What is a government-sponsored enterprise?

The idea behind creating a government-sponsored enterprise (GSE) is to increase stability and liquidity in the real estate industry. It’s a good way to guarantee the easy availability of loan products and financing, especially for consumers who may not otherwise qualify.

The ultimate goal is to keep money flowing efficiently throughout the major components of the U.S. economy such as housing. And that’s why the federal government lends a helping hand through government-sponsored enterprises. 

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So, what is a government-sponsored enterprise?

The United States Congress created this financial entity in 1916. The intent was to increase the flow of credit and money throughout the U.S. economy. Particularly, in the real estate market. Unlike government agencies that are run directly by the federal government, GSEs are private organizations. Basically, they are quasi-governmental entities that though privately held provide public financial services through capital market liquidity to those who may not qualify for conventional mortgage programs. 

These private companies are supported by the government to help improve the U.S. economy and to increase capital flow in the real estate market. They promise to buy a certain kind and quantity of loans, then sell them as mortgage-backed securities (MBS) to investors in the secondary market.

In a nutshell, GSE improves the flow of credit, adds stability, and improves affordability as well as liquidity. It facilitates financing for students, farmers, and homeowners.

What is MBS in the mortgage market?

A mortgage-backed security is a type of investment that is secured by a collection of mortgages purchased by the issuing banks. These securities can be bought and sold on the secondary market and are considered a type of asset-backed security. For example, Fannie Mae is known for developing MBS that have a beneficial ownership interest in a pool of residential mortgages backed by multifamily properties containing five or more units.

The primary purpose of an MBS is to increase returns and diversify risk. Essentially, when an investor buys an MBS, they are providing a loan to home buyers. Unlike other asset-backed securities, MBS is formed by pooling mortgages, which makes it unique. To purchase an MBS, an investor can go through a broker.

How does MBS benefit banks?

The bank combines a loan with numerous other mortgages. And, this pool of loans is sold to an investment bank as a single bond. The investment bank then categorizes the loans according to their quality and then sells them to different investors. The funds are utilized to offer loans to other borrowers, including low-income or at-risk borrowers who may qualify for subsidized loans. This makes MBS a highly fluid financial product. Additionally, MBS helps to mitigate the bank’s risk.

How does government-sponsored enterprise benefit the lender? 

Suppose a lender funds around 30 mortgages of $100,000 for a 30-year term. If they didn’t have a source for more money, they’d have to wait for 30 years before offering additional $100,000 mortgages. A GSE purchases loans from third-party lenders to give them more cash flow to lend – to keep the circle of lending and borrowing going.

Let’s take the example of Federal Home Loan Mortgage Corp. aka Freddie Mac. It was created for the housing sector – to encourage homeownership among the middle and working classes. 

Are there more examples of a government-sponsored enterprise?

Yes, there are many entities that work as GSEs. For instance, the Federal National Mortgage Association aka Fannie Mae, and the Government National Mortgage Association aka Ginnie Mae were introduced to improve the flow of credit with reduced costs in the housing market.

Similarly, the Federal Home Loan Bank (FHLB) system is another GSE in the housing finance market. The Student Loan Marketing Association or SLM Corp. aka Sallie Mae is a student loan GSE while the Farm Credit System or FCS and the Federal Agricultural Mortgage Corp. or Farmer Mac are agricultural GSEs.

Let’s compartmentalize these GSEs for easy comprehension. 

Mortgage GSEs

• Federal Home Loan Banks: The only GSE to directly issue mortgages.
• The Federal National Mortgage Association (FNMA or Fannie Mae): It provides mortgage funding to investors by buying them from large commercial banks.
• Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac): It purchases mortgages from smaller banks and lenders.

Student loan GSEs

• Sallie Mae: It is a private student loan servicer.

Agricultural GSEs

• Farm Credit System: It provides credit for farmers and ranchers as an endeavor to support the country’s agriculture. 
• Federal Agricultural Mortgage Corporation (FAMC or Farmer Mac): This GSE guarantees repayment to agricultural investors.

How does a GSE work?

GSEs don’t lend money directly to the public, they guarantee third-party loans and buy loans in the secondary market – providing money to financial institutions and lenders.

Moreover, GSEs also issue bonds – both short- and long-term bonds – also known as agency bonds. An agency bond issuer’s default risk depends on how much of an independent entity it is from the federal government. 

Many agency bonds’ interests are exempt from state and local taxes.

Different from treasury bonds, GSE bonds are not direct obligations of the U.S. government. Moreover, they offer a higher yield than treasury bonds as they come with a higher degree of credit risk and default risk.

Bottom line 

A GSE is a financial entity backed by the U.S. government. This type of quasi-governmental financing helps to enhance the flow of credit in the U.S. real estate market. It guarantees third-party loans by purchasing loans in the secondary market. This ensures liquidity.

The ultimate goal is to make it easy for low-income individuals or those with low credit scores to buy a home. GSE ensures that the U.S. mortgage market has access to liquidity and is stable.

Written by Ramona Sinha. March 24, 2023

Ramona is a content writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. An avid traveler, she’s a digital nomad at heart and an animal lover from the depths of her soul.