Speech

The GSEs: Where Do We Stand? CharteredFinancialAnalystsofSt.Louis St.Louis,Missouri January17,2007 PublishedintheFederalReserveBankofSt.LouisReview,May/June2007,89(3),pp.143-51 One of the Federal Reserve’s most firmsleavesinplaceapotentialsourceoffinan- important responsibilities is main- cialcrisis.Althoughthereispendinglegislation tenance of financial stability. The inCongress,amajorrestructuringofthesefirms job obviously, and sometimes dra- andgenuinereformappeartobeasdistantasever. matically,encompassescrisisresponse.However, MyinitialcuriosityabouttheGSEswasstoked the very existence of a crisis, when one occurs, simplybythesizeofthesefirms.AsIinvestigated often demonstrates a failure of some sort, on the further,Ibecameconcernedabouttheirthincapi- part of the firms involved, the government, or talpositionsandtherealizationthatifanyof the Federal Reserve. It would not be difficult to themgotintofinancialtroublethemarketsand cite examples of such failures. thefederalgovernmentwouldlooktotheFederal NotlongaftercomingtotheSt.LouisFed Reservetodealwiththeproblem.AsIworked in1998,Ibecameinterestedingovernment- throughtheissues,Ibegantospeakonthesub- sponsoredenterprises,orGSEs.Myinterestarose ject;myfirstsuchspeechwasinOctober2001 whenIbegandiggingintoaggregatedataonthe (Poole,2001).IlastspokeonaGSEtopictwoyears financialmarketsanddiscoveredhowlargethese ago,beforetheSt.LouisSocietyofFinancial firmsare.ThebulkofallGSEassetsareinthe Analysts.Mytitlethenwas“GSERisks”(Poole, housingGSEs—FannieMae,FreddieMac,and 2005).Giventhattherisksdidnotseemlikelyto the12federalhomeloanbanks(FHLBs).Using disappearanytimesoon,aboutsixmonthsagoI informationasofSeptember30,2006—thelatest settledonaGSEtopiconceagain. availableasofthiswriting—these14firmshave TodayIwanttolookbackoverthepastfew totalassetsof$2.67trillion;giventheirthincapital yearstosummarizeafewofthechangesthat positions,theirtotalliabilitiesareonlyalittle haveoccurredattheGSEsandintheregulatory smaller.Justtwofirms—FannieMaeandFreddie environmenttheyface.Itisnoexaggerationto Mac—accountfor$1.65trillionoftheassets,or saythesehavebeenevent-filledyearsforthe 62percentofallhousingGSEassets.Moreover, GSEs,primarilybecauseofdisclosuresofaccount- FannieMaeandFreddieMachaveguaranteed ingirregularitiesatFannieMaeandFreddieMac. mortgage-backedsecuritiesoutstandingof$2.82 Althoughthesefirmsstoppedgrowingwhenthe trillion.Thus,thehousingGSEliabilitieson irregularitiesweredisclosed,Iwillemphasize theirbalancesheetsandguaranteedobligations thatoncetheygettheirhousesingoodorderthey offtheirbalancesheetsareabout$4.47trillion, willlikelyresumerapidgrowthbecauseofthe whichmaybecomparedwithU.S.government specialadvantagestheyenjoyinthemarketplace debtinthehandsofthepublicof$4.83trillion. fromtheirtiestothefederalgovernment.Iremain Inwhatfollows,I’llconfinemostofmycom- hopefulthatCongresswilleventuallypassmean- mentstoFannieMaeandFreddieMac,where ingfulGSEreformlegislation.Privatesectorfinan- thelargestissuesarise.Mypurposeistomake cialfirmsoughttohaveanintenseinterestin thecaseonceagainthatfailuretoreformthese reformlegislation.Still,giventhatthereseems 1 FINANCIALMARKETS tobesolittleappreciationoftheimportanceof gagemarketwasnegligible.Similarly,when theGSEissue,wheredothey—andwe—gofrom Fannie’saccountingirregularitiesweredisclosed here? onSeptember22,2004,itsstockfellby6.5per- Beforeproceeding,Iwanttoemphasizethat centthatdayandbyatotalof13.5percentover theviewsIexpressherearemineanddonot athree-dayperiod;themortgageratewasagain necessarilyreflectofficialpositionsoftheFederal unaffected. ReserveSystem.Ithankmycolleaguesatthe Fortunatelyforfinancialstability,theaccount- FederalReserveBankofSt.Louisfortheircom- ingirregularitiesatFreddieMachadbeen ments—especiallyBillEmmons,senioreconomist, designed,aswelaterlearned,tounderstateearn- whoprovidedspecialassistance. ingsbyatotalofabout$9billionoveraperiod ofyears.Thus,therewasnoquestionofFreddie Macdefaultingonanyofitsobligationsand THE HOUSING GSEs SINCE immediatelyunleashingunpredictableeffects JUNE 9, 2003 onitscounterpartiesorthefinancialsystem.In 2004,welearnedthatFannieMae’saccounting AlthoughthehousingGSEsarelessobscure wasrevealedtobefaulty.InDecember2006, thantheyusedtobe,theyarenotmuchdiscussed Fannierestateditsearningsfor2002,2003,and inrecentmonths.AyearagoIwouldhavenoted thefirsthalfof2004,revealingthatithadover- thatitwasnotunusualtofindstoriesaboutthe stateditsearningsbyatotalofabout$6billion. GSEsonthefrontpagesofmajorfinancialnews- FannieandFreddiearesupervisedbythe papers.Theywerethesubjectofsubstantial OfficeofFederalHousingEnterpriseOversight, debateinCongressandamongfinancialpolicy orOFHEO.Inbothcases,OFHEO’searlyresponse experts.Theyhadescapedfromobscurity,pri- todisclosureoftheaccountingirregularitieswas marilybecauseofpublicityinrecentyearsover todeclaretheenterprises“significantlyunder- theiraccountingirregularities.Buttodaythey capitalized”becausetheirextremelyhighlever- seemtobereturningtoobscurity. agemakesuncertaintyofanykindaboutthetrue ForFannieMaeandFreddieMac,thetwo capitalbackingoftheirportfoliosarisktotheir stockholder-ownedhousingGSEs,historycanbe ownsafetyandsoundness,aswellasthestability dividedintotwodistincteras—beforeJune2003 ofthefinancialsystem.Beginninginthefirst andafter.June9,2003,wasthedaytheboardof quarterof2004,OFHEOrequiredFreddieMacto directorsofFreddieMacannounceddiscovery ofsignificantaccountingirregularities.Thestock holdcapitalatleast30percentabovethestatutory pricesofbothFreddieMacandFannieMae minimumlevel;OFHEOimposedtheidentical plunged,asinvestorsimmediatelyrealizedthat requirementonFannieMaeinthethirdquarter somethingmighthavegoneterriblywrongwith of2005.Inaddition,OFHEOrequiredthefirms bothGSEs.Subsequentinvestigationsbyprivate tocorrecttheiraccounting;undertakeathorough expertsandpublicauthoritiesconfirmedthefears reviewofcorporategovernance,incentives,and ofmanyinvestorsandfinancialsupervisors. compensation;appointanindependentchief Thesegiant,fast-growingfirmshadpooraccount- riskofficer;andrefrainfromincreasingtheir ingsystemsandfinancialcontrols. retainedportfolios. Becauseitisimportantformyanalysislater, Thestunningaccountingirregularitiesat keepinmindthesefacts:First,theeffectofdis- FreddieMacandFannieMaeservedaswake-up closureofaccountingirregularitiesatFreddie callsbothtotheGSEsthemselvesandtothe MaconJune9,2003,ledtoadeclineof16percent supervisoryandlegislativecommunities.Freddie inFreddie’sstockpriceand5percentinFannie’s Macfiredvirtuallyallofitstop-levelmanagement stockpricethatday.However,asI’lldocument immediatelyinJune2003andthen,afewmonths later,theeffectofthesedisclosuresonthemort- later,firedthenewCEOithadhiredtoreplace 2 TheGSEs:WhereDoWeStand? theoriginaldisgracedCEO.1Barelyayear-and-a- withtheirsupervisor,theFederalHousing halflater,FannieMaeejecteditsowntopman- FinanceBoard(FHFB),torectifyportfoliorisk- agers,whohadrepeatedlydeclaredthat,unlike managementdeficiencies.Then,in2005,10of Freddie’s,itsownbookswereclean.Theboards the12FHLBsfailedtomeettheiragreeddead- ofbothcompaniesagreedtoaseriesofgovernance linetoregistertheirstockwiththeSEC.Like reformsdesignedtobringtheGSEsintolinewith FannieMaeandFreddieMac,alloftheFHLBs otherlargefinancialfirms.Hundredsofmillions restatedtheirearningsforrecentyears;allhave ofshareholderdollarswerecommittedtorebuild- nowreturnedtotimelyfilingofaccounting ingaccountingandcontrolsystemsatbothfirms. statements. Bothfirmsagreedtorestateearningsforthepast Sowheredowestand?Iwouldcharacterize fewyears;somassivewasthisundertakingthat thecurrentsituationasaperiodofuneasywait- neitherfirmiscurrentonitsfinancialreporting. ing.TheGSEshavegrownmuchmoreslowly, Freddiedidreleaseitsannualreportfor2005 andtheyhavebeenmorereticentinpublicin but,accordingtoitspressreleaseofJanuary5, recentquartersthantheyhadbeenduringthe 2007,mayreviseitsresultsmateriallyforthefirst pre-2003decade.Itappearsthattheywantto ninemonthsandthethirdquarterof2006.Nor pursuealow-keystrategywhilememoriesof isFanniefilingcurrentreports.InDecember2006, theiraccountingandcontrolfailuresgradually FanniefileditsForm10-Kfor2004withthe fade.Theiraim,apparently,istoreturntothe SecuritiesandExchangeCommission(SEC). environmentbeforeheightenedscrutinyarosein Currently,investorsincommonstockordebt 2003. obligationsissuedbybothcompaniesrelyon partialandincompleteinformationsubjectto materialrevision. WHAT HAS BEEN TheGSEaccountingscandalsconstituteda ACCOMPLISHED: ANALYSIS OF rudeawakeningforOFHEOandCongress.OFHEO GSE RISKS wascaughtnappingatFreddieMacbut,toits credit,thenidentifiedFannieMae’sshortcomings AlthoughIthinkmuchmoreneedstobedone, onitsown.Oncealertedtotheproblems,OFHEO’s itwouldbeamistaketobelievethatnothinguse- tenaciousinvestigationsintowrongdoingatboth fulwasdoneaftersevereaccountingproblems FreddieMacandFannieMaespurredinvestiga- surfacedinJune2003.Ingeneralterms,themost tionsbytheSECandtheDepartmentofJustice. importantachievementisamuchbroaderand Congressionalhearingswereheld,andGSEreform better-informeddiscussionoftheriskstofinancial legislationwaspassedinoversightcommittees stabilityposedbytheGSEs.2Wewerefortunate ofbothhousesofCongressin2004and2005, thattheGSEaccountingandgovernancescan- althoughnofinallegislationhasbeenenactedas dalsdidnotthreatentheimmediatesolvencyof ofthistime.I’llhavemoretosayaboutreform theenterprisesandthattheproblemssurfaced legislationlater,becauseIthinkthisisanimpor- whentheeconomyandfinancialmarketswere tantmissingpieceoftheoverallpuzzle. strong. Meanwhile,theFHLBs—the“otherhousing Iwillpointtosixmajorcontributionstothe GSEs”—wereenduringaccountingandcontrol publicinvestigationinto,anddebateabout,the crisesoftheirown.TwoofthetwelveFHLBs risksposedbytheGSEs.Therehavebeenother signedwrittenregulatoryagreementsin2004 contributors,tobesure,butthislistprovides 1 FreddieMac’sboardofdirectorshadmisjudgedatfirsthowdeeplyingrainedtheinternal-controlandgovernanceproblemswereandhad hiredtheformerCFOtobecomethenewCEO. 2 Foramoredetaileddiscussionofthistopic,seePoole(2005). 3 FINANCIALMARKETS whatIthinkisagoodoverviewoftheissuesand theycanfunctionperfectlywellaspurelyprivate whatwehavelearnedsofar: firms. Akeyissueformanyiswhetherprivatizing • a2003studybyDwightJaffeeofinterest FannieandFreddiewouldraisemortgagerates raterisksrunbytheGSEs; paidbyborrowers.Wenowhavesomesolidevi- • a2003studybyOFHEOofthepotential denceonhowthemortgagemarketwouldfunc- systemicrisksposedbytheGSEs; tionifthehousingGSEsbecamefullyprivate • aseriesoftestimoniesandspeechesby firms.Acarefuleconometricinvestigationby FederalReserveBoardChairmanAlan threeeconomistsattheBoardofGovernorslast Greenspan; year(Lehnert,Passmore,andSherlund,2006, • aseriesofresearchpaperspreparedby abstract)reachedthisconclusion:“Wefindthat FederalReserveSystemstaffmembers; GSEportfoliopurchaseshavenosignificanteffects oneitherprimaryorsecondarymortgagerate • theresultsofaFederalReserveadhoc spreads.”Putanotherway,the30-yearmortgage studygroupinvestigatingcounterparty ratefluctuatesintandemwiththerateon10-year exposuresandrisksintheover-the- TreasurybondsandthespreadovertheTreasury counterinterestratederivativesmarkets; rateisnotaffectedbyportfoliopurchasesby • andaneconomic-capitalanalysisof FannieandFreddie. FannieMaeandFreddieMacpreparedby Anotherapproachtoacquiringevidenceon KennethPosner,anequityanalystat theeffectsonthemortgagerateofmortgagepur- MorganStanley. chasesbyFannieandFreddieistoexaminewhat Thesebulletpointsprovidetheflavorof happenedwhentheirportfoliosstoppedgrowing someoftherecentworkontheGSEs.Theappen- inthewakeofdisclosuresofaccountingirregu- dixtothisspeechprovidesabriefsummaryof larities.ThosedisclosuresledOFHEOtoimpose eachoftheseitemsandcitations. 30percenttemporarysurchargesonthefirms’ Consideringtheseresultsasawhole,wehave requiredminimumcapitallevels.FreddieMac’s learnedagreatdealinrecentyearsaboutthe capitalsurchargewasimposedinJanuary2004, waytheGSEsoperate,theriskstheyaretaking whereasFannieMae’scapitalsurchargebecame andhowtheyattempttomanagethem,andwhat effectiveinSeptember2004.3Tomeetthehigher effectstheGSEshaveonfinancialmarketsduring capitalratio,thetwofirmshadtodosomecom- normaltimesaswellasduringperiodsofmarket binationofraisingnewcapitalandreducingtheir turbulence.Armedwiththisknowledge,law- portfolios. makersandpolicymakersareinamuchbetter Theretainedportfoliosofmortgagesand positiontomakeneededimprovementsinthe mortgage-backedsecurities(MBS)heldbyFannie statutoryandregulatoryenvironmentinwhich andFreddiegrewstronglyintheyearspreceding theGSEsoperate. theOFHEOorders.Forexample,ifwelookat year-endfiguresfor2002and2003,weseethat overthecourseof2003thetwofirms’retained portfoliosgrewbyanetof12.3percentand,at THE CASE FOR FUNDAMENTAL theendof2003,theyheld22percentofoutstand- REFORM ingmortgageson1-to4-familyproperties.Net Icontinuetobelievethatthenationwould growthoftheirretainedportfoliosthenstopped; bewell-servedbyturningtheGSEsintogenuinely overthecourseofboth2004and2005,theirtotal privatefirms,withoutgovernmentbacking, portfoliosofmortgagesandMBSfellslightly.In impliedorexplicit.Iftheybolstertheircapital, 2006,theirretainedportfolioscontinuedto 3 Seewww.ofheo.gov/media/pdf/capclass93004.pdf. 4 TheGSEs:WhereDoWeStand? declineandbytheendofthethirdquartertheir theGSEs.Onereasonissimplythatbanksand portfolioswerebelowyear-end2005.Meanwhile, otherfinancialfirms,andmanynonfinancial thetotalmarketcontinuedtoexpand.Thecom- firms,holdlargeamountsofGSEobligationsand binedmarketshareofFannieandFreddiefell GSE-guaranteedMBS.Ibelievethatmanyrisk from22percentattheendof2003to14percent managerssimplyacceptthatGSEsareeffectively attheendofthethirdquarterof2006. backstoppedbytheFederalReserveandthefed- Whathappenedtothemortgagespreadwhen eralgovernmentwithouteverthinkingthrough theGSEsstoppedaccumulatingever-largerport- howsuchimplicitguaranteeswouldactually folios?Nothing.Becausefixed-ratemortgages workinacrisis.Theviewseemstobethatsome- aresubjecttoprepaymentrisk,whereasthe10- one,somehow,woulddowhatisnecessaryina yearTreasurybondisnot,thereisadegreeof crisis.Goodriskmanagementrequiresthatthe variabilityofthemortgagespread.Butiftheces- “someone”beidentifiedandthe“somehow”be sationoftheGSEs’portfoliogrowthhadmadea specified.Ihaveemphasizedbeforethatifyou difference,itsurelywouldhaveshownupinthe arethinkingabouttheFederalReserveasthe data.Theannualaverageofthespreadin2003, “someone,”youshouldunderstandthattheFed beforetheOFHEOordersthatrestrictedFannie canprovideliquiditysupportbutnotcapital.4 andFreddie’sportfoliogrowth,was180basis Asforthe“somehow,”Iurgeyoutobesureyou points;thespreadwas157basispointsinboth understandtheextentofthepresident’spowers 2004and2005. toprovideemergencyaid,thelikelyspeedof Nordidweobserveanysortofshocktothe congressionalaction,andthepossibilitythat marketwhentheaccountingirregularitiesat politicaldisputeswouldslowresolutionofthe FreddieweredisclosedinJune2003.Thespread situation. was196basispointsinMay2003,198basispoints Thereisalong-runissuethatgoesbeyond inJune,and196basispointsinJuly.Consider thatoftoday’ssystemicrisk.Thefactisthatitis alsoJanuary2004,whenOFHEOimposedacapi- veryprofitableforafirmtobeabletoborrowat talsurchargeonFreddie.Thatmonth,themort- closetotheTreasuryrate,lendatthemarketrate, gagespreadwas159basispoints.Themonth andholdlittlecapital.Thatiswhythepromise before,thespreadwas161basispoints;themonth ofconstraintsontheportfoliogrowthatFannie after,156basispoints.TheOFHEOorderapply- andFreddiehadasignificanteffectontheirstock ingtoFanniecameinSeptember2004.That prices.Anyfirmwithsuchaprivilegedposition monththespreadwas163basispoints;themonth willwanttoextenditsscopeofoperations.Over before,159;themonthafter,162. thepast15years,FannieMaeandFreddieMac Towardthebeginningofmyremarks,Inoted havegrownmuchmorerapidlythanhasthe thatdisclosureoftheaccountingirregularities stockofmortgagesoutstandingand,asaconse- didaffectthestockpricesofthetwofirms.Now quence,nowholdorguaranteealargefractionof weseethattherewasnoeffectonthemortgage U.S.homemortgages.Attheendof1990,they market.Theissue,clearly,istheprofitabilityof heldintheirportfolios5percentofthemortgages thefirmsandnoteffectsonthemortgagemarket. for1-to4-familyproperties;thesharepeakedat TheeffectsofproblemsatFannieandFreddie 22percentattheendof2003;and,attheendof onthemortgagemarkethavebeenminimal thethirdquarterof2006,thesharewas14per- becausethemarketcontainsmanycompetent cent.GiventhepowerfulincentiveFannieand andwell-capitalizedcompetitorsthatcanreadily Freddiehavetogrow,thesystemicrisktheypose pickuptheslackwhenotherplayersstumble. totheeconomywillalsogrow. Financialfirmsthroughouttheeconomy Oncetheircurrentaccountingproblemsare oughttohaveanintenseinterestinreforming fullyresolved,FannieandFreddiewillwantto 4 ForadiscussionofFederalReserveemergencypowers,seePoole(2004). 5 FINANCIALMARKETS resumetheirgrowth.Itissimplyveryprofitable weak,astheGAOhaspointedoutonnumerous tobeabletoborrowatclosetotheTreasuryrate occasions.5Thus,structuralchangeoftheGSEs andinvestinmortgageswhileholdingminimal andtheirsupervisionshouldbeatthetopofthe capital.Banksmaintaincapitalratiosdoubleor reformagenda.Thereisaglaringneedforlegis- moretheratiosthatFannieandFreddiemaintain. lationtoclarifythebankruptcyprocessshoulda Bankspaydepositinsurancepremiumstothe GSEfail.Atpresent,thereisnoprocessandno FederalDepositInsuranceCorporation,whereas oneknowswhatwouldhappenifaGSEbecomes FannieandFreddiepaynoinsurancepremiums. unabletomeetitsobligations. Assumingthattheimpliedguaranteewould,ina FreddieMacandFannieMaebothgotinto crisis,leadtoafederalbailout,U.S.taxpayers troublewithaccountingirregularitiesinpart beartheriskwhiletheshareholdersandman- becauseofthecomplexitiesundergenerally agersofFannieandFreddieenjoytheprofits. acceptedaccountingprinciplesforderivatives Thissituationencouragesthesefirmstogrow positionsandrulesdeterminingwhichassets vigorously. shouldbereportedatmarketvalueandwhich Thesetwofirms,however,cannotmeettheir shouldbereportedatamortizedhistoricalcost. growthtargetsinthelongruniftheyconfine Soundriskmanagementpracticesrequirethat theiroperationstoconforminghomemortgages. GSEmanagementbasedecisionsonmarketvalues, Theirinterestinincreasingtheconformingmort- orestimatesasclosetomarketvaluesasfinancial gagelimitisclear.Moreover,inmyopinion,itis theoryandpracticepermit.Thereasonissimple: inevitablethattheywilllookforwaystoextend FannieMaeandFreddieMacpursuepolicies theiroperationsintonewareas.Theyhavethat thatinherentlyexposethefirmstoanextreme clearincentivebecauseoftheimplicitfederal asset/liabilitydurationmismatch.Theyhold guaranteetheyenjoy.Forthemtoextendtheir operationsintomarketsegmentsalreadywell long-termmortgagesandMBSfinancedbyshort- servedbyexistingprivatefirmswillnotenhance termliabilities.Giventhisstrategy,theymust theefficiencyofmortgagemarketsorreduce engageinextensiveoperationsinderivatives coststomortgageborrowers. marketstocreatesyntheticallyadurationmatch Therearetwopossiblewaystoconstrainthe onthetwosidesofthebalancesheet.Theseoper- operationsoftheGSEstoareaswithaclearpublic ationsexposethefirmtoahugeamountofrisk purpose.Oneistoendtheimpliedfederalguar- unlessthepositionsaremeasuredatmarketvalue. anteesothatFannieMaeandFreddieMaccom- Almostalltheassetsandliabilitiesofthe peteonanequalbasiswithotherfullyprivate GSEsareeithertradedactivelyinexcellentmar- firms.Theotheristoplacerestrictionsonthe ketsorhavevaluesthatcanbeaccuratelymeas- sizeoftheirownedportfoliosiftheyretaintheir uredbypricesinsuchmarkets.Forthisreason, privilegedposition.Theirownedportfoliosshould thefinancialconditionoftheGSEsoughttobe belimitedtomortgagesheldtemporarilyinthe measuredthroughfair-valueaccountingandsuch processofsecuritization. accountsoughttobetheprincipalyardstickof Absentcompleteprivatization,orontheway conditionandperformance. toit,Congressshouldstrengthenthepowersof OFHEOorasuccessorregulator.OFHEOhas weakerpowersthanprovidedbylawtothefed- CONCLUSIONS eralbankregulators—theOfficeoftheComptroller oftheCurrency,theFederalReserve,andthe SincetheGSEaccountingscandalsemerged FederalDepositInsuranceCorporation.TheGSE inmid-2003,onethinghasremainedrock-solid: supervisoryframeworkremainsfragmentedand TheGSEshavecontinuedtoborrowatyields 5 Mostrecently,theGAOcriticizedGSEoversightinWalker(2005). 6 TheGSEs:WhereDoWeStand? onlyslightlyhigherthanthoseoftheU.S.govern- IbeganthisspeechnotingthattheFederal mentandnoticeablylowerthanthoseavailable Reservehasaresponsibilitytomaintainfinancial toanyotherAAA-ratedprivatecompanyorentity. stability.Thatresponsibilityincludesincreasing Inotherwords,despitethevastrecentaccumu- awarenessofthreatstostabilityandformationof lationofknowledgeaboutthesignificantrisks recommendationsforstructuralreform.Idonot runbytheGSEs,aswellastheirinability(or believethataGSEcrisisisimminent.However, unwillingness)tomanagetheserisks,investors forthosewhobelievethataGSEcrisisisunthink- inGSEdebtsecuritiesappearunmoved.Upon ableinthefuture,Isuggestacourseineconomic reflection,thelackofmarketdisciplineevident history. duringthiscrisisperiodisstriking—likeadog thatdidnotbark.Thisfactindicatestomethat therestillisasignificantproblemwiththeGSEs REFERENCES thatneedstobefixed. 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Walker,DavidM.“HousingGovernment-Sponsored “SystemicRisk:FannieMae,FreddieMac,andthe Enterprises:ANewOversightStructureIsNeeded.” RoleofOFHEO.”ReporttoCongress,February TestimonybeforetheCommitteeonBanking, 2003;www.ofheo.gov/Media/Archive/docs/ Housing,andUrbanAffairs,U.S.Senate,April21, reports/sysrisk.pdf. 2005;www.gao.gov/new.items/d05576t.pdf. Passmore,Wayne.“TheGSEImplicitSubsidyandthe ValueofGovernmentAmbiguity.”RealEstate Economics,Fall2005,33(3),pp.465-83. Passmore,Wayne;Sherlund,ShaneM.andBurgess, Gillian.“TheEffectofHousingGovernment- SponsoredEnterprisesonMortgageRates.”Real EstateEconomics,Fall2005,33(3),pp.427-63; www.federalreserve.gov/pubs/feds/2005/200506/ 200506pap.pdf. 8 TheGSEs:WhereDoWeStand? APPENDIX Summaries of Recent Studies on GSE Issues Jaffee (2003) Study of GSE Interest Rate Risk DwightJaffeewasoneofthefirstto“peerthrough”thepublicdisclosuresprovidedbytheGSEs abouttheinterestrateriskstheyincurredandhowtheymanagedthem.Jaffeeconcludedthatthe GSEsactuallyincurredsignificantinterestrateandliquidityrisks,despitetheirowncharacterization ofsuchrisksasbeingminimal.SubsequenteventsandanalysishaveprovenJaffeecorrect. OFHEO (2003) Study of Potential Systemic Risks Posed by GSEs EvenbeforetheGSEaccountingscandalsbroke,theGSEs’safety-and-soundnesssupervisorhad preparedastudycomprisingscenariosinwhichtheGSEsmightcontributetosystemicrisk.Although OFHEOconcludedthatthelikelihoodofoneorbothGSEscontributingtofinancial-systeminstability wasverysmall,theagencyrecommendedtoCongressthatits(OFHEO’s)supervisorypowersshould beenhancedtofurthersafeguardtheGSEsandthefinancialsystem. Public Statements by Chairman Alan Greenspan (2005a,b,c) FederalReserveChairmanGreenspan(2005a)rejectedtheideaofstrongerGSEregulationinfavor ofportfoliolimits,statingthat, World-classregulation,byitself,maynotbesufficientand,indeed,mightevenworsenthepotentialfor systemicriskifmarketparticipantsinferredfromsuchregulationthatthegovernmentwouldbemore likelytobackGSEdebtintheeventoffinancialstress…WeattheFederalReservebelievethisdilemma wouldberesolvedbyplacinglimitsontheGSEs’portfoliosofassets. ChairmanGreenspanalsodrewattentiontothestrainstheGSEscouldplaceontheover-the- counterinterestratederivativesmarketsduetotheirportfolio-hedgingactivities. Research Papers by Federal Reserve Staff6 Oneofthesepapersestimatedthepass-throughbyFannieMaeandFreddieMacoftheirfunding- costadvantageintoprimarymortgagerates,findingamere7basispointsofpass-through.Another paperprovidedevidenceagainsttheGSEs’claimsthattheirpurchasingbehaviorstabilizesmortgage ratesduringperiodsofmarketturbulence.Otherpapersdiscuss(i)likelycompetitiveinteractions betweentheGSEsandlargebanksthatwillbesubjecttoBaselIIcapitalregulationand(ii)theill- structuredincentivestheGSEsfacetoincreasethesizeoftheirportfolios. Ad Hoc Federal Reserve Study Group Examining GSE Impacts on Interest Rate Derivatives Markets (Board of Governors, 2005) ThestudygroupidentifiedpotentialchannelsthroughwhichdisruptionsattheGSEscouldflow throughtoothermarketparticipantsintheover-the-countermarketsforinterestratederivatives,like swaps,interestrateoptions,andswaptions(optionsonswaps).Thestudygroupreportedthatmarket participantsfeltcurrentrisk-managementpracticesweresufficienttocontainrisksposedbythe GSEs. 6 TheseincludePassmore(2005),Sherlund,andBurgess(2005),Lehnert,Passmore,andSherlund(2006),Hancocketal.(2005),Frameand White(2005,andEmmonsandSierra(2004). 9 FINANCIALMARKETS Economic-Capital Analysis of GSEs by Morgan Stanley (Posner, 2005) KennethPosner,anequityanalystatMorganStanley,isolatedthedistincteconomicrisksfacedby theGSEsandestimatedhowmuchcapitalthefirmswouldneedtoprovideadequateprotectionto debtholderstojustifyanAAsenior-unsecuredbondrating.Thisanalysisassumedthattherewouldbe nosupportforthcoming(orexpectedbyfinancial-marketparticipants)fromthefederalgovernment. Hisestimateoftherequiredequity-to-assetscapitalratiowasintherangeof4to7percent,about twiceashighasthecurrentGSEratiosofcloserto3percent.Thus,theGSEswouldbesignificantly undercapitalizedtodayiftherewerenoexpectationofgovernmentsupportoftheirliabilities. 10

William Poole (2007, January 16). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20070117_poole

@misc{wtfs_speech_20070117_poole,
  author = {William Poole},
  title = {Speech},
  year = {2007},
  month = {Jan},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20070117_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}