Subsidies in a Context of Efficient Markets: A New Framework for Evaluating the Role of Fannie Mae

Abstract

Fannie Mae and Freddie Mac have been the focus of extensive Congressional, academic, and journalistic scrutiny in recent years. Much of this attention has been due to a claim that their shareholders and employees benefit inordinately from the companies' Congressional charter and that this charter permits unlimited portfolio growth. The impact of their status has been labeled an implicit in several controversial studies. The theoretical underpinning of the implicit observation is an application of the standard microeconomic model of subsidies for producers of tangible goods. The standard goods model concludes that the subsidized producer will capture all or most of the subsidy and will expand without limit until it becomes a monopolist. The goods model cannot be applied to financial assets. Because financial markets are efficient, Fannie Mae is unable to benefit through its retained portfolio from any lowering of debt yields because mortgage backed security (MBS) yields will be lowered by at least the same amount. Selling agency debt to buy agency MBS is accomplished at prices set in a broad and competitive market. The spread between these two securities reflects the prepayment risk in mortgages and liquidity differences between MBS and debt. For Fannie Mae's portfolio to earn above-normal returns, the spread between MBS and debt would have to be in some way too large. Because many investors are able to trade in these securities to capture any deviations from a market rate of return given the inherent risk, all abnormal returns are traded away. In fact, the sale of agency debt to finance MBS redistributes risks to those investors best able to manage them and thus lowers risk premiums, causing MBS yields to fall at least as much as debt yields. We note that the agency debt and mortgage-backed securities markets are predicated on the Congressional charter. That charter provides access to the market, opens up classes of investors to agency securities, provides stability to investors and lowers the yields of both agency debt and of MBS, thus fostering the 30-year mortgage.