What Are Government Sponsored Enterprises?
Government sponsored enterprises (GSEs) are a category of financial services corporations created by the United States Congress. Although privately owned or shareholder-owned, their primary purpose is to enhance the flow of credit to specific sectors of the U.S. economy, such as housing, agriculture, and education. GSEs generally do not lend money directly to the public. Instead, they operate by guaranteeing third-party loans and purchasing loans from lenders, which helps to create liquidity in the capital markets and reduce the cost of borrowing for the targeted sectors. The most prominent examples of government sponsored enterprises are Fannie Mae and Freddie Mac, which play a crucial role in the secondary mortgage market by purchasing mortgages and packaging them into mortgage-backed securities (MBS).
History and Origin
The concept of government sponsored enterprises emerged from periods of economic hardship in the United States, aiming to address market inefficiencies and ensure access to credit. The first GSE, the Farm Credit System, was established in 1916 to support agriculture. In the housing sector, the creation of GSEs was driven by the need for a more robust and liquid mortgage market. The Federal Home Loan Bank System was formed in 1932 during the Great Depression to provide liquidity to member financial institutions.
A significant development came with the establishment of the Federal National Mortgage Association (Fannie Mae) in 1938 as part of the New Deal, initially to create a secondary market for mortgages insured by the Federal Housing Administration (FHA)19, 20. Fannie Mae was reorganized in 1968, becoming a shareholder-owned company, though still operating under a congressional charter18. Following this, the Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered by Congress in 1970 to provide further competition in the secondary mortgage market and ensure a continuous supply of mortgage funds, particularly by purchasing mortgages from smaller lenders16, 17. These government sponsored enterprises were designed to stabilize the mortgage market, expand homeownership, and provide an affordable supply of funds for housing15.
Key Takeaways
- Government sponsored enterprises (GSEs) are privately owned corporations chartered by Congress to support specific sectors like housing, agriculture, and education.
- GSEs enhance credit flow by guaranteeing loans and purchasing them from lenders, thereby providing market liquidity.
- Fannie Mae and Freddie Mac are the two largest GSEs, critical to the U.S. housing finance system.
- While not direct government agencies, GSEs have an implicit government backing, which influences their debt and market perception.
- The 2008 financial crisis highlighted the inherent risks and the significant government intervention required to stabilize GSEs.
Interpreting Government Sponsored Enterprises
Government sponsored enterprises are interpreted within the financial system as entities that blend public purpose with private operation. Their existence facilitates the flow of funds from capital markets to sectors deemed vital for economic stability and social welfare, such as homeownership. By purchasing and securitizing loans, GSEs help reduce interest rate risk for primary lenders and enable them to originate more loans. The implicit government backing of these entities significantly lowers their borrowing costs, which in turn is intended to translate into lower borrowing costs for consumers in the targeted sectors. For instance, in housing, this support influences mortgage rates, impacting affordability and access to housing. Understanding GSEs is crucial for analyzing the dynamics of the housing market and the broader economy, particularly concerning credit risk and government intervention in financial markets.
Hypothetical Example
Consider a local bank, "Community Home Lenders," that has originated many new mortgages to homebuyers in its area. While these mortgages generate income, they also tie up the bank's capital, limiting its ability to issue more loans. To free up capital, Community Home Lenders can sell these mortgages to a government sponsored enterprise like Fannie Mae.
Fannie Mae purchases a pool of these mortgages, providing Community Home Lenders with fresh cash. Fannie Mae then bundles these purchased mortgages into bonds known as mortgage-backed securities (MBS) and sells them to investors on the secondary market. Because these MBS carry a guarantee from Fannie Mae, investors perceive them as lower risk, even though the underlying mortgages are from individual homeowners. This process allows Community Home Lenders to continue making new loans, and investors gain access to a relatively safe investment backed by housing assets.
Practical Applications
Government sponsored enterprises have widespread practical applications across various financial and economic domains. Their primary role is to ensure a stable and affordable supply of credit in specific sectors.
In housing finance, Fannie Mae and Freddie Mac are central. They provide the necessary liquidity for the mortgage market by purchasing mortgages from lenders, allowing those lenders to free up capital and originate more loans13, 14. This mechanism helps standardize mortgage products and makes mortgage credit broadly available across different regions and economic cycles.
In capital markets, GSEs issue debt known as agency bonds, which are highly regarded due to their implicit government backing. These bonds are a significant component of fixed-income portfolios for institutional investors seeking relatively low-risk investments.
For financial stability, GSEs are critical conduits, ensuring that capital continues to flow even during periods of market stress. However, their size and interconnectedness also mean that their stability is paramount to the broader financial system, a point sharply highlighted during the 2008 financial crisis12. Policymakers continue to consider various strategies for managing the role and structure of these entities to minimize taxpayer exposure while maintaining their core functions, advocating for robust capital standards and clarified market structures11.
Limitations and Criticisms
Despite their vital role, government sponsored enterprises face several limitations and criticisms, primarily stemming from their unique hybrid structure. A significant concern is the "implicit guarantee" from the U.S. government. While GSEs are privately owned, the market generally perceives their debt as implicitly backed by the full faith and credit of the government. This perception allows GSEs to borrow at lower rates than fully private entities, creating a competitive advantage and potentially encouraging excessive risk-taking, as the cost of failure is ultimately borne by taxpayers10.
The vulnerabilities associated with this implicit backing were starkly exposed during the 2008 subprime mortgage crisis. Fannie Mae and Freddie Mac, facing massive losses from their mortgage portfolios, required significant government intervention. On September 7, 2008, the Federal Housing Finance Agency (FHFA) placed both Fannie Mae and Freddie Mac into conservatorship, an action described as one of the most extensive government interventions in private financial markets in decades8, 9. This conservatorship continues more than a decade later, demonstrating the deep-seated challenges in reforming these entities and their impact on taxpayer funds7. Critics argue that their current "wards of the state" status prevents genuine market-driven competition and creates an uneven playing field for fully private capital6.
Government Sponsored Enterprises vs. Government Agencies
While both government sponsored enterprises (GSEs) and government agencies are established or authorized by Congress, a key distinction lies in their ownership and operational structure. Government agencies are direct arms of the federal government, fully owned and operated by the state, and their obligations are explicitly backed by the U.S. Treasury. For example, the Government National Mortgage Association (Ginnie Mae) is a government agency that guarantees mortgage-backed securities composed of FHA, VA, and other government-insured loans, carrying the full faith and credit of the U.S. government.
In contrast, government sponsored enterprises, such as Fannie Mae and Freddie Mac, are chartered by Congress but are privately owned or shareholder-owned corporations. They operate with a public mission to facilitate credit flow but manage their operations as private businesses. Although they benefit from an implicit government backing, their obligations are not explicitly guaranteed by the Treasury in the same way direct government agency debt is. This hybrid nature creates a unique position in the financial landscape, offering advantages like lower borrowing costs but also posing risks regarding potential taxpayer liability if the GSEs face financial distress.
FAQs
What is the primary purpose of government sponsored enterprises?
The main goal of government sponsored enterprises (GSEs) is to enhance the flow of credit to specific sectors of the economy, such as housing, agriculture, and education. They achieve this by purchasing loans from lenders and providing guarantees, which helps ensure market liquidity and affordability for borrowers.
Are Fannie Mae and Freddie Mac government agencies?
No, Fannie Mae and Freddie Mac are not direct government agencies. They are government sponsored enterprises, meaning they are privately owned corporations chartered by the U.S. Congress with a public mission. While they have an implicit government backing, their obligations are not explicitly guaranteed by the U.S. Treasury in the same way as a direct government agency.
How do GSEs impact the average homebuyer?
Government sponsored enterprises like Fannie Mae and Freddie Mac significantly impact the average homebuyer by ensuring a steady and affordable supply of mortgage funds. By purchasing mortgages from lenders, they allow banks to continue making new loans, which helps keep mortgage rates lower and makes long-term, fixed-rate mortgages more widely available4, 5.
What are some other examples of government sponsored enterprises?
Besides Fannie Mae and Freddie Mac, other notable government sponsored enterprises include the Federal Home Loan Banks (FHLBs) System, which provides funding to banks and other financial institutions for housing and community development, and the Farm Credit System and Farmer Mac, which serve the agricultural sector3.
Did the government bail out Fannie Mae and Freddie Mac?
Yes, during the 2008 financial crisis, the U.S. government placed Fannie Mae and Freddie Mac into conservatorship and provided substantial financial support to stabilize them and the broader mortgage market1, 2. This intervention was necessary to prevent a collapse that would have had severe repercussions for the U.S. economy.