Speech

Panel on Government-Sponsored Enterprises The40thAnnualConferenceonBankStructureandCompetition FederalReserveBankofChicago TheFairmontHotel Chicago,Illinois May6,2004 In a speech in March of last year, “Housing toreadtheclassicbyCharlesP.Kindleberger, in the Economy,” I argued that the capital Manias,PanicsandCrashes:AHistoryof positionsofonlyabout3½percentofassets FinancialCrises(FourthEdition.JohnWileyand maintained by the housing GSEs and the Sons,2001). ambiguity of the status of these firms creates a AfterreadingKindlebergerandobserving risk of financial instability.1 My purpose today crisesinrealtime,manybelievethatcrashesand is to amplify that argument. My discussion will crisesarecreatedbyirrationalmarketbehavior. apply directly to Fannie Mae, Freddie Mac and Acrisispatternseemstooccuroverandover the Federal Home Loan Banks. However, I will again.Investorsareseizedbyasuddenfearof draw primarily on published material from lossesandtheyengageinamadscrambletosell Fannie Mae and Freddie Mac because I am more suspectassetsandconvertthemintohighlyliquid, familiar with these firms than with the Home safeassets. Loan Banks. For convenience, I’ll refer to Fannie Theremaybeanelementofirrationalbehavior Mae and Freddie Mac jointly as “F-F”; most of atthetimeofamarketcrisis;however,Ibelieve my analysis applies equally to both firms. thatatleastasimportantisthatinvestorslack Beforeproceeding,Iwanttoemphasizethat thefullinformationnecessarytomakereasoned theviewsIexpressherearemineanddonot judgments.Moreover,somecrashesarefully necessarilyreflectofficialpositionsoftheFederal rational,suchasthecollapseofEnron.Themys- ReserveSystem.Ithankmycolleaguesatthe tery,inmyview,isnotthatcrisesoccurbutthat FederalReserveBankofSt.Louis,especially duringthemonthsandsometimesyearspreced- FrankA.Schmid,senioreconomistintheresearch ingacrisisinvestorsseemblissfullyunawareof division,whoprovidedvaluableassistance. theriskstheyarerunning. However,Iretainfullresponsibilityforerrors. Somecrises,suchastheonethatbrought downEnron,arewellcontainedanddonot spreadtootherfirms.Others,suchasLongTerm IMPERFECT INFORMATION AND CapitalManagement,havewidereffects.There isnoquestionbutthatacrisisaffectingeither AMBIGUITY AS SOURCES OF FannieMaeorFreddieMacwouldhavewide- MARKET CRISES spreadeffectsbecausethesefirmsaresolarge. Marketcrisesarewellunderstoodatadescrip- Iwanttoemphasizethat,onthebasisof tivelevel,buttheirunderlyingcausesaresome- informationIhave,nocrisisisathandinthe thingofamystery.Togainabetterperspective marketforGSEobligations.However,itdoes onmarketcrises,Iurgeeverymarketparticipant seemtomethatinvestorshavepricedtheseobli- 1 FederalReserveBankofSt.LouisReview,May/June2003,85(3),pp.1-8. 1 FINANCIALMARKETS gationsundertheassumptionthatthereareno theassetspurchasedandthebondsissuedto possiblerisksthatmightstrainGSEcapitalposi- financethem,atthetimeofthetransaction. tions.Thisisexactlythebehaviorthathaspre- F-Fhavenotpursuedtheclassicstrategybut cededtheclassiccrisesdescribedbyKindleberger. insteadhavefinancedalargefractionoftheir Inmyopinion,GSEcapitalpositionsareunde- portfoliosoflong-termmortgageswithshort-term sirablythinandleavethesefirmsunnecessarily debt,intheorderof38percentofthenetmortgage vulnerabletosurpriseshocks.Thereisnowayto portfolioor34percentoftotalassets.Theyhedge predictwhatkindofshockmightshakemarket interest-rateriskbymaintainingpositionsin confidence,butthereasonashockcouldhave interest-rateswaps.Thesecontractsprovidethat, seriousadverseeffectsisthatF-Fpursueastrategy forexample,FannieMaewillpayafixedrateof ofborrowingshortandlendinglong,withathin interestforthedurationoftheswapandreceive capitalmargin. avariablerateofinterest,tiedtotheLondon Interbankofferingrate,orLIBOR.Mostswapsin themarketuseLIBORasthereferencerateinthe DANGERS OF BORROWING swapcontract,andsotheGSEs’useofthesecon- tractsisperfectlystandardmarketpractice. SHORT AND LENDING LONG Itistruethatthecombinationofshortliabili- Ithaslongbeenacanonofsoundfinance tiesandinterestrateswapssyntheticallycreates, thatafirmshouldnotborrowshorttofinance almost,theequivalentofalong-term,fixed-rate long-termassets.Therearetworeasonsforthis liability.Therearetwosignificantcaveatsthat principle.First,afinancialfirmexposesitselfto explainthe“almost”andneitheroftheseare interest-rateriskwhenthedurationofassetsand adequatelydiscussedintheannualreportsof liabilitiesdoesnotmatch.Second,afirmmust FannieMaeandFreddieMac. continuouslyrollovershort-termliabilitiesthat Thefirstcaveatconcernsbasisrisk,whichis areusedtofinancelong-termassets. brieflymentionedinFreddieMac’s2002Annual Underthemostconservativefinancialstrat- Report(p.76)butasfarasIcantellnotinFannie egy,F-Fwouldissuelong-termbondstomatch Mae’s2002AnnualReportorits200310Kreport. theirlong-termmortgageassets.Thebonds,ora Basisriskariseswheneverahedgingstrategy significantfractionofthem,wouldhavetobe reliesonacontractthatisnotidenticaltothe callabletoprotectagainstprepaymentriskon goodbeinghedged.InthecaseoftheGSEs,the mortgages.Thisclassic,benchmarkstrategycould yieldontheshort-termdebttheyissuemaydiffer berefinedinvariousways,butthebasicstructure fromLIBOR.Moreimportantly,thespreadofthe ofthestrategyisasdescribed. agencydebtyieldoverLIBORmaychange,and Afinancialinstitutionfollowingtheclassic haschangedsignificantlyinthepast.Theinterest- strategyisprotectedagainstallinterest-ratedis- ratestresstestsreportedbyFannieMaeand turbances.Thereisnoriskfrominterest-rate FreddieMacdonotconsiderthispossibility. fluctuationsbecausethedurationofassetsand Itisnotdifficulttomakeaback-of-the-enve- liabilitiesmatch.Prepaymentriskishandledby issuingcallablebondsandthencallingthem lopecalculationofexposuretobasisrisk.Atthe whenassetsprepay.Theinstitution’sriskiscon- endof2003,FannieMaehadapproximately$335 finedtothecreditriskontheassets.Creditrisk billionofshort-termdebtswappedintofixed-rate onmortgagescanbehandled,asF-Finfactdo long-termdebt.Currently,6-monthagencypaper veryeffectively,throughapolicyofgeographic tradesabout10basispointsaboveU.S.Treasury diversification,ofnotbuyingasignificantnum- 6-monthobligations.However,thatspread berofhighloan-to-valuemortgages,andthrough reached50to70basispointsintheperiodfrom theuseofmortgageinsuranceandcreditguaran- 1998to2001.Shouldthecurrentspreadrise tees.Theprofitabilityofthefinancialinstitution from10basispointsto60basispointsforasus- thendependsontheinterest-ratespreadbetween tainedperiod,theextra50basispointswould 2 PanelonGovernmentSponsoredEnterprises costFannieMaeabout$1.7billioninextrainter- avoidmarketchaoswillbetohaveclearproce- estexpenseperyear,whichwouldreduceannual duresinplace,inadvance,tohandletheproblem. earningsbyabout21percentbasedon2003net Marketuncertaintyatthetimeofacrisiswill income. quicklyleadtoadeeperandmoreextensiveprob- A21percentreductioninnetincomewould lemintheworld’sfinancialmarkets. notbeenoughtoshakethefirm;clearly,though, GiventhatF-Fobligationsarenotguaranteed, alargerincreaseinthespreadwouldbeamatter thefederalgovernmentneedstomakeclearthat ofseriousconcern.Suchanincreasecouldoccur itintendstoliveuptothestatementmadebyF-F shouldthemarketcometodistrustthecredit- whentheyissuesecurities,thattheobligations worthinessofeitherFannieMaeorFreddieMac. arenotguaranteedbytheUnitedStates.Tomake ThesecondriskF-Frunisthatthecreditmar- thispositioncredible,thegovernmentneedsto ketsmightrefusetoacceptF-Fpaper.Everyweek, haveplansinplaceastohowtohandleacrisis F-Fmustrolloverroughly$30billionofmaturing shouldoneoccur. short-termobligations.Shouldthemarketcome TherecentannouncementbytheOfficeof tofearthecreditworthinessofeitherfirm,F-F FederalHousingEnterpriseOversightthatitwill wouldbeforcedtoliquidatenon-mortgageassets developconservatorshipproceduresisawelcome toobtainfundstoredeemmaturingobligations. developmentbecauseitincreasesthecredibility FannieMae’s10Kreportfor2003containsadis- oftheclaimF-Fmakeregardingtheabsenceofa cussionofliquidity(pp.113ff)andreportsaliq- federalguaranteeoftheirobligations.Asacom- uidityreserveof$65billion.Thisreserveisnet plementtothisstep,theauthorityoftheSecretary ofassetspledgedascollateral.Attheendof2003, ofTreasurytoprovidetemporaryfunds,inthe only$487millionofshort-termassetswere amountof$2.25billioneachtoFannieMaeand pledgedascollateral;thepolicystatement(p.115 FreddieMac,shouldberepealed.Thisprovision of200310Kreport)thatFannieMaewillmain- istoosmalltohaveanypracticalvalueinhandling tainaliquidreserveofatleast5percentoftotal acrisis,andisofsymbolicvalueonly. assetsdoesnotstatewhetherthepolicyrefersto unencumberedliquidassets.Intheeventofa crisis,FannieMaecouldfinditselfforcedtocol- FEDERAL RESERVE EMERGENCY lateralizeitslargederivativesposition,which POWERS wouldleaveaminimalliquidreserveshouldthe Iamacutelyawarethatshouldtherebea marketsbecomeunreceptivetonewissues.The marketcrisis,theFederalReservewillhavethe factisthatF-Fdependcriticallyoncontinuous responsibilitytomanagetheproblem.Justas marketaccess,andwiththeirminimalcapital manymarketparticipantsapparentlybelieve positionsthataccesscouldbedeniedwithout thatGSEobligationshavetheimplicitbacking warning. ofthefederalgovernment,theymayalsobelieve Thestrategyoffinancingshortandmanaging thattheFederalReservehasallthepowersnec- interest-rateriskthroughswapsdoesnotcom- essarytomanageacrisis.TheFed’ssuccessful pletelyreplicatetheclassicstrategy.F-Farevul- effortstohandlethestockmarketcrashin1987, nerabletobasisriskandimpairedaccesstothe thenear-insolvencyofLongTermCapitalManage- markettorollovertheirmaturingobligations. mentin1998,andthefinancialeffectsofthe9/11 tragedyalljustifiablyincreasemarketconfidence intheFederalReserve.Intheinterestofafull RECEIVERSHIP/CONSERVATORS understandingoftheFederalReserve’spowers HIP AUTHORITY intheeventofacrisisinthemarketforGSE ShouldeitherFannieMaeorFreddieMac obligations,I’lloutlinetheFed’spowersaspro- becomefinanciallystressed,theonlywayto videdbytheFederalReserveAct. 3 FINANCIALMARKETS TheFederalReserveroutinelymakesloans maturingobligationsandwould,therefore,solve todepositoryinstitutions.Thesearefullycollat- partofacrisisproblem.However,suchloans eralizedloans,subjecttohaircutsonthecollateral mightnotrestoreliquiditytoGSEdebtbefore toprotecttheFederalReserve’sposition.Tomy redemptionandwouldnotperserestorenormal knowledge,F-Fhavenotnegotiatedstandbylines functioningofthemortgagemarket.Clearly, ofcreditwithbankstoprovideemergencyfunds FederalReservesupportfortheGSEswouldhelp ineventofacrisis.Suchagreementsarecommon topreventabroadeningcrisis,butmostlikely amongfirmsthatissuecommercialpaper,sothat wouldbeincapableofpreventingsomeconsid- thefirmscanretirematuringobligationsevenif erabledisruption. theysuddenlyfindtheiraccesstothecommercial TheFederalReservehasamplepowertodeal papermarketimpaired.Inanemergency,F-F withaliquidityproblem,bymakingcollateral- couldworkwithbankstoprovidecreditandthe izedloansasauthorizedbytheFederalReserve FederalReservecouldinturnprovideloansto Act.TheFeddoesnothavepowertodealwitha banksundertheprimarycreditfacilityofthe solvencyproblem.Shouldasolvencyproblem discountwindow.Theseloanswouldhavetobe arisewithanyoftheGSEs,thesolutionwillhave fullysecuredbygoodcollateral. tobefoundelsewherethanthroughtheFederal Themainpointaboutmanagingacrisis Reserve. throughthismechanism,withF-Fobtainingcredit InapressreleasedatedFebruary5,2004,2 frombanksandtheFederalReserveproviding theBoardofGovernorsannouncedthateffective loanstothebanks,isthattheenormousscaleof July2006itwouldrequirethatgovernment- F-Fobligationswouldstrainthebankingsystem. sponsoredenterprisesandinternationalagencies Thismechanismmightnotsufficetohandlea havesufficientfundsintheirFederalReserve majorcrisisasthebankswouldinsistthatF-F accountsbeforetheFederalReservewouldrelease postcollateral.Inacrisis,themortgagemarket fundsforinterestandredemptionpaymentson wouldbeseverelydisruptedandmortgagesand securitiesissuedbytheseentities.Thischange mortgage-backedsecuritieswouldnodoubttrade inpracticewilleliminatethedaylightoverdrafts atlowerprices,thusimpairingthevalueofthe routinelycreatedtodaywhenGSEsmakeinterest collateralF-Fcouldpost.Thedeclineinthevalue andredemptionpaymentsbeforedepositingfunds ofF-Fassetswouldstraintheircapitalpositions, fromsaleofnewsecurities.TheBoard’spress andleadtofearsthateitherorbothFannieMae releasenotedthatthepracticeofpermittingintra- andFreddieMacmightbecomeinsolvent. daycredit“isinconsistentwiththatofprivate UnderSection13(3)oftheFederalReserve issuingandpayingagentsfortheircustomers’ Act,FederalReserveBankshavetheauthorityto securities.”ThepolicychangeeffectiveJuly2006 discountpaperforindividuals,partnershipsor will,therefore,aligntheFederalReserve’spractice corporations.DirectlendingtotheGSEswould withthataccordedprivateentities,reflectingthe havetocomeunderprovisionsofthispartofthe private,thoughgovernment-sponsored,statusof FederalReserveAct.Criticalprovisionsinclude theGSEs.Thepolicychangewillalsoreducerisk afindingofunusualandexigentcircumstances totheFederalReserveSystem. andanaffirmativevoteofnotlessthanfivemem- bersoftheBoardofGovernors.Theloanswould havetobefullycollateralized. CONCLUDING COMMENTS Therehasbeennolendingunderthisprovi- sionoftheFederalReserveActsincethe1930s. Thereasonswhyitisimportanttostrengthen Suchlending,wereittobeauthorizedbythe thecapitalpositionsoftheGSEsshouldbeclear. BoardofGovernors,wouldpermitGSEstoredeem Itisalsoimportantthatambiguitiesastothesta- 2 SeethepressreleaseontheBoardofGovernors’website:www.federalreserve.gov/boarddocs/press/other/2004/20040205. 4 PanelonGovernmentSponsoredEnterprises tusoftheGSEsbeclearedup,andthatconserva- FannieMaeandFreddieMacmanagerisks torshipprocedurestodealwithacrisisbeputin well,uptoapoint.Buttheunderlyingproblem place. offinancinglong-termmortgageswithshort-term Manyfinancialinstitutionsseemnottounder- assetsstillexists.Therisksmaybepassedalong standthenatureoftheissues.Itisinteresting toothersinthederivativesmarkets,butinthe thatGSEobligationstradeatmuchsmaller aggregatetheriskshavenotbeenextinguished. spreadsoverTreasuriesattheshortendofthe Theonlywaytomanagetheseriskscompletely maturityspectrumthanatthelongend.Investors isthroughacombinationofF-Fsubstitutingmore inshort-termobligationsapparentlybelievethat long-termforshort-termdebtandmaintaining theyarecompletelyprotectedfromcreditrisk strongercapitalpositions. becausetheywillhaveenoughwarningtopermit InotealsothatF-Fhaveapowerfulincentive themtoexittheseobligationsbylettingthem togrow.Theyreportreturnsonequityinthe matureinafewmonths.Theproblemisthat neighborhoodof30percentperyear.Theyare shouldacrisisoccur,itwilltakeholdsoquickly abletoachievethesereturnsbyexploitingthe thatGSEobligationswillinamatterofhours,or implicitfederalguaranteeoftheirobligations, days,becomeilliquid.Whileanyoneholderof whichenablesthemtoborrowatnearTreasury GSEdebtcanexit,notallholderstogethercan ratesdespitetheirthincapitalpositionsand exitatonce.Theeconomicsofthismarketare investinmortgagesatprivatemarketrates.Their similartothoseofbankingmarkets.Ascramble growthobjectivesinsurethattheirscalewill toconvertallbankdepositsintocashcannotsuc- increaseovertime,unlesstheybecomesubject ceedintheaggregatebecausenotenoughcash tofullprivatemarketincentivesthroughconvinc- existstoeffecttheconversion.Similarly,ascram- ingfederalpoliciesthatleadtomarketrecognition bletoconvertGSEobligationsintocashcannot thatthefederalgovernmentwillnotguarantee succeedintheaggregatebecausetheunderlying GSEobligationsinacrisis. mortgageassetscannotbequicklyconvertedto cash.Mortgagorsareundernoobligationtopre- paylong-termmortgages. 5

William Poole (2004, May 5). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20040506_poole

@misc{wtfs_speech_20040506_poole,
  author = {William Poole},
  title = {Speech},
  year = {2004},
  month = {May},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20040506_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}