX

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B

The Federal Home Loan Banks

In 1932, six years before it established Fannie Mae, 

the federal government created another governmentsponsored enterprise to support mortgage lending: the 

Federal Home Loan Bank (FHLBank) System.1

 As with 

Fannie Mae and Freddie Mac before they were taken into 

conservatorship, the FHLBanks’ status as GSEs creates 

the perception among most investors that their debt is 

protected by an implicit guarantee. That perception 

allows the FHLBanks to borrow money at lower cost than 

a comparable fully private financial institution would 

face. Unlike Fannie Mae and Freddie Mac, the banks are 

exempt from federal income taxes; however, they are obligated to pay 20 percent of their net income to meet the 

cost of bonds issued to resolve the savings and loan crisis 

and to use 10 percent of their net income to support 

affordable housing. 

The FHLBank system is a cooperative one consisting of 

12 regional banks, each owned by member institutions—

such as commercial banks, thrift institutions, credit 

unions, and insurance companies—in its region. Unlike 

Fannie Mae and Freddie Mac, which purchase and securitize mortgages, the FHLBanks provide low-cost funding 

to their members in the form of highly collateralized 

loans, called advances. Originally, those advances went 

mainly to thrifts specializing in mortgage loans, with the 

mortgages serving as collateral against the advances. As 

the FHLBank system has evolved, it has expanded its 

lending to areas other than housing finance, although 

mortgages still make up the majority of collateral for its 

advances.

The FHLBanks fund advances by issuing debt securities 

and selling them to investors, at interest rates somewhat 

above those on comparable Treasury securities. Each 

regional bank operates fairly independently, although it 

must comply with common regulatory requirements set 

by the Federal Housing Finance Agency, which oversees 

the system (and also regulates Fannie Mae and Freddie 

Mac). The 12 banks are jointly and severally liable for the 

system’s debt obligations, meaning that if any one of the 

FHLBanks fails, the remaining banks become responsible 

for making good on its debt. At the end of 2009, the system had a total of $1 trillion in assets, over $900 billion 

in outstanding debt, and more than 8,000 member 

institutions.

Although some of the FHLBanks have experienced significant losses and declines in capital since the financial 

crisis began, the system as a whole has remained solvent.2

It was made eligible for federal assistance under the 

Housing and Economic Recovery Act of 2008, but it has 

not required any capital injections from the Treasury. 

In the past two years, the Federal Reserve purchased a 

relatively small amount of the system’s debt (less than 

$40 billion, or about 4 percent of the debt outstanding at 

the end of 2009) along with its much larger purchases of 

debt and mortgage-backed securities (MBSs) from Fannie 

Mae and Freddie Mac. 

The Role of the Federal Home 

Loan Banks

Today, the FHLBanks are still primarily in the business of 

making advances to their members, which remain a relatively low cost source of funding to financial institutions. 

The collateral that smaller institutions are eligible to use 

for advances has broadened beyond mortgages, and 

FHLBank advances appear to be just as likely to fund

1. For more details, see Congressional Budget Office, The Federal 

Home Loan Banks in the Housing Finance System (July 1993).

2. The FHLBank system has remained solvent both as measured by 

generally accepted accounting principles and as measured on a 

fair-value (or, equivalently, a mark-to-market) basis.
56 FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET

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other types of bank loans as to fund single-family 

mortgages.3

Although advances are not risk-free, no FHLBank has 

ever suffered a credit loss on an advance. One reason is 

that at the time one is made, the value of the collateral 

exceeds the size of the advance. Another reason is that the 

FHLBanks take priority for repayment over depositors, 

the Federal Deposit Insurance Corporation, and almost 

all other creditors if a member institution becomes insolvent. In those respects, FHLBank advances are similar to 

covered bonds (described at the end of Chapter 4). 

The FHLBanks have provided liquidity to the financial 

system during the recent crisis, but in normal times, they 

appear to provide few benefits to mortgage borrowers 

beyond serving as a source of low-cost funding for financial institutions (especially small banks that lack the scale 

to gain access to capital markets efficiently on their 

own).4

 However, the FHLBanks play a statutory role in 

affordable-housing programs: one-tenth of the system’s 

income (or $258 million in 2009) goes to communitybased programs that provide housing assistance for 

low-income households.

The Banks’ Activities in the Secondary 

Mortgage Market

Although the main way that the FHLBanks increase 

liquidity in the mortgage market is by making advances 

collateralized by mortgages to their members, the banks 

also purchase and resell individual mortgages through 

several programs aimed at providing liquidity to their 

member institutions. In addition, they buy limited 

amounts of private-label and agency MBSs for their 

portfolios.

The FHLBanks’ mortgage purchase programs help some 

community banks by offering risk-management benefits 

similar to those provided by securitization through 

Fannie Mae and Freddie Mac, but at a lower cost. The 

first of those programs began in 1997, when several of the 

banks began purchasing mortgages from their member 

institutions, putting them in limited competition with 

Fannie Mae and Freddie Mac.5

 Under those programs, 

members generally retained most of the credit risk on the 

mortgages, and the FHLBanks usually accepted the interest rate and prepayment risk, which they managed by 

using derivatives and other hedging techniques. However, 

two of the FHLBanks (those in Chicago and Seattle) 

experienced problems managing those risks, which in 

2004 led regulators to restrict the growth of the two 

banks’ mortgage purchase programs.6

Several of the FHLBanks now have a program under 

which they aggregate their members’ mortgage loans 

and sell them to Fannie Mae and Freddie Mac at prices 

more favorable than the members could receive on their 

own. That program allows member institutions to retain 

servicing rights on the loans and reduces their requirements for risk-based capital relative to the traditional 

mortgage purchase programs. Moreover, unlike the situation in some of the earlier programs that helped smaller 

banks manage risk, the FHLBanks have little exposure to 

interest rate and prepayment risk. 

Portfolio Holdings and Performance

In addition to advances, the FHLBanks hold whole mortgages, private-label MBSs, and agency securities in their 

portfolios. Those other holdings expose the system to 

differing amounts of risk.7

The system’s holdings of whole mortgages peaked at over 

$110 billion near the end of 2003, when they represented 

about 14 percent of total assets. By the end of 2009, 

those holdings had declined to about $70 billion, or 

3. W. Scott Frame, Diana Hancock, and Wayne Passmore, Federal 

Home Loan Bank Advances and Commercial Bank Portfolio Composition, Working Paper 2007-17 (Federal Reserve Bank of Atlanta, 

July 2007), www.frbatlanta.org/pubs/wp/working_paper_2007-

17.cfm. 

4. Adam Ashcraft, Morten L. Bech, and W. Scott Frame, The Federal 

Home Loan Bank System: The Lender of Next-to-Last Resort? Working Paper 2009-4 (Federal Reserve Bank of Atlanta, February 

2009), www.frbatlanta.org/pubs/wp/working_paper_2009-4.cfm. 

5. W. Scott Frame, “Federal Home Loan Bank Mortgage Purchases: 

Implications for Mortgage Markets,” Economic Review, Federal 

Reserve Bank of Atlanta (Third Quarter 2003), pp. 17–31, 

www.frbatlanta.org/filelegacydocs/erq203_frame.pdf.

6. Statement of Ronald A. Rosenfeld, Chairman, Federal Housing 

Finance Board, before the Subcommittee on Capital Markets, 

Insurance, and Government Sponsored Enterprises, House 

Committee on Financial Services, March 9, 2005. 

7. In addition, the banks hold smaller amounts of other classes of 

assets, whose amounts and types are limited by the system’s 

regulator.
APPENDIX B FANNIE MAE, FREDDIE MAC, AND THE FEDERAL ROLE IN THE SECONDARY MORTGAGE MARKET 57

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roughly 7 percent of the system’s total assets. Today, only 

7 of the 12 regional banks still purchase whole mortgages. 

The whole mortgages held by the FHLBanks have had 

much lower delinquency rates than those guaranteed by 

Fannie Mae and Freddie Mac. At the end of 2009, less 

than 2.4 percent of the banks’ mortgage holdings were 

seriously delinquent (90 days past due or in foreclosure), 

compared with 4.8 percent for Fannie Mae and Freddie 

Mac and 9.7 percent for the industry as a whole. The 

lower delinquency rates may be partly attributable to 

higher lending standards on the part of smaller banks and 

to the types of mortgages purchased by the FHLBanks. 

The lower rates also reflect the fact that many of those 

mortgages were bought prior to 2004, well before 

housing prices peaked.8

Like their holdings of whole mortgages, the FHLBanks’ 

holdings of private-label MBSs have declined in recent 

years—from more than $80 billion in total book value at 

the end of 2007 to $48 billion at the end of 2009. Those 

private-label holdings, which are limited by the banks’ 

regulator and make up less than 5 percent of the system’s 

assets, expose the FHLBanks to credit, interest, and prepayment risk.9

 Losses on private-label MBSs have weakened the system and adversely affected several of the 

banks.

Another 10 percent of the system’s asset holdings consist 

of debt securities and MBSs issued by Fannie Mae, 

Freddie Mac, and other government-sponsored enterprises. Those agency securities pose minimal credit risk 

to the system, although they entail interest rate and 

prepayment risk.

8. Federal Housing Finance Agency, Securitization of Mortgage Loans 

by the Federal Home Loan Bank System (report submitted to the 

Senate Committee on Banking, Housing and Urban Affairs and 

the House Committee on Financial Services, July 30, 2009), 

www.fhfa.gov/webfiles/14699/.

9. Federal Housing Finance Agency, Report to Congress: 2009

(May 25, 2010), p. 67, www.fhfa.gov/Default.aspx?Page=240.