The Link Between GSE Reform and QE3


By: Mark Semotiuk

On August 17th, the Treasury Department revamped its financial support of Fannie Mae and Freddie Mac. The new agreements increased the share of profits payable to the Treasury. The Treasury Department also accelerated the pace at which the mortgage-finance giants are required to wind down their mortgage portfolios and pay back the government for their rescue four years ago.

The initial agreements (FNMA, FHLMC), which were entered into in September of 2008, provided up to $100 billion each in exchange for senior preferred stock which accrued dividends at 10%. The agreements were subsequently amended in May and December of 2009 to increase the funds available to more than $200 billion each. As of June 2012, over $187 billion of support, part of which has gone to pay the Treasury dividends, has been provided.

The August 17th agreement (FNMA, FHMLC) replaced the fixed 10% dividend payment with a variable “net worth sweep” beginning in the first quarter of 2013. The agreement allows the government sponsored enterprises (“GSE”) to build a net worth reserve of $3 billion each during 2013.  The agreement also requires any net worth above this amount to be paid out as a dividend. The reserve will be reduced by $600 million each year beginning in 2014 until it reaches zero in 2018.

Further, the new agreement also amended the pace at which the GSEs would be required to wind down their mortgage portfolios. The original agreement required the size of the GSE’s mortgage related investment portfolios to be less than 90% of the portfolios held in the prior year. By contrast, the new agreement subjects the GSE’s portfolios to a cap of $650 billion on December 31, 2012 and requires decreases of 15% each year thereafter until the portfolio reaches $250 billion.

Together, the GSEs currently hold over $1.24 trillion in their mortgage portfolios. In order to meet their 15% reduction requirements, the GSEs will be net sellers of approximately $186 billion in mortgage backed securities. To put this in perspective, from 1999 to 2009 the GSEs issued on average nearly $1.04 trillion per year in mortgage securities. $186 billion represents an 18% increase in supply over the long term yearly origination amount. Because bond prices and interest rates are inversely related, the increased supply would lower prices and raise mortgage backed security and mortgage rates.

Source: Fact Sheet 2011

Further, the MBS market is currently facing pressures from lower bank demand for MBS holdings, and increased supply from overseas investors, although this is somewhat counterweighted by increased demand from money managers (including REITs). The chart to the right provides a sense of the purchasing power of each of these sources by showing their relative holdings of the entire $5.5 trillion universe of agency MBS. As a result of all of these forces, higher mortgage rates would further put pressure on the housing market, which would in turn weaken the current recovery.


Since the financial crisis that began in 2007, the Federal Reserve has been implementing increasingly unconventional policies to help buoy the housing market and the economy. One set of actions, which had not been used since the 1930s, was to lend to entities other than banks. Pursuant to section 13(3) of the Federal Reserve Act the Fed was able to act as the lender of last resort to support Treasury guarantee programs, and lend $85 billion to AIG, as the financial crisis presented the appropriate unusual and exigent circumstances.

The second set of unconventional policies involved a new take on monetary policy. The Fed influences a broader range of interest rates and consequently economic activity by raising and lowering a short term interest rate known as the Fed Funds rate. By December of 2008, however, the Fed Funds rate neared zero and conventional monetary policy was exhausted. The Fed thus targeted long term interest rates through Large Scale Asset Purchases (LSAP), or Quantitative Easing (QE). By purchasing long dated Treasuries and Fannie and Freddie Mortgage Backed Securities, the Fed reduces the supply of these securities in the market. This lowers the supply of these securities, increases the bond prices, and as discussed, decreases the interest rate.

In March 2009, November 2010 and September 2011, the Fed announced QE1, QE2 and Operation Twist, respectively. (As opposed to the QEs which are outright unsterilized LSAP purchases, under Operation Twist, the Fed sold its short dated holdings and purchased longer dated ones, having no net impact on its balance sheet, while favoring reductions in long term over short term interest rates). Through the QE programs the Fed has increased its balance by an additional $2 trillion dollars and consequently reduced mortgage rates from above 6% to about 3.5%.

Bernanke is well aware that there are structural factors in the housing market which are preventing a more robust recovery. In a recent lecture he indicated that there is an excess supply of housing resulting in low house prices. On the demand side he indicated that while prices are down and mortgage rates are low, mortgage lending conditions generally have been much tighter. Bernanke concluded that even though housing is very affordable and monthly payments are affordable, a lot of people are unable to get mortgages. In fact, as the chart to the left shows, even though mortgage rates are at historic lows, mortgage payments as a percent of qualifying income are just now near 1990s levels, suggesting further home price declines as interest rates increase.

As a result, in order to facilitate both the broader economic recovery, and the wind down of the GSEs, it was necessary for the Fed to engage in another round of quantitative easing to offset the GSEs looming $186 billion yearly sale of mortgage backed securities. On September 13th 2012, the Fed announced QE3 wherein it would purchase $40 billion in mortgage backed securities per month (or $480-billion per year) in addition to its current ongoing Operation Twist activities. Accordingly, this new set of economic policies will allow the GSEs to wind down their mortgage portfolios at a healthy clip while keeping mortgage rates low. This thereby provides support to the area of the economy which needs it most – housing.


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Fordham Journal of Corporate & Financial Law