Mortgage Banking
April 2003
A new report from the Office of Federal Housing Enterprise Oversight (OFHEO) explores the attendant risks posed by the growing retained loan portfolios of the government-sponsored enterprises (GSEs). Fannie and Freddie hedge those risks expansively, but even the scope of the hedging efforts raises its own questions.
By Robert Stowe England
CAN ONE HAVE TOO MUCH OF A good thing? And how much is too much? Those are some of the questions one increasingly hears asked about Fannie Mae and Freddie Mac.
The two government-sponsored enterprises (GSEs) are widely credited with doing a lot of good-helping to lower mortgage rates, increase homeownership and make the mortgage market more efficient. Their oft-admired accomplishments are made possible by their GSE status, which many industry analysts and observers contend leads investors to treat their securities as though they were guaranteed by the federal government, even though there is no explicit guarantee.
While the GSEs originally focused on securitizing loans and selling the resulting mortgage-backed securities (MBS) to investors, increasingly over the years their GSE advantage has helped them expand into portfolio lending and take market share from traditional portfolio lenders, such as community banks and savings and loans (S&Ls).
Portfolio lending is more profitable than buying and packaging loans for the secondary market, and the GSEs are expected to continue to expand into this business to sustain the consistently high returns they have provided shareholders. But are there risks to the mortgage industry and the broader capital markets if the GSEs control an ever-larger share of portfolio loans?
Armando Falcon Jr., outgoing director of the Office of Federal Housing Enterprise Oversight (OFHEO), initiated a study of systemic risk involving Fannie Mae and Freddie Mac three years ago to look at the questions raised by the continued expansion of the GSEs, as well as the potential fallout should one fail.
Why undertake such a study? Falcon, an attorney who served eight years on the legal staff of the House Banking and Financial Services Committee, explains his decision to launch the study this way: "A couple of years ago, in the wake of large corporate failures, people began to speculate about what would happen in the event of a failure of Fannie Mae and Freddie Mac." As experts at OFHEO and elsewhere began to look at the issue, they discovered there was very little research on this subject. Thus, to fill this void and better understand the odds of systemic risk and what to do to prevent or contain it, "we felt it would be a useful avenue of research," Falcon says.
The OFHEO study Falcon authorized, Systemic Risk: Fannie Mae, Freddie Mac and the Role of OFHEO, was released in February 2003, on the same day President George W. Bush announced the nomination of a new executive director for the GSE oversight agency, Mark Brickell, a former managing director in the derivatives group at J. P. Morgan & Co.
Falcon, ahead of releasing the study, made it clear that "Fannie Mae and Freddie Mac are very strong financial institutions today, and the possibility of either enterprise failing or contributing to a financial crisis is remote," he says.
While it contains some unlikely scenarios (see sidebar), the bulk of the report looks at risks that may be likely to accompany the further expansion of Fannie Mae and Freddie Mac into the portfolio lending market. The central question of the study is quite simple: Will there be a sufficient supply of the derivatives that the GSEs use to hedge interest rate risk for their ever-growing retained portfolios-- and will derivative supplies be sufficient in the event of interest rate shocks?
"It's a reasonable and prudent question to ask. Not only are Fannie and Freddie growing larger, but the servicing asset is more and more in concentrated hands," says Doug Duncan, chief economist for the Mortgage Bankers Association of America (MBA).
In such a situation, there are counterparty risks-that is, if one of the counterparties fails, it poses risks for all other parties in the system.
In the past there have been surprise failures of large financial institutions that had many counterparties, Duncan notes. Typically, those events have required intervention by the federal government to prevent a single failure from causing additional failures.
Duncan cites the unexpected crisis with Long Term Capital Management (LTCM) in 1998 as an example. In that case, the New York Fed used its influence to assemble major financial institutions in New York that had counterparty risk to advance more than $3 billion to assure LTCM's liquidity and, in the process, assume ownership of the firm.
Growth in retained portfolios
Retained portfolios are a focus of the OFHEO study because that is both where Fannie Mae and Freddie Mac are growing and where they are earning their best returns.
Profits from retained portfolios accounted for 75 percent of Freddie Mac's total income and 65 percent of Fannie Mae's total income in 2001, according to an analysis titled "Fannie Mae, Freddie Mac, and Interest Rate Risk," by Kenneth A. Posner, specialty/mortgage analyst at Morgan Stanley, New York. Posner predicts that while the retained portfolios of Fannie Mae and Freddie Mac represent 20 percent of the total stock of mortgage debt in 2002, by 2020 the two mortgage giants "should hold" in portfolio 50 percent of mortgage loans.
At year-end 2002, Fannie Mae's retained portfolio stood at 5790.8 billion or 43 percent of the S1.82 trillion total book of business, which includes $1.03 trillion in net outstanding MBS. Freddie Mac's retained portfolio at year-end stood at $568 billion, also 43 percent of its $1.311 trillion total mortgage portfolio, which includes $743 billion in net outstanding MBS.
The growth of the retained portfolios increases interest rate risk at Fannie Mae and Freddie Mac, Posner says. The fact that the GSEs are also highly leveraged magnifies this risk, according to Posner. At year-end 2001, for example, the ratio of capital to total assets was about 4 percent for both Fannie Mae and Freddie Mac, pro forma for their voluntary capital commitments, according to Posner. By comparison, banks and thrifts are required to hold 5 percent risk-based capital for the whole asset portfolio (but only 2 percent for mortgage-backed securities), according to Posner.
When the duration of a GSE's assets (its mortgages) goes out of line with the duration of its liabilities (its debt issues), it increases the chances that Fannie Mae or Freddie Mac will face the same sort of problem that felled the savings-and-loan industry in the late 1980s and early 1990s. The S&Ls' assets were mostly long-term 30-year mortgages, while their liabilities were short-term, including demand deposits and certificates of deposits (CDs). As current market rates rose, the institutions had to pay higher rates to banking customers on their CDs and demand deposits, while the rates borrowers were paying on their 30-year long-term mortgages were locked in at much lower rates.
Definition of systemic risk
While the OFHEO study was devised to examine systemic risk, there is no consensus definition of systemic risk. In its study, OFHEO defined a systemic event as "a financial crisis that causes a substantial reduction in aggregate economic activity, such variables as housing starts, home sales, consumption, output and employment." Such a definition sees the cause as being, say, the oil shock of 1973 or the 1998 global financial crisis prompted by the collapse of Russian bonds.
MBA's Duncan defines systemic risk as "the potential for the surprise failure of a large institution or business with a lot of counterparties, whose failure has the potential to make the market illiquid, and which requires intervention to keep the markets liquid."
Duncan cites as examples the near-failure of Long Term Capital Management in 1998, as well as such prior events as the failure of the Bank of New England in 1991, the failure of Continental Illinois National Bank and Trust Company in 1984 and Penn Central Railway Company's bankruptcy in 1970.
Some observers, however, question whether the focus on "size" alone (as in "too big to fail") is really helpful. Eugene Ludwig, former comptroller of the currency during the Clinton administration and managing partner of Promontory Financial Group LLC, Washington, D.C., states in a paper released in February by Fannie Mae that "the size of particular institutions is not necessarily related to systemic risk, and an excessive concern about largeness can be counterproductive."
Ludwig says, "There are a variety of reasons why many larger institutions with advanced risk management and efficiency strengths actually tend to decrease overall systemic risk."
He argues that the failure of the Federal Reserve Board to provide liquidity to the marketplace "greatly contributed" to the Great Depression that began in 1933. By contrast, in 1987, the Fed, more mindful of the need to liquefy the market to prevent a panic, made the stock-market crash in October less painful than it might otherwise have been.
Similarly, Ludwig argues, the Fed's efforts minimized the impact of Penn Central's difficulties on the commercial paper market in 1970 and stopped a run on the bank at Continental Illinois in 1984.
Focusing only on large institutions, then, takes the focus away from important systemic risk issues and systems that should be addressed, and puts too much focus on institutions where risk is being aggressively addressed, Ludwig concludes. He cites a study by the Group of Ten and the Federal Reserve Board in January 2001, which concludes that consolidation has actually decreased systemic risk because larger firms benefit from geographic diversification and multiple product and business lines. (The report did, however, identify an increasing operational risk in large organizations, where individual malfeasance can go undetected.)
Ludwig, like so many observers, sees important lessons to be learned from the bailout of Long Term Capital Management. "The experience of LTCM clearly demonstrates that unregulated opaque institutions can represent a systemic risk through their interdependencies with the banking system," he says.
In recent years there have been some concerns expressed by government regulators about the increasing interest rate risk that Fannie Mae and Freddie Mac are assuming and will continue to assume as they expand their portfolio lending.
In April 2002, Fed Chairman Alan Greenspan addressed the issue of counterparty risk in the large interest rate hedging efforts of Fannie Mae and Freddie Mac. While noting that such risks can be managed effectively through use of credit limits, netting and collateral agreements, he worried aloud that the "perception of government support may induce the counterparties of GSEs to apply less vigorously some of the risk controls that they apply to manage their over-the-counter [OTC] derivatives exposures."
Regulators, policy-makers and market participants, Greenspan admonished, should not allow the implicit federal guarantee "to unduly disturb an efficient financial structure that so clearly contributed to increased economic stability."
The Minneapolis Fed weighs in
The Minneapolis Fed in 1996 raised the question of whether or not the expansion of portfolio lending by Fannie Mae and Freddie Mac might not put the taxpayer at risk. Ron Feldman at the Minneapolis Fed raised the issue in an article titled "Uncertainty in Federal Intervention: Fannie Mae, Freddie Mac and the Housing Subsidy Trail."
Feldman wrote: "By issuing debt and holding mortgages, Fannie and Freddie may bear the risk that interest rates will fall, thereby encouraging homebuyers to prepay their mortgages, possibly leaving Fannie and Freddie with less income to repay the debt they have issued. The implied guarantee practically, but not legally, shifts this risk to taxpayers." He continues: "In contrast, these risks are borne by investors when Fannie and Freddie issue mortgage-backed securities. The greater the risks taxpayers bear, the greater the subsidy they provide to Fannie and Freddie. Thus, Fannie and Freddie can increase their subsidy through the portfolio lending option."
While the OFHEO study identifies potential credit risks associated with counterparties to derivatives contracts, it sees the risk of default on mortgages as less important than interest rate risk. Morgan Stanley's Posner, in his analysis of systemic risks at Fannie Mae and Freddie Mac, would agree.
Hedging prepayment risk
In a speech this January before the Exchequer Club in Washington, D.C., Falcon highlighted the issue of hedging and interest rate risk ahead of the release of OFHEO's study of systemic risk. He noted that over the space of a decade, Fannie Mae and Freddie Mac had tripled the level of mortgages they guaranteed while they increased by seven times-to $1.3 trillion-the size of their combined portfolio of retained loans. As a share of residential mortgages, their share rose from 6 percent to 20 percent.
"Managing the interest rate risk of these portfolios is a significant undertaking. Virtually all of their mortgages can be prepaid at anytime without penalty," Falcon told the Exchequer Club.
So far, Falcon explains, Fannie Mae and Freddie Mac have been able to find a sufficient supply of the options used to hedge prepayment and duration risk. These are provided from a small number of counterparties. Should one of them fail, Falcon notes, it could pose problems for the GSEs until they could obtain contracts to replace them.
Close observers of the markets agree that increased demand for certain derivatives could lead to a situation where there were inadequate supplies and where the demand for them by the GSEs could aggravate a crisis by their very size.
A sudden demand for certain types of hedges by Fannie Mae and Freddie Mac could produce the situation of the "tail wagging the dog," says Robert Husted, managing director, MIAC Risk Management, New York. "Given the tremendous size and presence of the agencies, are their hedging requirements of such magnitude to move the markets?" he asks. His answer: "There is a pretty strong possibility" this could happen, because "there is not an unlimited universe of instruments to hedge one's positions."
Interest rate risk is typically hedged with over-thecounter options such as swaps and swaptions, which are options to enter into interest rate swaps. The GSEs have also used mortgage future options, principal-only strips and other instruments. "There is a finite supply and often a herd mentality," Husted notes. This means that when interest rates swing, institutions will use similar instruments. "Under rapidly moving markets, their demand could drive some instability in the pricing in the markets," he says.
There are also technical issues to consider, Husted says, about the ability of hedging models to accurately predict prepayment behavior. In recent refinancing waves, the tendency to prepay has increased. To the extent that Fannie Mae and Freddie Mac are relying on models based on prior experience-and hedging accordingly-sudden changes in prepayment speeds could leave them unprotected.
"Over a broad period of time, dealing with such large numbers, can any group of managers and systems account for the changing convexity profile of mortgages?" Husted asks.
While prepay models have been increasingly perfected, new refi waves find the experts moving more into "unchartered waters in prepay behavior sensitivity," Husted says.
The derivatives market
Fannie Mae and Freddie Mac are each the biggest customers for financial derivatives. The notional amount of the derivatives used by both agencies combined have increased from $72 billion at the end of 1993 to $1.6 trillion at year-end 2001, according to the OFHEO study.
Fannie Mae's derivatives totaled just more than $500 billion, while Freddie's were more than $1.1 trillion. Falling interest rates drove the purchase of these derivatives sharply higher in 2001, the study reports, pushing the notional value of Fannie Mae's and Freddie Mac's derivatives even higher.
Increasingly, Fannie Mae and Freddie Mac represent a significant slice of the market. On June 20, 2001, the combined notional amount of the GSEs' interest rate derivatives, $996 billion, comprised more than 7.5 percent of the over-the-counter singlecurrency, dollar-denominated interest rate derivatives of all end-users, according to the OFHEO study. It represented 10.5 percent of all such derivatives used by financial institutions.
To date, nearly all the derivatives used by Fannie Mae and most of those used by Freddie Mac have been over-the-counter contracts, mostly interest rate swaps and swaptions. They have also used swaps and swaptions in combination with debt instruments to create long-term synthetic debt and to obtain options to shorten or extend the maturity of their debt. They've used interest rate floors and caps to withstand the effect of interest rate swings. They've entered foreign currency swaps to hedge the exchange-rate risk of issuing foreign currency-denominated debt. Fannie Mae and Freddie Mac have also used futures, options on futures and short sales to hedge the future purchases of mortgages.
Exposure to derivatives credit risk
While the notional values of the derivatives contracts are staggering in size, the credit exposure of Fannie Mae and Freddie Mac is much less. The GSEs have credit exposures to the counterparties with whom they have interest rate and foreign-currency derivatives contracts. That is, if the counterparties fail, Fannie Mae and Freddie Mac will be deprived of the cash flow they may need when interest rates move in an adverse direction for a portion of their portfolio, the OFHEO report explains.
The GSEs, however, are not exposed to the full notional value of the contracts, but to the cost of replacing them. Those costs vary as interest rates and currency exchange rates change in the marketplace relative to where they stood when the contracts were signed.
According to the 2001 annual reports of Fannie Mae and Freddie Mac, they only do derivatives business with highly rated counterparties, monitor their levels of exposure to individual firms and require those not rated AAA to post collateral to cover positive market value. Fannie Mae and Freddie Mac each generally enter into netting agreements covering all contracts with each counterparty. The net positions are marked to market daily and counterparties post collateral daily, if needed. Neither Fannie Mae nor Freddie Mac, however, have to post collateral for their exposures to the counterparties, which the OFHEO study attributes to the 'investors' perception of an implicit federal guarantee of Enterprise obligations."
Several trends are expected to increase the exposure of individual financial institutions to Fannie Mae and Freddie Mac. The agencies are taking an increasing share of portfolio loans. A handful of brokerage firms and commercial banks are counterparties to at least one side of virtually all derivatives contracts, the OFHEO study states. These include J.P. Morgan Chase, Citigroup (including Salomon Smith Barney), Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley Dean Witter.
The net market value of Fannie Mae's derivatives portfolio was $800 million at year-end 2001, while Freddie Mac's was $17 billion, according to the OFHEO report. The net uncollateralized exposures of the GSEs' was much smaller, $110 million for Fannie Mae and $69 million for Freddie Mac. The credit exposure of Fannie Mae's counterparties was $7 billion at year-end 2001, while it was $2.6 billion for
Freddie Mac, according to the OFHEO report.
The OFHEO report notes that a problem at Fannie Mae and Freddie Mac "may not only contribute to the possibility of a financial crisis and a systemic event, but may also create problems at counterparties that could translate into their contributing to such events."
Further, the OFHEO report notes, "each of the counterparties . . . are of such size, and the concentration of total derivatives activity with them is of such importance, that problems at the counterparties alone may be enough to result in a financial crisis transmuting into a systemic event, and the Enterprises could find themselves unwilling participants in a problem only partially of their own doing."
The OFHEO report, recalling the Long Term Capital Management crisis, warns that "in the times of greatest financial stress, collateral may not provide the level of protection it would under normal market conditions." It adds, however, that the types of derivative instruments used by Fannie Mae and Freddie Mac are "simple instruments," and the market for them is "likely to remain liquid in all but the most extreme circumstances."
The OFHEO report suggests that one possible outcome of continued expansion of the GSEs' share of portfolio lending is that demand is greater than the supply of derivatives, which would lead to less favorable terms for the GSEs, including higher costs of hedging and depressed net interest margins. Indeed, in an information statement on March 29, 2002, Freddie Mac noted a lack of sufficient capacity or liquidity in the derivatives market could limit its activities and increase its interest rate risk. It could also make derivatives unavailable or prohibitively expensive.
One approach to hedging interest rate risk has been called dynamic rebalancing. OFHEO suggests that dynamic rebalancing poses the risk of pushing interest rates further in the direction they are moving (both up and down) and, thus, they can cause interest rates to move even further in the same direction.
Fannie's 2002 duration gap
In the third quarter of 2002, the response of the markets to a sudden spike in the duration gap at Fannie Mae provided an illustration of how rebalancing can sometimes increase the volatility of interest rates.
In August 2002, Fannie Mae reported a 14-month negative duration gap, the largest mismatch in its history, and a spike in the gap from a negative nine months in July. A spurt in refinancings widened the duration gap.
Fannie Mae's hedging strategy left it more exposed to refinancings than Freddie Mac (whose duration gap remained zero), according to Mike McMahon, managing director at Sandler O'Neill Mortgage Finance Corporation, Emeryville, California.
The difference can be traced to the level of option-embedded debt instruments, which allow the GSEs to call debt and replace it with new debt whose duration better matches its assets. According to McMahon, Freddie Mac was better prepared for the big wave of refinancings because 75 percent of its debt had embedded callable options, while about 57 percent of Fannie Mae's debt had embedded callable options.
Freddie Mac rebalances its debt portfolio more frequently, McMahon says, but at an additional cost of 25 to 50 basis points on its interest margins. Thus, Freddie Mac is paying a slightly higher cost for the funds it lends out for its mortgages held in portfolio, but is better protected when mortgages prepay.
When the duration gap at Fannie Mae emerged, the OFHEO report notes, investors bid up the cash and futures markets of 10-year and 30-year Treasury securities in a rush to benefit from the expected moves of Fannie Mae to reduce its duration gap by buying longer-maturity Treasuries or by buying interest rate swaps. The actions of the investors, coupled with Fannie Mae's rebalancing, sent yields to lows not seen since the 1950S on 10-year and 30-- year Treasuries. "This episode illustrates how Enterprise rebalancing may increase the volatility of interest rates in some circumstances," the OFHEO report states.
McMahon recalls that wild rumors were circulating at the time that Fannie Mae would buy up to $100 billion in Treasuries. "They did not," he recalls. "They did exactly what they said they would do to get back in the target range by buying more mortgages" to match the duration of their debt. Since then, McMahon adds, Fannie Mae has also increased the level of callable debt in its portfolio. Its duration gap has, since last summer, hovered closer to the six-months-positive/six-months-negative range that Fannie Mae targets. In December the gap was minus two months.
In the fourth quarter, a big write-down in Fannie Mae's derivatives portfolio reduced its net earnings by 52 percent over the prior year, while favorable interest rate margins and strong refinancing demand boosted operating income, according to Fannie Mae's statement of its performance in the fourth quarter. The value of Fannie Mae's options fell $1.88 billion in the fourth quarter with a year-- long decline of mark-to-market loss of $4.53 billion, according to Fannie Mae's fourth-quarter report. The reported losses were not realized, as Fannie Mae said at the time it expected to hold its options until maturity.
Last year's increase in Fannie Mae's duration gap prompted critics to call for more extensive disclosures about how Fannie Mae and Freddie Mac conduct their hedging operations. "Fannie Mae apparently gambled that interest rates would not stay at record lows, but would begin to go back up, and that the flood of mortgages refinancings would slow," claims Leslie K. Paige, president of Citizens Against Government Waste. "It miscalculated badly. . . ."
Both Fannie Mae and Freddie Mac have since adopted a policy of voluntarily making the types of disclosures to the Securities and Exchange Commission (SEC) that private corporations are required to make, including the filing of 10-K forms. Under their charters, the GSEs are not required to make filings with the SEC. Paige comments, "Regardless of what they do voluntarily, I'm only interested in what they are required to do." She notes that since all other financial institutions have to file with the SEC, Fannie Mae and Freddie Mac should be required to as well.
The most persistent criticism of Fannie Mae and Freddie Mac is that they are slow or unwilling to provide adequate disclosure about their business and finances. "They're like Saddam Hussein. You don't get anything out of them unless you threaten total war," says Peter Wallison, resident fellow at the American Enterprise Institute. Wallison thinks the voluntary SEC filings will improve disclosure.
The OFHEO systemic risk study also called for more disclosure, but fell short of recommending mandatory filings with the SEC. Representatives Christopher Shays (R-Connecticut) and Edward J. Markey (D-Massachusetts) have supported legislation requiring Fannie Mae and Freddie Mac to register their securities with the SEC and make the same periodic disclosures required of other publicly traded companies-and are likely to reintroduce legislation in this Congress, according to Israel Klein, Markey's press secretary.
A January 2003 study of the MBS market by Treasury, OFHEO and the SEC calls for more "pool-- level" disclosure about loans backing up mortgagebacked securities. The additional information sought would cover: loan purpose, original loan-tovalue (LTV) ratios, standardized credit scores of borrowers, servicer information, occupancy status and property type.
In February, both Fannie Mae and Freddie Mac announced they would provide the six new information disclosures to MBS investors recommended in the study by Treasury, OFHEO and the SEC. MBA welcomed the announcement. MBA Chairman John Courson stated: "The actions of Fannie Mae and Freddie Mac will improve prices in the MBS market, which will translate into more-affordable credit rates for borrowers."
The GSEs suffer under the hot glare of public scrutiny frequently, but some in the industry take issue with much of the criticism. McMahon counters the critics on nearly all counts. He chastises them for first complaining that Fannie Mae and Freddie Mac use too many derivatives and then complaining about the duration gap at Fannie Mae that was the result of not using enough derivatives. "It turns out Fannie Mae could have controlled that gap issue by making better use of options," he notes.
McMahon rejects the claim that Fannie Mae or Freddie Mac are taking interest rate bets, a strategy that brought down Long Term Capital Management. Falcon agrees. "While [the managers of LTCM] were using derivatives as a speculative device, the Enterprises use derivatives to hedge risk, to lay off risk," Falcon notes.
McMahon expands on that point. "Neither Fannie nor Freddie needs to take an aggressive position on interest rates, either long or short. They can operate efficiently with a stable low basis point spread and low credit costs. They don't need to speculate or take a position on interest rates."
Turning to a baseball analogy, McMahon says that when the GSEs hedge against interest rate risks, "all they have to do is hit singles-they do not need to try for a double, triple or home run." By contrast, LTCM was in the business of taking big bets on where rates were going, McMahon says. LTCM was not prepared for the loo-year flood phenomenon, where its own hedges failed to protect it in the event its interest rate bet was wrong. LTCM's hedges, instead of moving in the opposite direction of interest rates, moved in the same direction.
Others question OFHEO's capabilities as a regulator in the face of the risks that the GSEs carry. OFHEO's own study of systemic risk recommends that the regulatory body be given the power to permanently fund itself instead of going to Congress every year for appropriations, and that it be given authority to close an insolvent GSE and appoint a receiver. Currently, OFHEO has the power of conservatorship, which would allow it to use its authority to manage the affairs of a GSE that experienced severe solvency problems. Meanwhile, other financial institution regulators-the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS) and the Farm Credit Administration-have the authority to close and place in receivership the institutions they regulate, according to the OFHEO report.
Washington, D.C.-based FM Watch Executive Director Mike House supports permanent funding because "it would be very advantageous to OFHEO if you're going to have a strong independent regulator." He also thinks the GSEs should come under required SEC oversight.
MBA also supports permanent funding of OFHEO from its own revenues, independent of the congressional appropriations process. MBA supported Fannie's and Freddie's decision last summer to voluntarily register their common stock with the SEC. MBA has taken no position on OFHEO's recommendation to seek authority to appoint a receiver for a failed GSE.
Some observers believe Congress would be reluctant to expand OFHEO's role from conservator to receivership, as the OFHEO report recommends. Freddie Mac spokesperson Sharon McHale says that she "didn't see how that would alter their fundamental enforcement power." She notes that the General Accounting Office (GAO) concluded in a 2001 report that OFHEO "had the tools to address safety and soundness."
McMahon also tackles OFHEO critics who call for privatizing Fannie Mae and Freddie Mac. Noting that the OFHEO study of systemic risk points out the vulnerability of Fannie Mae and Freddie Mac to a meltdown of one of the derivative counterparties, he contends this is "all the more reason Fannie and Freddie need a good, knowledgeable regulator to make sure this doesn't happen." If they were privatized, there would be less government oversight. He points out replacing OFHEO with the SEC as its sole regulator would not be a sufficient regulatory regime, noting that while banks are under SEC oversight, they are also under another regulator-the OCC-while thrifts come under OTS.
How to address the derivatives supply risk Ultimately, Fannie Mae and Freddie Mac may have to develop strategies to deal with a changed derivatives marketplace to remain profitable and competitive, while also remaining safe and sound. How can they do this?
Morgan Stanley's Posner doesn't see a future potential shortage of derivatives as a fundamental problem for the GSEs. If, however, Fannie Mae and Freddie Mac fail to manage their interest rate risk properly, it would lead to new limitations and restrictions on their business model and could potentially jeopardize their long-term growth opportunities, he says.
Posner, after concluding a new study of interest rate risk at the GSEs last September, "tempered" Morgan Stanley's longterm outlook for the companies, while still giving them the firm's highest rating. In a prior study of Fannie Mae and Freddie Mac in February 2002, Morgan Stanley had predicted earnings at the GSEs would grow 12 percent a year for the next 20 years. In September, however, Posner scaled back the projection of earnings growth to an average of 9 percent a year.
The reduced-earnings forecast was done "primarily to reflect the possibility that the GSEs' growing size relative to the rest of the fixed-income markets will make rebalancing more difficult in future periods," Posner wrote. "Put differently, without better understanding of the supply and liquidity of duration, we feel it prudent not to project the GSEs growing faster than the fixed-income markets in the outer years of our forecast," he added.
In his September 2002 report, Posner assessed the capital adequacy of the GSEs using a theoretical approach that assumes that equity capital and derivatives used to hedge risk are substitutes. "The more hedges you use, the less capital you need," Posner explains.
Posner calculates that the GSEs need about 3 percent to 3.5 percent of the principal balance in the combined values of capital plus hedges to properly capitalize their retained portfolios. The GSEs' actual combined capital and hedges falls within the range, leading Posner to conclude that Fannie Mae and Freddie Mac have approximately the right amount of capital for their retained portfolios.
In the future, "in the event Wall Street doesn't provide enough derivatives, they'd have to hold more capital," Posner says, if they intended to "grow faster than the fixed-income market." Thus, he does not see the shortage of hedging instruments as an insurmountable obstacle to continuing to grow the retained portfolio at Fannie Mae and Freddie Mac.
Posner sees steady growth and market share gains in the retained portfolio until 2020. Yet, is there some point at which growth in the retained portfolio becomes too costly because of the cost of funding or hedging? While noting there may be theoretical limits for banks to provide derivatives, he sees the broadening of the callable debt market as "an encouraging sign of capacity in the capital markets."
Posner looked at future events that might test the ability of the GSEs both in a crisis and in a market of steady, continuous gains in market share of retained mortgages. Using a computer model, he tested the effect of an immediate 100-basis-point and an immediate 200-basis-point drop in interest rates on the derivatives markets and the GSEs.
A 100-basis-point shock would amount to one day's trading volume in the Treasury coupon and Eurodollar futures markets and nearly four days' average trading volume in the Chicago Board of Trade (CBOT) Treasury futures market, based on the size of the GSEs' retained portfolio at year-end 2001. Rebalancing following a 100-basis-point shock would likely be spread over several days or a few weeks, during which time the portfolio would be vulnerable to additional shocks. "Nevertheless, the liquidity of the markets should not be a concern in our view," he writes.
Posner contends that GSE interest rate swap positions (1.3 percent of the global OTC derivatives market book at yearend 2001) leaves plenty of capacity for growth. He further suggests that potential counterparty limits at broker dealers are not likely to constrain GSE derivatives trades, because the odds that counterparties might not be able to expand their credit limit capacity is "remote." He cites the experience over the last decade, when derivatives markets have grown as fast as or faster than GSE portfolios.
As banks deploy more capital into their derivatives business, their counterparty limits will increase, Posner notes. Further, dealers that come close to their counterparty limits on their GSE exposure can use credit derivatives to lay off some or all of their exposures to other traders and investors, and thus be able to continue doing business with the GSEs.
The future, however, may not be all wine and roses. An immediate 200-basis-point change could pose "a major risk to equity holders," according to Posner.
Based on the size of the GSEs' retained portfolio at year-end 2001 ($1.3 trillion), the GSEs would have to rebalance $2.6 trillion in derivatives to get the duration gap back to zero. This would account for one or more days of trading volume in the primary markets, and represents 2.6 percent of the total outstanding dollar-duration equivalents in the entire fixed-income market.
"Needless to say, in the wake of such a shock, many other mortgage investors likely would be scrambling to rebalance at the same time. As a result, we believe it would take many weeks for the GSEs to complete their rebalancing without affecting the market," Posner states. He cautions, however, that an immediate 200-basis-point shock should be seen as a remote possibility.
If counterparties could not expand their capacities fast enough, at some point the cost of hedging an ever-larger retained portfolio could theoretically create a limit to growth for the GSEs by raising the cost of funding. Calling this "a highly speculative train of thought" to pursue, McMahon says that in such a case Fannie Mae and Freddie Mac might rethink or change their business model in order to maintain their levels of profitability. It might, he said, prompt Fannie Mae and Freddie Mac to become more of a guarantor of mortgages and do less in the way of expanding the retained portfolio. They might even consider surrendering their charters so they could enter other business lines with higher rates of return, such as jumbo loans, mortgage insurance, risk-based pricing, real estate-owned (REO) management-or even acquire a mortgage originator, according to McMahon.
Like Posner, he thinks that the chances the markets cannot supply the derivatives the GSEs might need is remote. But the world is full of surprises, he adds. "The market is a humbling place."
END of Main Story
Side Bar: Imagine the Worst
THE OFFICE OF HOUSING ENTERPRISE Oversight (OFHEO) study of systemic risk released in February 2003, Systemic Risk: Fannie Mae, Freddie Mac and the Role of OFHEO, contained three simulations involving Fannie Mae and/or Freddie Mac in the midst of a potential theoretical financial crisis. No explanation is given for how each of the three crises might come about, as the study concentrates only on the housing market, financial sector and macroeconomic impact of three scenarios.
In scenario one-an event like the Russian debt crisis of 1998-Fannie Mae and Freddie Mac would remain solvent and help mitigate the systemic risk, the study finds.
In scenario two, one of the government-sponsored enterprises (GSEs) reports an unexpectedly large loss and OFHEO classifies it as significantly undercapitalized (while the other GSE remains healthy). In this situation, the mortgage market and housing market may or may not be affected depending
on how quickly the other GSE and other housing finance institutions move to fill the void. While the housing sector might be affected in this scenario, the functioning of the financial sector is not disrupted and there is no systemic risk, the OFHEO study concludes.
Scenario three-dubbed the "Doomsday Scenario" by some-is a more severe crisis in which one of the GSEs suffers large losses and other financial institutions are also weakened. In this case, investors dump the debt of the troubled GSE, and the price of the GSE's mortgagebacked securities (MBS) plummets. If the healthy GSE cannot move quickly to expand its activities, there could be a significant short-term decline in mortgage lending, home sales and housing starts, aggravating other problems in the economy.
If there is a panic in the market for the securities of the troubled GSE, it could exacerbate liquidity problems at many banks and thrifts, which hold a high level of MBS in their capital base.
These problems could, in turn, increase the risk of contagious illiquidity spreading through the banking system, the financial sector and even the global economy. In the worst case, if government intervention cannot contain the crisis, there could be a "very large" decline in economic activity.
OK, now relax."The fact is, it could never happen," notes Armando Falcon Jr., former director of OFHEO. In fact, notes Sharon McHale, spokesperson for Freddie Mac,"the Doomsday Scenario is not credible." Since the OFHEO report states that the chances of this scenario are remote, McHale states, "it was inappropriate to focus on systemic risk by focusing on two organizations in isolation."
Falcon disagrees. Such speculation is useful because it "can help educate the public and policy-makers on this issue," he says. It can help them answer the question of "how we mitigate systemic risk and how we mitigate the destruction" that might come from a crisis, Falcon says.
In the worst case, if government intervention cannot contain the crisis, there could be a "very large" decline in economic activity.
While the OFHEO study identifies potential credit risks associated with counterparties to derivatives contracts, it sees the risk of default on mortgages less important than interest rate risk.
While the notional values of the derivatives contracts are staggering in size, the credit exposure of Fannie Mae and Freddie Mac is much less.
Last year's increase in Fannie Mae's duration gap prompted critics to call for more extensive disclosures about how Fannie Mae and Freddie Mac conduct their hedging operations.
Some observers believe Congress would be reluctant to expand OFHEO's role from conservator to receivership, as the OFHEO report recommends.
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Robert Stowe England
6,964 words
1 April 2003
Mortgage Banking 34
Volume 63, Issue 7; ISSN: 0730-0212
English
Copyright (c) 2003 ProQuest Information and Learning. All rights reserved. Copyright Mortgage Bankers Association of America Apr 2003
