-->In a crisis, the mortgage market would be severely disrupted and mortgages and mortgage-backed securities would no doubt trade at lower prices, thus impairing the value of the collateral FF could post. The decline in the value of FF assets would strain their capital positions, and lead to fears that either or both Fannie Mae and Freddie Mac might become insolvent.
Under Section 13(3) of the Federal Reserve Act, Federal Reserve Banks have the authority to discount paper for individuals, partnerships or corporations. Direct lending to the GSEs would have to come under provisions of this part of the Federal Reserve Act. Critical provisions include a finding of unusual and exigent circumstances and an affirmative vote of not less than five members of the Board of Governors. The loans would have to be fully collateralized.
There has been no lending under this provision of the Federal Reserve Act since the 1930s. Such lending, were it to be authorized by the Board of Governors, would permit GSEs to redeem maturing obligations and would, therefore, solve part of a crisis problem. However, such loans might not restore liquidity to GSE debt before redemption and would not per se restore normal functioning of the mortgage market. Clearly, Federal Reserve support for the GSEs would help to prevent a broadening crisis, but most likely would be incapable of preventing some considerable disruption.
The Federal Reserve has ample power to deal with a liquidity problem, by making collateralized loans as authorized by the Federal Reserve Act. The Fed does not have power to deal with a solvency problem. Should a solvency problem arise with any of the GSEs, the solution will have to be found elsewhere than through the Federal Reserve......
I note also that FF have a powerful incentive to grow. They report returns on equity in the neighborhood of 30 percent per year. They are able to achieve these returns by exploiting the implicit federal guarantee of their obligations, which enables them to borrow at near Treasury rates despite their thin capital positions and invest in mortgages at private market rates. Their growth objectives insure that their scale will increase over time, unless they become subject to full private market incentives through convincing federal policies that lead to market recognition that the federal government will not guarantee GSE obligations in a crisis.
<ul> ~ http://www.stlouisfed.com/news/speeches/2004/05_06_04.html</ul>
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