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Will Pulling Out The Rug Help? Uncertainty About Fannie And Freddie'S Federal Guarantee And The Cost Of The Subsidy

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  • KARAN BHANOT

    (College of Business Administration, The University of Texas at San Antonio, USA)

  • DONALD LIEN

    (College of Business Administration, The University of Texas at San Antonio, USA)

  • MARGOT QUIJANO

    (McCoy College of Business Administration, Texas State University, USA)

Abstract

Comments by the Federal Reserve Chairman often evoked concerns about whether the government would protect bondholders in the event of default by Fannie Mae and Freddie Mac (F&F). Using a model of capital structure, we analyze the impact of this uncertainty on the value of the implicit subsidy for F&F (and similar institutions). We show that, counter to intuition, an increase in the likelihood that the government will not subsidize these entities via a guarantee may increase the expected cost of the subsidy to the federal government. A cap on the value of the investment portfolio is a more effective mechanism to reduce the risk exposure of the federal government. We also assess the design and impact of proposed receivership rules and highlight the problems in regulating GSE portfolios. Even though F&F are now in conservatorship, the framework is applicable to other government sponsored entities where there is ambiguity about the extent of government backing.

Suggested Citation

  • Karan Bhanot & Donald Lien & Margot Quijano, 2008. "Will Pulling Out The Rug Help? Uncertainty About Fannie And Freddie'S Federal Guarantee And The Cost Of The Subsidy," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 4(01), pages 1-28.
    • Handle: RePEc:wsi:afexxx:v:04:y:2008:i:01:n:s2010495208500024
    DOI: 10.1142/S2010495208500024
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    References listed on IDEAS

    as
    1. Andreas Lehnert & Wayne Passmore & Shane Sherlund, 2008. "GSEs, Mortgage Rates, and Secondary Market Activities," The Journal of Real Estate Finance and Economics, Springer, vol. 36(3), pages 343-363, April.
    2. Robert S. Seiler, 2003. "Market Discipline of Fannie Mae and Freddie Mac," FHFA Staff Working Papers 03-04, Federal Housing Finance Agency.
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    More about this item

    Keywords

    GSEs; federal guarantee; bankruptcy; G2;
    All these keywords.

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services

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