Research Notes and News highlights recently published research as well as other news from the Federal Reserve Bank of Atlanta. For complete text of summarized articles and publications, see the Atlanta Fed’s World Wide Web site at www.frbatlanta.org/publ.cfm.
Fannie Mae’s and Freddie Mac’s changing roles and reform initiatives
Three government-sponsored enterprises (GSEs) — Fannie Mae, Freddie Mac and the Federal Home Loan Bank System — were created to make home mortgage financing more readily available by supplementing local funding. But today retail lenders can tap national markets, so now the main contribution of the three housing GSEs is providing homebuyers an interest rate subsidy.
In two recent articles, W. Scott Frame and Larry D. Wall examine a number of issues concerning these GSEs. The first article looks at the economic issues arising from the GSEs’ provision of interest rate subsidies. The GSEs can provide lower rates to home mortgage borrowers mainly because of the subsidies the GSEs receive via their relationship with the federal government. The largest subsidy is the financial markets’ perception that the GSEs’ securities are implicitly guaranteed by the government. The authors focus on two public policy debates sparked by this relationship: whether the GSEs are efficient mechanisms for subsidizing housing and whether implicit guarantees of their liabilities are the best way to subsidize them.
In their second article, Frame and Wall evaluate six voluntary initiatives that Fannie Mae and Freddie Mac announced in 2000. One initiative would enhance market discipline by having the GSEs issue subordinated debt. A second would require the GSEs to maintain more liquid securities portfolios. The other initiatives would increase transparency through the GSEs’ disclosures of credit and interest rate losses, annual credit ratings and compliance with capital adequacy standards.
Frame and Wall evaluate the initiatives from the perspective of current banking standards. Their analysis suggests that Fannie Mae’s and Freddie Mac’s initiatives are beneficial but could be made more effective.
Payment finality keeps the economy running
Payment finality is critical to decentralized exchange. By specifying how the transfer of one type of claim extinguishes another, the rules governing finality minimize opportunities for default along credit chains and allocate other risks.
Authors Charles M. Kahn and William Roberds provide a basic analysis of finality and its role in facilitating exchange. They first present a simple, historically based model of transferable debt and finality. The discussion demonstrates the desirability of transferable debt and why rules governing payment finality are needed to sort out who will bear the losses in the event of default. Over time, the introduction of such rules helped establish the concept of negotiability, which greatly increased the efficiency of trade.
A second model shows how a more modern payment system works. The large volume and scope of payments in modern systems have resulted in disparate sets of finality rules. For example, the finality of check payments is generally tentative, and the risks are often concentrated on a single party. Credit and debit card payments are generally more final, and the liability for potential losses tends to be shared among participants. Choosing the degree of finality for a given situation involves a trade-off between the benefits of finality and the costs of an erroneous or fraudulent transfer. The introduction of new technologies for payments may improve these trade-offs, but finality will remain the essential service provided.
Credit scoring affects the small business credit market
Credit scoring is the process of using statistical methods to predict the probability of borrower default. While this more automated approach to credit underwriting has been pervasive in the consumer credit arena for some time, it became popular for small business lending only in the late 1990s. The widespread adoption of small business credit scoring has the potential to alter the fundamentals of this credit market to the extent that it lowers bank costs and/or improves bank risk measurement.
In a recent working paper, Allen N. Berger, W. Scott Frame and Nathan H. Miller examine the economic effects of small business credit scoring and find that it is associated with expanded quantities, higher average prices and greater risk levels for small business credits under $100,000. These findings are consistent with a net increase in lending to relatively risky marginal borrowers who would otherwise not receive credit but who would pay relatively high prices when they are funded.
The authors also find that (1) bank-specific and industrywide learning curves are important; (2) small business credit scoring effects differ for banks that adhere to rules rather than discretion in using the technology; and (3) small business credit scoring effects differ for slightly larger credits.
Atlanta Fed co-sponsors conference on venture capital and technology
A hallmark of the recent economic expansion was the formation of high-tech firms and the development of financial market innovations, especially venture capital markets, to support them. Prospects for new technologies affected securities markets, which first responded exuberantly and then burst. These developments have complicated the formulation of monetary policy as the Federal Reserve has attempted to determine how much these events have permanently altered the economy’s potential growth path and how the newly generated wealth has affected spending and consumption. Given recent economic activity and uncertainty about the current productivity path, these issues are especially important.
Venture Capital and Technology: What’s Next? — the Federal Reserve Bank of Atlanta 2002 Financial Markets Conference, co-sponsored with the New York University Leonard N. Stern School of Business — offered a perspective on the innovation process and the financial mechanisms that make it possible. Research discussed at the conference included papers and commentaries led by experts on a range of issues related to the venture capital industry, its historical roots in the process of technology and the role of public policy.
For more information about the conference agenda and the papers presented, visit the bank’s Web site at www.frbatlanta.org and go to News and Events.