WILL PULLING OUT THE RUG HELP? UNCERTAINTY ABOUT FANNIE AND FREDDIE'S FEDERAL GUARANTEE AND THE COST OF THE SUBSIDY

Karan Bhanot (), Donald Lien and Margot Quijano
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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

Annals of Financial Economics (AFE), 2008, vol. 04, issue 01, 1-28

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.

Keywords: GSEs; federal guarantee; bankruptcy; G2 (search for similar items in EconPapers)
Date: 2008
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DOI: 10.1142/S2010495208500024

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