A Backward Induction Analysis of the GSEs’ Meltdown

Note from the Digital Editor: In order to highlight the high-level of research and scholarship from the authors who have published in the William & Mary Policy Review’s peer-reviewed print journal, we have reproduced the abstracts from Volume 3, Issue 1 along with a link to an electronic copy of the full form of the piece. 

Fannie Mae and Freddie Mac, the two giant government-sponsored enterprises (GSEs), stand in the spotlight of our recent financial crisis. A multitude of articles and other publications attribute part of our economic decline to these GSEs and seek to root out causes, solutions, and everything in between regarding their faltering. The two owe this recent infamy to the 5.3 trillion dollars in mortgage loans they either guarantee or hold as part of their portfolios, and the receipt of 1.4 trillion dollars in government money, to keep the firms alive. A backward induction analysis, through the viewpoint of the GSEs’ managers, can explain the unprecedented growth and collapse of Fannie and Freddie. Using a three-period lens, this paper analyzes the opportunistic decision-making strategies Fannie and Freddie’s managers engaged in as well as the inevitable systemic risks these strategies posed for the global economy. This analysis describes how the unilateral benefits conferred upon these GSEs compelled management to take on greater risks, which confirmed the necessity of a guarantee by the government. It concludes with an examination of how the Dodd-Frank Act could prevent similar troubles for future Fannies and Freddies. First, a brief history of Fannie and Freddie and an overview of economic conditions lays the foundation for the GSEs’ crashes into conservatorship

Find the full version of this article in PDF form here.

Charles Abrams is J.D. expected at Florida State University College of Law.