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 firmsleavesinplaceapotentialsourceoffinanimportant 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,Ibecameconcernedabouttheirthincapipart 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,Ibegantospeakonthesubsponsoredenterprises,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- hopefulthatCongresswilleventuallypassmeanmentstoFannieMaeandFreddieMac,where ingfulGSEreformlegislation.Privatesectorfinanthelargestissuesarise.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,tounderstateearnwhoprovidedspecialassistance. 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,revealingthatithadoverthatitwasnotunusualtofindstoriesaboutthe stateditsearningsbyatotalofabout$6billion. GSEsonthefrontpagesofmajorfinancialnews- FannieandFreddiearesupervisedbythe papers.Theywerethesubjectofsubstantial OfficeofFederalHousingEnterpriseOversight, debateinCongressandamongfinancialpolicy orOFHEO.Inbothcases,OFHEO’searlyresponse experts.Theyhadescapedfromobscurity,pritodisclosureoftheaccountingirregularitieswas marilybecauseofpublicityinrecentyearsover todeclaretheenterprises“significantlyundertheiraccountingirregularities.Buttodaythey capitalized”becausetheirextremelyhighleverseemtobereturningtoobscurity. 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),torectifyportfolioriskagers,whohadrepeatedlydeclaredthat,unlike managementdeficiencies.Then,in2005,10of Freddie’s,itsownbookswereclean.Theboards the12FHLBsfailedtomeettheiragreeddeadofbothcompaniesagreedtoaseriesofgovernance linetoregistertheirstockwiththeSEC.Like reformsdesignedtobringtheGSEsintolinewith FannieMaeandFreddieMac,alloftheFHLBs otherlargefinancialfirms.Hundredsofmillions restatedtheirearningsforrecentyears;allhave ofshareholderdollarswerecommittedtorebuild- nowreturnedtotimelyfilingofaccounting ingaccountingandcontrolsystemsatbothfirms. statements. Bothfirmsagreedtorestateearningsforthepast Sowheredowestand?Iwouldcharacterize fewyears;somassivewasthisundertakingthat thecurrentsituationasaperiodofuneasywaitneitherfirmiscurrentonitsfinancialreporting. 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 itwouldbeamistaketobelievethatnothingusetenaciousinvestigationsintowrongdoingatboth fulwasdoneaftersevereaccountingproblems FreddieMacandFannieMaespurredinvestiga- surfacedinJune2003.Ingeneralterms,themost tionsbytheSECandtheDepartmentofJustice. importantachievementisamuchbroaderand Congressionalhearingswereheld,andGSEreform better-informeddiscussionoftheriskstofinancial legislationwaspassedinoversightcommittees stabilityposedbytheGSEs.2Wewerefortunate ofbothhousesofCongressin2004and2005, thattheGSEaccountingandgovernancescanalthoughnofinallegislationhasbeenenactedas 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 denceonhowthemortgagemarketwouldfuncsystemicrisksposedbytheGSEs; 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- inthewakeofdisclosuresofaccountingirregudixtothisspeechprovidesabriefsummaryof larities.ThosedisclosuresledOFHEOtoimpose eachoftheseitemsandcitations. 30percenttemporarysurchargesonthefirms’ Consideringtheseresultsasawhole,wehave requiredminimumcapitallevels.FreddieMac’s learnedagreatdealinrecentyearsaboutthe capitalsurchargewasimposedinJanuary2004, waytheGSEsoperate,theriskstheyaretaking whereasFannieMae’scapitalsurchargebecame andhowtheyattempttomanagethem,andwhat effectiveinSeptember2004.3Tomeetthehigher effectstheGSEshaveonfinancialmarketsduring capitalratio,thetwofirmshadtodosomecomnormaltimesaswellasduringperiodsofmarket 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.Theviewseemstobethatsomearesubjecttoprepaymentrisk,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,asaconsedidaffectthestockpricesofthetwofirms.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,thesharewas14perbecausethemarketcontainsmanycompetent 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.ThereisaglaringneedforlegismoretheratiosthatFannieandFreddiemaintain. lationtoclarifythebankruptcyprocessshoulda Bankspaydepositinsurancepremiumstothe GSEfail.Atpresent,thereisnoprocessandno FederalDepositInsuranceCorporation,whereas oneknowswhatwouldhappenifaGSEbecomes FannieandFreddiepaynoinsurancepremiums. unabletomeetitsobligations. Assumingthattheimpliedguaranteewould,ina FreddieMacandFannieMaebothgotinto crisis,leadtoafederalbailout,U.S.taxpayers troublewithaccountingirregularitiesinpart beartheriskwhiletheshareholdersandmanbecauseofthecomplexitiesundergenerally agersofFannieandFreddieenjoytheprofits. acceptedaccountingprinciplesforderivatives Thissituationencouragesthesefirmstogrow positionsandrulesdeterminingwhichassets vigorously. shouldbereportedatmarketvalueandwhich Thesetwofirms,however,cannotmeettheir shouldbereportedatamortizedhistoricalcost. growthtargetsinthelongruniftheyconfine Soundriskmanagementpracticesrequirethat theiroperationstoconforminghomemortgages. GSEmanagementbasedecisionsonmarketvalues, Theirinterestinincreasingtheconformingmortorestimatesasclosetomarketvaluesasfinancial gagelimitisclear.Moreover,inmyopinion,itis theoryandpracticepermit.Thereasonissimple: inevitablethattheywilllookforwaystoextend FannieMaeandFreddieMacpursuepolicies theiroperationsintonewareas.Theyhavethat thatinherentlyexposethefirmstoanextreme clearincentivebecauseoftheimplicitfederal asset/liabilitydurationmismatch.Theyhold guaranteetheyenjoy.Forthemtoextendtheir operationsintomarketsegmentsalreadywell long-termmortgagesandMBSfinancedbyshortservedbyexistingprivatefirmswillnotenhance termliabilities.Giventhisstrategy,theymust theefficiencyofmortgagemarketsorreduce engageinextensiveoperationsinderivatives coststomortgageborrowers. marketstocreatesyntheticallyadurationmatch Therearetwopossiblewaystoconstrainthe onthetwosidesofthebalancesheet.TheseoperoperationsoftheGSEstoareaswithaclearpublic ationsexposethefirmtoahugeamountofrisk purpose.Oneistoendtheimpliedfederalguar- unlessthepositionsaremeasuredatmarketvalue. anteesothatFannieMaeandFreddieMaccom- Almostalltheassetsandliabilitiesofthe peteonanequalbasiswithotherfullyprivate GSEsareeithertradedactivelyinexcellentmarfirms.Theotheristoplacerestrictionsonthe ketsorhavevaluesthatcanbeaccuratelymeassizeoftheirownedportfoliosiftheyretaintheir 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 forthosewhobelievethataGSEcrisisisunthinkinGSEdebtsecuritiesappearunmoved.Upon ableinthefuture,Isuggestacourseineconomic reflection,thelackofmarketdisciplineevident history. duringthiscrisisperiodisstriking—likeadog thatdidnotbark.Thisfactindicatestomethat therestillisasignificantproblemwiththeGSEs REFERENCES thatneedstobefixed. BoardofGovernorsoftheFederalReserveSystem Theobviousanswertowhythedogdidnot (Parkinson,PatrickandGibson,Michael)and barkisthattheso-called“implicitguarantee”— FederalReserveBankofNewYork(Mosser,Patricia; thatis,thebeliefbyinvestorsthattheU.S.govern- Walter,StefanandLaTorre,Alex).“Concentration mentwouldnotallowtheGSEstodefaulton andRiskintheOTCMarketsforU.S.DollarInterest theirdebtobligations—hasnotbeenremoved. RateOptions,”March2005; Indeed,thetalkofincreasedGSEregulationand www.federalreserve.gov/BoardDocs/Surveys/ thefailureofstructural-reformlegislationto OpStudySum/OptionsStudySummary.pdf. becomelawmayactuallyhavereinforcedthe beliefofmanythat,overall,thegovernmentis Emmons,WilliamR.andSierra,GregoryE. perfectlyhappywiththesituationasitis.The “IncentivesAskew?ExecutiveCompensationat GSEsremainpoliticallypowerful,iflessstrident FannieMaeandFreddieMac.”Regulation,Winter 2004,27(4),pp.22-28. thantheywereafewyearsago. Threeessentialreformsareneededtoelimi- Frame,W.ScottandWhite,LawrenceJ.“Fussing natetheGSEs’threattofinancialstability.First andFumingoverFannieandFreddie:HowMuch isalimitontheirportfoliogrowth,secondisan Smoke,HowMuchFire?”JournalofEconomic increaseintheirminimalrequiredcapital,and Perspectives,Spring2005,19(2),pp.159-84. thirdissatisfactorybankruptcylegislationsothat, shouldtheworsthappen,federalauthoritiescan Greenspan,Alan.“RegulatoryReformofthe dealwiththeprobleminanorderlyway. Government-SponsoredEnterprises.”Testimony FreddieMacapparentlydoesnotexpectany beforetheCommitteeonBanking,Housing,and significantincreasesinconstraintsonitsopera- UrbanAffairs,U.S.Senate,April6,2005a; tions.Fundsthatcouldhavebeenusedtobuild www.federalreserve.gov/boarddocs/testimony/ capitaltobetterprotecttaxpayershaveinstead 2005/20050406/default.htm. beenusedtoincreasecommonstockdividends. Freddiesetaquarterlydividendof$0.22inthe Greenspan,Alan.“RiskTransferandFinancial Stability.”Speechatthe41stAnnualConference fourthquarterof2002andhasincreasedthedivonBankStructureandCompetition,Federal idendeveryyearsince.Asofthefourthquarter ReserveBankofChicago,May5,2005b; of2006,thedividendstandsat$0.50perquarter, www.federalreserve.gov/boarddocs/speeches/ morethantwiceitslevelfouryearsearlier. 2005/20050505/default.htm. FannieMaecutitsdividendinhalfinearly2005 tobuildcapital,butI’llhazardaguessthatonce Greenspan,Alan.MonetaryPolicyReporttothe itstartsissuingregularfinancialstatementsthe Congress.Questionandanswersessionaftertesticompanywillincreaseitsdividendratherthan monybeforetheCommitteeonFinancialServices, buildcapitalfurther. U.S.HouseofRepresentatives,July20,2005c. 7

FINANCIALMARKETS Hancock,Diana;Lehnert,Andreas;Passmore,Wayne Poole,William.“TheRoleofGovernmentinU.S. andSherlund,ShaneM.“AnAnalysisofthe CapitalMarkets.”PresentedbeforetheInstituteof PotentialCompetitiveImpactsofBaselIICapital GovernmentalAffairs,UniversityofCaliforniaat StandardsonU.S.MortgageRatesandMortgage Davis,October18,2001;www.stlouisfed.org/ MarketSecuritization.”BaselIIWhitePaperNo.4, news/speeches/2001/10_18_01.html. BoardofGovernorsoftheFederalReserveSystem, April2005. Poole,William.Remarkspresentedtothepanelon government-sponsoredenterprises,40thAnnual Jaffee,Dwight.“TheInterestRateRiskofFannieMae ConferenceonBankStructureandCompetition, andFreddieMac.”JournalofFinancialServices FederalReserveBankofChicago,May6,2004; Research,August2003,24(1),pp.5-29. www.stlouisfed.org/news/speeches/2004/ 05_06_04.html. Lehnert,Andreas;Passmore,WayneandSherlund, ShaneM.“GSEs,MortgageRates,andSecondary Poole,William.“GSERisks.”FederalReserveBank MarketActivities.”FinanceandEconomics ofSt.LouisReview,March/April2005,87(2,Part1), DiscussionSeriesWorkingPaper2006-30,Divisions pp.85-92;http://research.stlouisfed.org/ ofResearchandStatisticsandMonetaryAffairs, publications/review/05/03/part1/Poole.pdf. BoardofGovernorsoftheFederalReserveSystem, September2006;www.federalreserve.gov/pubs/ Posner,Kenneth.“FannieMae,FreddieMac,andthe feds/2006/200630/200630pap.pdf;forthcomingin RoadtoRedemption.”MorganStanleyEquity JournalofRealEstate,FinanceandEconomics. Research,July2005. OfficeofFederalHousingEnterpriseOversight. 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-thecounterinterestratederivativesmarketsduetotheirportfolio-hedgingactivities. Research Papers by Federal Reserve Staff6 Oneofthesepapersestimatedthepass-throughbyFannieMaeandFreddieMacoftheirfundingcostadvantageintoprimarymortgagerates,findingamere7basispointsofpass-through.Another paperprovidedevidenceagainsttheGSEs’claimsthattheirpurchasingbehaviorstabilizesmortgage ratesduringperiodsofmarketturbulence.Otherpapersdiscuss(i)likelycompetitiveinteractions betweentheGSEsandlargebanksthatwillbesubjecttoBaselIIcapitalregulationand(ii)theillstructuredincentivestheGSEsfacetoincreasethesizeoftheirportfolios. 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