Our paper compares mortgage securitization undertaken by government-sponsored enterprises (GSEs) with that undertaken by private firms, with an emphasis on how each type of mortgage securitization affects mortgage rates. We build a model illustrating that market structure, government sponsorship, and the characteristics of the mortgages securitized are all important determinants of mortgage rates. We find that GSEs generally-but not always-lower mortgage rates, particularly when the GSEs behave competitively, because the GSEs' implicit government backing allows them to sell securities without the credit enhancements needed in the private sector. Using our simulation model, we demonstrate that when mortgages eligible for purchase by the GSEs have characteristics similar to other mortgages, the GSEs' implicit governmentbacking generates differences in mortgage rates similar to those currently observed in the mortgage market (which range between zero and fifty basis points). However, if the mortgages purchased by GSEs are less costly to originate and securitize, and the if the GSEs behave competitively, then the simulated spread in mortgage rates can be much larger than that observed in the data. 2 Fannie and Freddie also directly held about $1.0 trillion of mortgages and mortgage-backed securities at year-end 2000. During the 1990s, their yearly securitization rate is estimated to have fluctuated between 45 percent and 78 percent of conventional conforming mortgage originations. Information about Fannie's and Freddie's holdings is from their quarterly and annual reports, whereas information about the fully private market is from Inside MBS & ABS, February 2, 2000, page 7. The securitization rate is from Inside Mortgage Finance Publications (2000). 3 For a review of efforts to measure the size of the GSE subsidy, see Feldman (1999). For an exposition of how the GSE subsidy benefits shareholders and others, see Congressional Budget Office (1996, 2001) and General Accounting Office (1996). 4 Note that Fannie and Freddie-like all insurers of credit risk-face an adverse selection problem that requires they include a "lemons premium" in the purchase price they offer for mortgages. Theoretically, their subsidy could be completely absorbed by the GSEs' efforts to avoid adverse selection (Passmore and Sparks, 1996 & 2000).
Lenders either sell or obtain insurance for many of the mortgages they originate to reduce credit risk and enhance liquidity. An overwhelming majority of the mortgages sold are purchased by government-sponsored enterprises. The prevailing view is that government-sponsorship of mortgage securitization causes mortgage rates to be lower than they would otherwise be. Using a model that incorporates asymmetric information and adverse selection, we provide an example in which government-sponsored mortgage securitization raises the mortgage rate.Lenders either sell or obtain insurance for many of the mortgages they originate to reduce credit risk and enhance liquidity. An overwhelming majority of the mortgages sold are purchased by government-sponsored enterprises (GSEs), The prevailing view is that government sponsorship of mortgage securitization causes mortgage rates to be lower than they would otherwise be. As the argument goes, government sponsorship provides a cost advantage that is passed on to borrowers in the form of lower mortgage rates. This conclusion follows from standard economic models under the assumption of symmetric information.In our paper, we follow the recent literature on insurance markets by making the more realistic assumption of asymmetric information. We assume that the originator of the mortgage (which we will refer to as a bank) has an information advantage over the mortgage securitizer. 2 The bank may acquire, at some cost, information on a mortgage applicant's default risk, while the securitizer is unable to acquire such information. In other words, the bank may screen the applicant but the securitizer cannot. Under this assumption, our model yields the unconventional result that mortgage rates may rise for realistic values of the model's parameters. We provide an example in which government-sponsored mortgage securitization raises the mortgage rate.The intuition for this result derives from the strategic behavior of the mortgage securitizer. The securitizer knows that banks have incentives to screeen applicants and then sell the high-risk mortgages (lemons) to the securitizer while keeping the profitable low-risk mortgages (cherries) in their own portfolios. This is a classic lemons problem. Yet, in our model, the securitizer may alter the proportion of lemons sold by manipulating the guaranteed rate of return provided to banks that sell mortgages.
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