From the book “Restoring Financial Stability: How to Repair a Failed System”.
Section II: Financial Institutions
The primary function of the two government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, is to purchase and securitize mortgages. The securitized mortgages are sold off to outside investors with a guarantee of full payment of principal and interest. In addition, the GSEs hold some of the purchased mortgages as investments, and, in theory, help provide liquidity to the secondary market by repurchasing the mortgage-backed securities (MBS). They are major enterprises and play an unquestionably important role in the market for residential mortgages. The residential mortgage market is approximately 10 trillion dollars in size, 55% of which is securitized. The GSEs retain a mortgage portfolio of $1.5 trillion and have securitized (and thus guaranteed the defaults of) $3.8 trillion of existing mortgages. Though private institutions, the GSEs accept some regulatory oversight in return for an implicit government guarantee of support. As a result, the GSEs’ activities are funded through “cheap” credit made available in capital markets under the presumed guarantee. The structure of the GSEs leads to the classic moral hazard problem in which the lack of capital market discipline and cheap credit provides an incentive for excessive risk taking. In fact, even though the GSEs’ portfolio contained a variety of risks, including nonprime mortgages and long-maturity prime ones, the GSEs had leverage ratios of the order of 25 to 1.