Informational frictions and incentive conflicts between issuers of financial claims and the owners of those claims are central topics in financial economics. Previous work has argued that the presence of large concentrated claimholders can be a powerful mechanism for disciplining issuing managers, as in the case of equity blockholders who can directly intervene in the management of firms and indirectly exert influence through the threat of exit; or the case of banks who actively screen and monitor borrowers.
This paper explores the disciplining effect of large investors in arms-length debt on issuer behavior. Specifically, we study the role played by two government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, as the largest investors in subprime private-label mortgage-backed securities (PLS) during the recent housing boom.
Fannie Mae and Freddie Mac together purchased roughly 30 percent of all subprime PLS volume (all rated triple-A) issued in 2003-2007, making them by far the largest single investors in this asset class. We identify the causal effect of large investors in mitigating agency conflicts in securitized arms-length debt by exploiting a unique feature of the PLS market. By law, Fannie Mae and Freddie Mac are only allowed to acquire mortgages below the conforming loan limit. During the mid-2000s, this restriction prompted the creation of separate loan pools within many PLS deals made up exclusively of conforming mortgages, while other pools in the same deals had a mix of conforming and non-conforming loans. This design allows us to isolate the securities that were purchased by the GSEs and to implement an identification strategy that compares the risk characteristics of securities bought by the GSEs with those aimed at other investors
within the same deals and rating class. Our analysis examines not only
observable risk characteristics at the time of deal issuance (as in Agarwal, Chang, and Yavas 2012 or Ambrose, LaCour-Little, and Sanders 2005), but also the
performance of the underlying loans. By doing so, we are able to test
See Shleifer and Vishny (1986), Burkart, Gromb, and Panunzi (1997), Brav, Jiang, Partnoy and Thomas (2008), and Morse (2013) for evidence of blockholder intervention in the management of firms; and Edmans (2009), McCahery, Sautner, and Starks (2008) and Parrino, Sias, and Starks (2003) on governance through exit. See Bhattacharaya and Thakor (1993) and Boot (2000) for surveys on the extensive literature on bank screening and monitoring; see Roberts and Sufi (2009) for more recent evidence.
In addition to investing in PLS and other residential mortgage-related assets, Fannie Mae and Freddie Mac play a central role in the U.S. mortgage market through their “credit guarantee” businesses, whereby mortgage originators exchange pools of loans for securities that represent an interest in the same pool; and the GSEs agree to ensure timely payment of principal and interest on the securities in exchange for a monthly insurance premium (“guarantee fee”). This paper focuses solely on the GSEs’ participation in the PLS market.