Thursday, February 10, 2005

Fed President Details GSE Risks

In a speech on Jan. 13, 2005, the President of the Federal Reserve Bank of St. Louis gave a detailed list of the risks facing GSEs like Fannie Mae and Freddie Mac ("F-F"). The following is a summary of the full text found here. William Poole said:

1. Credit risk-"Credit risk occurs because homeowners can and do default on mortgage loans".

2.Prepayment risk-"..for many years F-F have been accumulating a portfolio of their own MBSs and directly owned individual mortgages. For the two firms together, these portfolios are very large, amounting to over $1.5 trillion at the end of 2003. Thus, F-F assume prepayment risk by holding these assets".

3. Interest-Rate Risk-"Because of imperfect dynamic hedging, F-F may suffer a significant loss whenever there are unexpected and large interest rate movements in either direction...Fannie Mae and Freddie Mac are (also)exposed to the counterparty default risk in their derivative contracts".

4. Liquidity Risk-"Fannie Mae and Freddie Mac must roll over roughly 30 billion dollars of maturing short-term obligations every week. At a time of disrupted financial markets, the credit markets might refuse to accept the F-F paper..Therefore, if Fannie Mae and Freddie Mac are unable to sell new debt, then they may also be unable to carry out sales of the “liquid” securities from their investment portfolio".

5. Operational Risk-"In the past two years, there have been surprising news reports of accounting irregularities, first at Freddie and more recently at Fannie. In both cases senior executives have left the firms and audit attestations have been questioned. Both firms have been required to restate earnings for a number of years... The recent revelations are another example of our inability to predict shocks that will impact our financial system".

6. Political and Regulatory Risk-"The bottom line is that there is substantial uncertainty over the future regulatory structure that will apply to Fannie Mae and Freddie Mac, and over the likely behavior of the government should the solvency of either firm come into question...even if the federal government bailed out F-F, their obligations might be redeemed eventually but cease to trade actively in liquid markets. Finally, there is of course no guarantee that the federal government would in fact bail out F-F. Many observers, myself included, believe that a bailout would not be a good idea".


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