I. EXECUTIVE SUMMARY

Fannie Mae and Freddie Mac – the two government-sponsored enterprises (GSEs) chartered by the federal government to support the secondary market for residential mortgages – provide considerable benefits to the housing sector of the U.S. economy. The Enterprises support housing activity by supplying ample, low-cost liquidity to the primary mortgage market. Fannie Mae and Freddie Mac are in strong financial condition today, and the possibility of either Enterprise failing or contributing to a financial crisis is remote. The risk of either company causing a systemic disruption is highly unlikely under the comprehensive safety and soundness regulation of the Office of Federal Housing Enterprise Oversight (OFHEO). OFHEO employs examinations, a stringent risk-based capital stress test, and other tools to meet its responsibility and reduce systemic risk.

Nevertheless, it is useful to consider, hypothetically, what systemic impact an Enterprise could have on the housing market and financial system in two very different situations. In the first case, the Enterprises are strong and other parts of the financial system are destabilized. In the second, either Enterprise is itself experiencing financial difficulties.

If the Enterprises are financially strong during a stressful economic period in which many other financial institutions experience solvency and liquidity problems, the Enterprises are a source of stability. Their activities can protect mortgage lending and the housing sector. In addition, in those circumstances, the liquidity of Fannie Mae and Freddie Mac debt and mortgage-backed securities (MBS) can enhance the liquidity of institutions that hold those obligations and overall liquidity in financial markets. In both ways, the Enterprises mitigate systemic risk.

If Fannie Mae or Freddie Mac experienced financial difficulties the systemic implications might vary depending upon the circumstances. Any systemic disruption would likely be minimal as OFHEO took prompt corrective action and other market participants filled the short-term market void. Alternatively, in the unlikely circumstance that an enterprise experienced severe financial difficulties, they could cause disruptions to the housing market and financial system.

This report consists of six chapters:

• Chapter One presents the concepts used in the report and surveys the literature on financial crises and systemic risk.
  
• Chapter Two summarizes the relationship of the government to the Enterprises, and examines their operations and activities. The Enterprises support the housing sector and assist refinance activity by ensuring that residential mortgage lenders in all regions of the country have continual access to funds on comparable terms. Fannie Mae and Freddie Mac do so by purchasing single- and multifamily mortgages underwritten according to their standards and by guaranteeing MBS collateralized by such loans.
  
• Chapter Three discusses the fact that the activities of Fannie Mae and Freddie Mac have had several economic effects: local and regional markets for single-family mortgages that carry no federal guarantee or insurance are fully integrated into the capital markets; interest rates on conventional fixed-rate loans the Enterprises are eligible to purchase are lower than they otherwise would be; and the supply of credit to the housing sector is more stable than the supply of credit to most other sectors of the economy.
  
• Chapter Four analyzes hypothetical scenarios in which, under adverse financial conditions, the activities and financial health of Fannie Mae and Freddie Mac affect the rest of the financial sector. The scenarios illustrate how under some circumstances the Enterprises can be a source of strength for the U.S. housing finance system and the financial sector as a whole, and present other circumstances where Fannie Mae and Freddie Mac might or might not increase the risk of financial disruptions that could lead to large losses in aggregate economic activity.
  
• Chapter Five discusses how the safety and soundness regulation of Fannie Mae and Freddie Mac by OFHEO limits the systemic risk posed by the Enterprises by ensuring their safe and sound operation.
  
• Chapter Six describes the regulatory actions that OFHEO will undertake to enhance its supervision and offers two legislative recommendations.