The GSE Debt Market: An Overview

Government-sponsored enterprises (GSEs) are financing entities created by Congress to fund loans to certain groups of borrowers such as homeowners, farmers and students. Through the creation of GSEs, the government has sought to address various public policy concerns regarding the ability of members of these groups to borrow sufficient funds at affordable rates.

GSEs are also sometimes referred to as federal agencies or federally sponsored agencies. The reader should note, however, that there are organizational differences among the GSEs although all are established with a public purpose: Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) are privately owned corporations, while the Federal Home Loan Banks and the Federal Farm Credit Banks are systems comprising regional banks.

All GSE debt is not guaranteed by the federal government, whereas government agencies such as Government National Mortgage Association (Ginnie Mae) are divisions of the government whose securities are backed by the full faith and credit of the United States.

To conduct their lending business, GSEs have significant funding requirements. While many are stockholder-owned companies that can raise equity capital, most GSEs rely primarily on debt financing to fund their day-to-day operations. Among the most active issuers of debt securities are:

• Federal Home Loan Banks
• Freddie Mac
• Fannie Mae
• Federal Farm Credit Banks and
• Tennessee Valley Authority (TVA).

Supranational and international institutions, such as the World Bank, also issue debt securities.

Buyers of GSE-issued debt securities include domestic and international banks, pension funds, mutual funds, hedge funds, insurance companies, foundations, other corporations, state and local governments, foreign central banks, institutional investors and individual investors.

In general, debt securities issued by GSEs are considered to be of high credit quality. The senior debt of the GSEs is rated AAA/Aaa, while the subordinated debt of Fannie Mae and Freddie Mac is currently rated AA-/Aa-. Some GSEs have explicit, though limited, lines of credit from the U.S. Treasury. As a group, GSEs benefit from a perceived tie to the federal government as institutions established under federal legislation. In September 2008, the Federal Housing Finance Agency became the conservator of the housing GSEs. In connection with the conservatorship, Treasury has now committed to provide necessary funding to correct any deficiencies in their net worth.

However, debt securities issued by GSEs are solely the obligation of their issuer and, unless explicitly stated, do not carry any guarantee by the federal government. They are considered to carry greater credit risk than securities issued by the U.S. Treasury and certain government agencies (e.g., Ginnie Mae) whose securities have the full-faith-and-credit guarantee of the U.S. government. For this reason, GSE debt obligations often carry a yield premium over Treasury securities with comparable maturities. The premium varies with market volatility, and the structure, maturity, and general supply and demand for the particular security.

The GSEs utilize a variety of issuance formats for their securities. Most long-term debt is issued in public monthly security sales through designated dealer groups using both syndicate and auction pricing methodologies. Currently, the majority of GSE term debt is issued through various programmatic issuance formats, as outlined in greater detail below. All the GSEs have created issuance programs that incorporate funding calendars for large-size issues. Due to differences in the GSEs’ organizational and corporate structures, the separate funding calendars will vary as to specified issuance details.

In 1997, the Federal Home Loan Banks Office of Finance began using auctions in its issuance of short-term discount notes. Since then Freddie Mac and Fannie Mae have also incorporated auction formats in their programmatic short-term funding. Additionally, all the GSEs post daily rates for discount notes. Currently, most of the non-callable term debt that is issued is in the form of conventional notes having maturities of one, two, three, five, ten and thirty years. However, many GSEs have incorporated floating-rate and callable securities into their issuance programs and regularly issue these structures as well.

Today, GSEs increasingly choose to raise funds through a variety of formal debt issuance programs.

• Freddie Mac ‘Reference Notes™’, ‘Reference Bonds™’ and ‘Reference Bills™’;
• Fannie Mae ‘Benchmark Notes™’, ‘Benchmark Bonds™’ and ‘Benchmark Bills™’;
• Federal Home Loan Bank ‘TAP Issues™’; and
• Federal Farm Credit Bank ‘Designated Bonds™’ and Calendar Bond Program™

have all been developed to brand these particular securities with certain attributes of liquidity and pricing transparency.

The selective application of auction methodology in debt issuance by the GSEs in the last few years has introduced greater regularity and transparency to the securities pricing process and made possible for the first time a true “when issued” (WI) market in those short- and long-term issues which are scheduled to be auctioned.

Working through the Securities Industry and Financial Markets Association, the dealers and issuers have helped establish commonly used trading guidelines that govern WI trading in GSE auctioned issues of term debt with a maturity of two years and longer.

Additionally, advances in technology have enhanced the market for customized interest rate swaps, options and futures, and allowed the GSEs to issue a variety of structured products that can be highly tailored to simultaneously meet the very specific needs of issuers and investors.

For instance, the GSEs have various medium-term-note (MTN) programs that allow them to come to market on a continuous basis with different debt offerings. As a result, GSEs have gained the flexibility to structure the size and terms of their debt issues to meet the requirements of a particular investor or class of investors. Under these programs, issuers may choose a variety of maturities with either callable or fixed maturities as well as floating interest rates, interest rates linked to one or more market indices, different interest payment dates and other key features. The same flexibility can be achieved through individually negotiated security offerings.

The variety of issued securities enable GSEs to lower their cost of funding by targeting an issue to a particular investor need, since investors are typically willing to pay a premium to obtain a desired cash flow or implement a particular market view.

Issuers also use the structures to obtain options from investors in a cost-effective manner. For example, an investor will demand a yield premium for allowing the issuer the option to call a bond or note, but if interest rates decline the issuer might ultimately save money by exercising the call option.

In connection with these structures, issuers often enter into customized options and/or swap agreements with a third party. The third party may be an investment bank, a subsidiary of an investment bank, a swap dealer or another entity.

Under these agreements, the issuer receives a cash flow needed to fulfill the terms of the security offering while agreeing to pay its counterparty a rate that might better match the incoming cash flow on its assets. The GSE issuer assumes all counterparty credit risk; a default by the issuer’s counterparty on an option or swap agreement does not change the issuer’s obligations to investors in the related security.

• Resolution Funding Corporation (REFCORP)
• Tennessee Valley Authority (TVA)
• Federal Farm Credit System
• Financing Corporation (FICO)
• The Private Export Funding Corporation (PEFCO)
• Government Trust Certificates (GTC)
• The U.S. Agency for International Development (AID)
• The Financial Assistance Corporation (FAC)
• The General Services Administration (GSA)
• The Small Business Administration
• The U.S. Postal Service