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: University of Texas at San Antonio
Donald Lien: University of Texas at San Antonio
Margot Quijano: University of Texas at San Antonio

No 35, Working Papers from College of Business, University of Texas at San Antonio

Abstract: Recent comments by the Federal Reserve Chairman have renewed 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. 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 of F&F 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.

Keywords: Fannie and Freddie; Capital Structure; subsidy (search for similar items in EconPapers)
JEL-codes: G2 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2008-02-11
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