Remarks before 40th Annual Conference on Bank Structure & Competition, Fairmont Hotel, Chicago, May 6, 2004Government-sponsored enterprises

William Poole

English

Research Papers in Economics

1
Panel on Government-Sponsored Enterprises
The 40th Annual Conference on Bank Structure and Competition
Federal Reserve Bank of Chicago
The Fairmont Hotel
Chicago, Illinois
May 6, 2004
to read the classic by Charles P. Kindleberger,
Manias, Panics and Crashes: A History of
Financial Crises (Fourth Edition. John Wiley and
Sons, 2001).
After reading Kindleberger and observing
crises in real time, many believe that crashes and
crises are created by irrational market behavior.
A crisis pattern seems to occur over and over
again. Investors are seized by a sudden fear of
losses and they engage in a mad scramble to sell
suspect assets and convert them into highly liquid,
safe assets.
There may be an element of irrational behavior
at the time of a market crisis; however, I believe
that at least as important is that investors lack
the full information necessary to make reasoned
judgments. Moreover, some crashes are fully
rational, such as the collapse of Enron. The mys-
tery, in my view, is not that crises occur but that
during the months and sometimes years preced-
ing a crisis investors seem blissfully unaware of
the risks they are running.
Some crises, such as the one that brought
down Enron, are well contained and do not
spread to other firms. Others, such as Long Term
Capital Management, have wider effects. There
is no question but that a crisis affecting either
Fannie Mae or Freddie Mac would have wide-
spread effects because these firms are so large.
I want to emphasize that, on the basis of
information I have, no crisis is at hand in the
market for GSE obligations. However, it does
seem to me that investors have priced these obli-
I
n a speech in March of last year, “Housing
in the Economy,” I argued that the capital
positions of only about 3½ percent of assets
maintained by the housing GSEs and the
ambiguity of the status of these firms creates a
risk of financial instability.1 My purpose today
is to amplify that argument. My discussion will
apply directly to Fannie Mae, Freddie Mac and
the Federal Home Loan Banks. However, I will
draw primarily on published material from
Fannie Mae and Freddie Mac because I am more
familiar with these firms than with the Home
Loan Banks. For convenience, I’ll refer to Fannie
Mae and Freddie Mac jointly as “F-F”; most of
my analysis applies equally to both firms.
Before proceeding, I want to emphasize that
the views I express here are mine and do not
necessarily reflect official positions of the Federal
Reserve System. I thank my colleagues at the
Federal Reserve Bank of St. Louis, especially
Frank A. Schmid, senior economist in the research
division, who provided valuable assistance.
However, I retain full responsibility for errors.
IMPERFECT INFORMATION AND
AMBIGUITY AS SOURCES OF
MARKET CRISES
Market crises are well understood at a descrip-
tive level, but their underlying causes are some-
thing of a mystery. To gain a better perspective
on market crises, I urge every market participant
1 Federal Reserve Bank of St. Louis Review, May/June 2003, 85(3), pp. 1-8.gations under the assumption that there are no
possible risks that might strain GSE capital posi-
tions. This is exactly the behavior that has pre-
ceded the classic crises described by Kindleberger.
In my opinion, GSE capital positions are unde-
sirably thin and leave these firms unnecessarily
vulnerable to surprise shocks. There is no way to
predict what kind of shock might shake market
confidence, but the reason a shock could have
serious adverse effects is that F-F pursue a strategy
of borrowing short and lending long, with a thin
capital margin.
DANGERS OF BORROWING
SHORT AND LENDING LONG
It has long been a canon of sound finance
that a firm should not borrow short to finance
long-term assets. There are two reasons for this
principle. First, a financial firm exposes itself to
interest-rate risk when the duration of assets and
liabilities does not match. Second, a firm must
continuously roll over short-term liabilities that
are used to finance long-term assets.
Under the most conservative financial strat-
egy, F-F would issue long-term bonds to match
their long-term mortgage assets. The bonds, or a
significant fraction of them, would have to be
callable to protect against prepayment risk on
mortgages. This classic, benchmark strategy could
be refined in various ways, but the basic structure
of the strategy is as described.
A financial institution following the classic
strategy is protected against all interest-rate dis-
turbances. There is no risk from interest-rate
fluctuations because the duration of assets and
liabilities match. Prepayment risk is handled by
issuing callable bonds and then calling them
when assets prepay. The institution’s risk is con-
fined to the credit risk on the assets. Credit risk
on mortgages can be handled, as F-F in fact do
very effectively, through a policy of geographic
diversification, of not buying a significant num-
ber of high loan-to-value mortgages, and through
the use of mortgage insurance and credit guaran-
tees. The profitability of the financial institution
then depends on the interest-rate spread between
the assets purchased and the bonds issued to
finance them, at the time of the transaction.
F-F have not pursued the classic strategy but
instead have financed a large fraction of their
portfolios of long-term mortgages with short-term
debt, in the order of 38 percent of the net mortgage
portfolio or 34 percent of total assets. They hedge
interest-rate risk by maintaining positions in
interest-rate swaps. These contracts provide that,
for example, Fannie Mae will pay a fixed rate of
interest for the duration of the swap and receive
a variable rate of interest, tied to the London
Interbank offering rate, or LIBOR. Most swaps in
the market use LIBOR as the reference rate in the
swap contract, and so the GSEs’ use of these con-
tracts is perfectly standard market practice.
It is true that the combination of short liabili-
ties and interest rate swaps synthetically creates,
almost, the equivalent of a long-term, fixed-rate
liability. There are two significant caveats that
explain the “almost” and neither of these are
adequately discussed in the annual reports of
Fannie Mae and Freddie Mac.
The first caveat concerns basis risk, which is
briefly mentioned in Freddie Mac’s 2002 Annual
Report (p. 76) but as far as I can tell not in Fannie
Mae’s 2002 Annual Report or its 2003 10K report.
Basis risk arises whenever a hedging strategy
relies on a contract that is not identical to the
good being hedged. In the case of the GSEs, the
yield on the short-term debt they issue may differ
from LIBOR. More importantly, the spread of the
agency debt yield over LIBOR may change, and
has changed significantly in the past. The interest-
rate stress tests reported by Fannie Mae and
Freddie Mac do not consider this possibility.
It is not difficult to make a back-of-the-enve-
lope calculation of exposure to basis risk. At the
end of 2003, Fannie Mae had approximately $335
billion of short-term debt swapped into fixed-rate
long-term debt. Currently, 6-month agency paper
trades about 10 basis points above U.S. Treasury
6-month obligations. However, that spread
reached 50 to 70 basis points in the period from
1998 to 2001. Should the current spread rise
from 10 basis points to 60 basis points for a sus-
tained period, the extra 50 basis points would
FINANCIAL MARKETS
2cost Fannie Mae about $1.7 billion in extra inter-
est expense per year, which would reduce annual
earnings by about 21 percent based on 2003 net
income.
A 21 percent reduction in net income would
not be enough to shake the firm; clearly, though,
a larger increase in the spread would be a matter
of serious concern. Such an increase could occur
should the market come to distrust the credit-
worthiness of either Fannie Mae or Freddie Mac.
The second risk F-F run is that the credit mar-
kets might refuse to accept F-F paper. Every week,
F-F must roll over roughly $30 billion of maturing
short-term obligations. Should the market come
to fear the creditworthiness of either firm, F-F
would be forced to liquidate non-mortgage assets
to obtain funds to redeem maturing obligations.
Fannie Mae’s 10K report for 2003 contains a dis-
cussion of liquidity (pp. 113 ff) and reports a liq-
uidity reserve of $65 billion. This reserve is net
of assets pledged as collateral. At the end of 2003,
only $487 million of short-term assets were
pledged as collateral; the policy statement (p. 115
of 2003 10K report) that Fannie Mae will main-
tain a liquid reserve of at least 5 percent of total
assets does not state whether the policy refers to
unencumbered liquid assets. In the event of a
crisis, Fannie Mae could find itself forced to col-
lateralize its large derivatives position, which
would leave a minimal liquid reserve should the
markets become unreceptive to new issues. The
fact is that F-F depend critically on continuous
market access, and with their minimal capital
positions that access could be denied without
warning.
The strategy of financing short and managing
interest-rate risk through swaps does not com-
pletely replicate the classic strategy. F-F are vul-
nerable to basis risk and impaired access to the
market to roll over their maturing obligations.
RECEIVERSHIP/CONSERVATORS
HIP AUTHORITY
Should either Fannie Mae or Freddie Mac
become financially stressed, the only way to
avoid market chaos will be to have clear proce-
dures in place, in advance, to handle the problem.
Market uncertainty at the time of a crisis will
quickly lead to a deeper and more extensive prob-
lem in the world’s financial markets.
Given that F-F obligations are not guaranteed,
the federal government needs to make clear that
it intends to live up to the statement made by F-F
when they issue securities, that the obligations
are not guaranteed by the United States. To make
this position credible, the government needs to
have plans in place as to how to handle a crisis
should one occur.
The recent announcement by the Office of
Federal Housing Enterprise Oversight that it will
develop conservatorship procedures is a welcome
development because it increases the credibility
of the claim F-F make regarding the absence of a
federal guarantee of their obligations. As a com-
plement to this step, the authority of the Secretary
of Treasury to provide temporary funds, in the
amount of $2.25 billion each to Fannie Mae and
Freddie Mac, should be repealed. This provision
is too small to have any practical value in handling
a crisis, and is of symbolic value only.
FEDERAL RESERVE EMERGENCY
POWERS
I am acutely aware that should there be a
market crisis, the Federal Reserve will have the
responsibility to manage the problem. Just as
many market participants apparently believe
that GSE obligations have the implicit backing
of the federal government, they may also believe
that the Federal Reserve has all the powers nec-
essary to manage a crisis. The Fed’s successful
efforts to handle the stock market crash in 1987,
the near-insolvency of Long Term Capital Manage-
ment in 1998, and the financial effects of the 9/11
tragedy all justifiably increase market confidence
in the Federal Reserve. In the interest of a full
understanding of the Federal Reserve’s powers
in the event of a crisis in the market for GSE
obligations, I’ll outline the Fed’s powers as pro-
vided by the Federal Reserve Act.
Panel on Government Sponsored Enterprises
3The Federal Reserve routinely makes loans
to depository institutions. These are fully collat-
eralized loans, subject to haircuts on the collateral
to protect the Federal Reserve’s position. To my
knowledge, F-F have not negotiated standby lines
of credit with banks to provide emergency funds
in event of a crisis. Such agreements are common
among firms that issue commercial paper, so that
the firms can retire maturing obligations even if
they suddenly find their access to the commercial
paper market impaired. In an emergency, F-F
could work with banks to provide credit and the
Federal Reserve could in turn provide loans to
banks under the primary credit facility of the
discount window. These loans would have to be
fully secured by good collateral.
The main point about managing a crisis
through this mechanism, with F-F obtaining credit
from banks and the Federal Reserve providing
loans to the banks, is that the enormous scale of
F-F obligations would strain the banking system.
This mechanism might not suffice to handle a
major crisis as the banks would insist that F-F
post collateral. In a crisis, the mortgage market
would be severely disrupted and mortgages and
mortgage-backed securities would no doubt trade
at lower prices, thus impairing the value of the
collateral F-F could post. The decline in the value
of F-F assets would strain their capital positions,
and lead to fears that either or both Fannie Mae
and Freddie Mac might become insolvent.
Under Section 13(3) of the Federal Reserve
Act, Federal Reserve Banks have the authority to
discount paper for individuals, partnerships or
corporations. Direct lending to the GSEs would
have to come under provisions of this part of the
Federal Reserve Act. Critical provisions include
a finding of unusual and exigent circumstances
and an affirmative vote of not less than five mem-
bers of the Board of Governors. The loans would
have to be fully collateralized.
There has been no lending under this provi-
sion of the Federal Reserve Act since the 1930s.
Such lending, were it to be authorized by the
Board of Governors, would permit GSEs to redeem
maturing obligations and would, therefore, solve
part of a crisis problem. However, such loans
might not restore liquidity to GSE debt before
redemption and would not per se restore normal
functioning of the mortgage market. Clearly,
Federal Reserve support for the GSEs would help
to prevent a broadening crisis, but most likely
would be incapable of preventing some consid-
erable disruption.
The Federal Reserve has ample power to deal
with a liquidity problem, by making collateral-
ized loans as authorized by the Federal Reserve
Act. The Fed does not have power to deal with a
solvency problem. Should a solvency problem
arise with any of the GSEs, the solution will have
to be found elsewhere than through the Federal
Reserve.
In a press release dated February 5, 2004,2
the Board of Governors announced that effective
July 2006 it would require that government-
sponsored enterprises and international agencies
have sufficient funds in their Federal Reserve
accounts before the Federal Reserve would release
funds for interest and redemption payments on
securities issued by these entities. This change
in practice will eliminate the daylight overdrafts
routinely created today when GSEs make interest
and redemption payments before depositing funds
from sale of new securities. The Board’s press
release noted that the practice of permitting intra-
day credit “is inconsistent with that of private
issuing and paying agents for their customers’
securities.” The policy change effective July 2006
will, therefore, align the Federal Reserve’s practice
with that accorded private entities, reflecting the
private, though government-sponsored, status of
the GSEs. The policy change will also reduce risk
to the Federal Reserve System.
CONCLUDING COMMENTS
The reasons why it is important to strengthen
the capital positions of the GSEs should be clear.
It is also important that ambiguities as to the sta-
2 See the press release on the Board of Governors’ web site: www.federalreserve.gov/boarddocs/press/other/2004/20040205.
FINANCIAL MARKETS
4tus of the GSEs be cleared up, and that conserva-
torship procedures to deal with a crisis be put in
place.
Many financial institutions seem not to under-
stand the nature of the issues. It is interesting
that GSE obligations trade at much smaller
spreads over Treasuries at the short end of the
maturity spectrum than at the long end. Investors
in short-term obligations apparently believe that
they are completely protected from credit risk
because they will have enough warning to permit
them to exit these obligations by letting them
mature in a few months. The problem is that
should a crisis occur, it will take hold so quickly
that GSE obligations will in a matter of hours, or
days, become illiquid. While any one holder of
GSE debt can exit, not all holders together can
exit at once. The economics of this market are
similar to those of banking markets. A scramble
to convert all bank deposits into cash cannot suc-
ceed in the aggregate because not enough cash
exists to effect the conversion. Similarly, a scram-
ble to convert GSE obligations into cash cannot
succeed in the aggregate because the underlying
mortgage assets cannot be quickly converted to
cash. Mortgagors are under no obligation to pre-
pay long-term mortgages.
Fannie Mae and Freddie Mac manage risks
well, up to a point. But the underlying problem
of financing long-term mortgages with short-term
assets still exists. The risks may be passed along
to others in the derivatives markets, but in the
aggregate the risks have not been extinguished.
The only way to manage these risks completely
is through a combination of F-F substituting more
long-term for short-term debt and maintaining
stronger capital positions.
I note also that F-F have a powerful incentive
to grow. They report returns on equity in the
neighborhood of 30 percent per year. They are
able to achieve these returns by exploiting the
implicit federal guarantee of their obligations,
which enables them to borrow at near Treasury
rates despite their thin capital positions and
invest in mortgages at private market rates. Their
growth objectives insure that their scale will
increase over time, unless they become subject
to full private market incentives through convinc-
ing federal policies that lead to market recognition
that the federal government will not guarantee
GSE obligations in a crisis.
Panel on Government Sponsored Enterprises
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