Government-Sponsored Enterprise (GSE)

Definition

A Government-Sponsored Enterprise (GSE) is a type of financial services corporation created by the United States Congress. These enterprises are privately owned but were established to enhance the flow of credit to specific sectors of the economy such as agriculture, education, and housing. GSEs benefit from the implicit backing of the federal government, which allows them to raise funds at interest rates lower than those available to wholly private-sector entities.

Examples

Federal National Mortgage Association (FNMA or Fannie Mae): Created in 1938, Fannie Mae provides liquidity to the mortgage market by buying mortgages from lenders, enabling them to lend more money to homebuyers.
Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac): Established in 1970, Freddie Mac operates similarly to Fannie Mae, buying residential mortgages, and then issuing mortgage-backed securities.

Frequently Asked Questions

Q1: What is the main function of a GSE?
A1: The primary function of a GSE is to enhance the flow of credit to targeted economic sectors. This is achieved by guaranteeing or directly providing funding, which lowers the cost and increases the availability of credit.

Q2: How does the implicit backing from the U.S. Treasury benefit GSEs?
A2: The implicit backing allows GSEs to raise funds at lower interest rates compared to other private-sector entities, due to the reduced perceived risk of their debt securities.

Q3: Are GSEs publicly traded entities?
A3: Yes, GSEs like Fannie Mae and Freddie Mac are publicly traded companies, although they were originally established by the government.

Q4: What happened to Fannie Mae and Freddie Mac during the 2008 financial crisis?
A4: On September 6, 2008, the U.S. government took control of 80% of both enterprises to stabilize the financial system during the housing market collapse.

Mortgage-Backed Securities (MBS): Financial instruments that are secured by a mortgage or collection of mortgages. GSEs often purchase these instruments in order to provide liquidity to the mortgage market.

Implicit Guarantee: The unstated assumption that the government will provide financial backing if the GSEs face insolvency, although it is not enshrined in law.

Securitization: The process of pooling various types of debt (including mortgages) and selling them as bonds to investors.

Liquidity: The ability to quickly convert assets into cash with minimal loss in value; GSEs provide market liquidity by purchasing loans and creating MBS.

Online References

Suggested Books

“The Big Short: Inside the Doomsday Machine” by Michael Lewis
“Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again” by Peter J. Wallison
“Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon” by Gretchen Morgenson and Joshua Rosner
“All the Devils Are Here: The Hidden History of the Financial Crisis” by Bethany McLean and Joe Nocera

Fundamentals of Government-Sponsored Enterprise: Finance Basics Quiz

### What is the primary role of a Government-Sponsored Enterprise (GSE)? - [ ] To operate as a completely private entity - [x] To enhance the flow of credit to specific sectors such as housing and education - [ ] To withdraw liquidity from the market - [ ] To exclusively serve government interests > **Explanation:** GSEs were created to enhance the flow of credit to specific areas of the economy by providing guarantees or direct funding. ### Which of the following is a well-known example of a GSE? - [ ] Goldman Sachs - [ ] Citibank - [x] Fannie Mae - [ ] Bank of America > **Explanation:** Fannie Mae (Federal National Mortgage Association) is a well-known GSE created to enhance liquidity in the mortgage market. ### What significant event affected Fannie Mae and Freddie Mac in September 2008? - [ ] They were shut down - [x] The U.S. government took control of 80% of both enterprises - [ ] They declared bankruptcy - [ ] They merged into a single entity > **Explanation:** The U.S. government took control of 80% of both organizations to stabilize the financial system during the 2008 financial crisis. ### Why can GSEs raise funds at lower interest rates compared to other private-sector entities? - [ ] Because they have more assets - [x] Because of the implicit backing of the U.S. Treasury - [ ] Because they are more profitable - [ ] Because they operate internationally > **Explanation:** The implicit backing from the U.S. Treasury reduces the perceived risk to investors, enabling GSEs to raise funds at lower interest rates. ### What does "implicit guarantee" refer to in the context of a GSE? - [ ] A written document ensuring government bailouts - [ ] A corporate policy for financial assistance - [x] The unstated assumption of government support in case of financial trouble - [ ] A formal contract with private investors > **Explanation:** An implicit guarantee is the unstated assumption that the government will provide financial support if the GSEs face insolvency. ### How do GSEs like Fannie Mae provide liquidity to mortgage lenders? - [ ] By issuing stocks and bonds - [ ] By increasing interest rates - [x] By purchasing mortgages from lenders - [ ] By restricting the supply of loans > **Explanation:** GSEs like Fannie Mae buy mortgages from lenders, providing them with capital to issue more loans. ### What is securitization in the context of GSEs? - [ ] Consolidating various bank operations - [x] Pooling various types of debt including mortgages and selling them as bonds - [ ] Offering insurance policies - [ ] Managing a real estate portfolio > **Explanation:** Securitization involves pooling various types of debt, including mortgages, and selling them as bonds to investors. ### What area of liquidity does GSE primarily target? - [ ] Stock Market - [ ] Agricultural Market - [ ] Technology Sector - [x] Mortgage Market > **Explanation:** GSEs primarily target the mortgage market to ensure there is enough liquidity, making more funds available for home buyers and lenders. ### Can GSEs operate without government oversight? - [ ] Yes, they are private companies - [x] No, they are subject to government regulation despite being privately owned - [ ] They operate under international rules - [ ] Only during economic crises > **Explanation:** Despite being privately owned, GSEs are subject to government regulation to ensure they fulfill their public-purpose mandates. ### Which agency oversees Fannie Mae and Freddie Mac? - [ ] Federal Reserve - [ ] Department of the Treasury - [ ] Securities and Exchange Commission (SEC) - [x] Federal Housing Finance Agency (FHFA) > **Explanation:** The Federal Housing Finance Agency (FHFA) oversees both Fannie Mae and Freddie Mac as part of its regulatory mandates.

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