Market discipline of Fannie Mae and Freddie Mac: How do share prices and debt yield spreads respond to new information?

There is growing interest in enhancing market discipline of Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that support the secondary market in residential mortgages. This paper assesses empirically how the market responds to new information about those two GSEs. The share prices of each Enterprise and the spreads between the yields of each Enterprise's 10-year non-callable senior debt and the yields of comparable-maturity Treasury debt during the period from February 2000 through mid-June 2003 are examined. The results suggest that share prices and senior debt yield spreads respond predictably to events that provide new information about an Enterprise's financial risks, the likelihood that the government would protect the debt investors or other major creditors of an insolvent Enterprise, or the probability that Congress will enact legislation that would reduce each Enterprise's franchise value. Information about one Enterprise that has a positive effect on its share price also tends to have a similar positive effect on the other Enterprise's share price. Further, the release of information that tends to be followed by lower (higher) Enterprise stock prices also tends to be followed by higher (lower) senior debt yield spreads. Because neither Enterprise experienced a severe deterioration in its financial condition during the period analyzed, the results do not suggest how senior debt yields spreads would behave in such an event. The experiences of Fannie Mae in the late 1970s and early 1980s and the Farm Credit System in the mid-1980s suggest that a severely financially troubled Enterprise's senior debt yield spreads would not increase as much as they would if the Enterprise was not a GSE.