The effects of government sponsored enterprise (GSE) status on the pricing of bonds issued by the Federal Farm Credit Banks Funding Corporation (FFCB)

Abstract

PurposeMotivated by recent congressional interest in eradicating government sponsored enterprises (GSE), the purpose of this paper is to develop a framework to price the implicit government guarantee embedded in the bonds issued by the Farm Credit System.Design/methodology/approachThe paper uses the Black‐Scholes model to extract the implied volatilities of the guarantee and then substitute into the model the volatility in historical land prices. The model is developed along the lines of Merton's bond pricing formulation of implicit calls and puts on bond yield risk and default.FindingsBottom line results show that the average bond yield for a 3M Farm Credit bond from January 13th 2009 to February 10th 2011 would be 0.3744 percent if the Farm Credit System had no GSE status, which is 13.62 bps higher than the actual bond yield. The difference between the hypothetical yield and the actual yield increases with increasing maturity and reaches its peak with 10Y bond where the difference between the hypothetical yield and the actual yield is 68.81 bps. The paper concludes that given the current state of the agricultural credit market in the USA that loss of GSE status and the implied guarantee of Farm Credit bonds would have a minimal effect on short term notes, with a more substantive increase in longer term yields.Practical implicationsThe GSE status of the Farm Credit System is an important political issue. This paper provides first estimates of what impact might result from its loss of GSE status. The methods employed are consistent with current models of bond pricing and the results are of direct relevance to Farm Credit System regulators and congressional discussions.Social implicationsFarm credit is important, if the Farm Credit System loses its GSE status this might affect the competitive balance between commercial and system lenders.Originality/valueThis paper uses option price theory based upon the spread between farm credit bonds and treasury. The approach used requires daily data, but not all attributes of bonds are known. Nonetheless, the results show remarkable consistency for a problem that is largely understudied. There is a need for policy makers, including the US congress to understand the value of government guarantees whether implicit or explicit.