Alarm bells sound for Fannie and Freddie
By John Dizard in New York
SourcePublished: February 29 2004 20:29 | Last Updated: February 29 2004 20:29
Ordinarily, Alan Greenspan's testimony to Congress gives Prozac serious competition for medicating the over-anxious.
Last week, though, the Federal Reserve chairman's warnings about Fannie Mae and Freddie Mac, the government sponsored enterprises, or "Sodom and Gomorrah", as one friend of mine calls them, came as something of a shock. He said that "we assess [systemic risk] as likely if GSE expansion continues unabated".
Mr Greenspan's warning was accompanied by one from Gregory Mankiw, the chairman of the President's Council of Economic Advisors, who warned: "Even a small mistake in GSE risk management could have ripple effects throughout the economy."
What's most odd about these warnings is that they appeared to come out of the blue. Over the past two or three years there has been a stream of articles, speeches, conference calls, and tedious op-ed columns by people such as yours truly about the potential systemic risk posed by Fannie and Freddie.
Since Mr Greenspan is the master of acting hyper-political while posing as non-political, and since Mr Mankiw is on a very short leash held by the White House's political operators, one has to wonder the following: what do they know that we don't know?
Is some buttress in the financial system going to fail soon? Why are the pilot and co-pilot putting on their parachutes? Should we buy some more canned food and ammunition for the country house?
Not that I don't agree with everything both men said. They were entirely correct. However, there is no chance at all that there will be limits placed on housing finance in an election year. These are ass-covering memos.
There is also a red herring buried in Mr Mankiw's remarks. He said: "The [GSE] charters do not require the federal government to bail out a troubled GSE." This is true. Furthermore, the GSEs themselves say they do not need a back-up federal bailout. Their derivatives book, they say, enormously reduces their risk from a rapid increase or decrease in interest rates.
Both statements are subtly deceptive because they don't identify the parts of the financial system that would truly be at risk in the event of a serious "rate shock".
I don't believe the GSEs will have to be rescued by the Fed in a crisis. Nope. The people who sold them protection will have to be bailed out and, sorry Mr Mankiw, but the Fed does have an obligation to take care of them.
Let's go back to the GSEs' own defences against more regulation and limits on their growth. The real threat posed by the GSEs, in the view of Mr Greenspan and Mr Mankiw and their staffs, is that they're just getting too darn big.
Mr Greenspan would like to limit Fannie and Freddie to repackaging mortgages and redistributing them through the financial system.
This function gives a "liquidity discount" to mortgage interest costs. What he doesn't like is their trillion dollar purchases of their own paper and the tiny equity bases on which they do that.
In the central banking equivalent of a scrawled insult on a bathroom wall, Fannie Mae publishes a series of Fannie Mae Papers, an "occasional series on policy issues". These pour contempt on warnings such as Mr Greenspan's. In one such paper from last October, one of Fannie's distinguished contributors, Christopher Culp, wrote about "myths" he cited as a "concern of central bankers" (no names, please). One was that "Fannie Mae's use of derivatives poses systemic risk". Mr Culp, the author of the recent Art of Risk Management, trivializes the risks imposed by the $811bn of notional derivative principal Fannie had on its books last June.
He does touch on Mr Greenspan's real concern: that the counterparties for those derivative contracts are too highly concentrated among a small number of securities houses and banks. But he does so only to dismiss the problem, writing that "these concerns play much more on fear than on any actual empirical evidence legitimating the concern".
The problem with Fannie and Freddie's party line is that there is no "empirical evidence" because history has no precedent for their risk concentration. The failure of Drexel Burnham or Long Term Capital Management's problems, which Mr Culp cites, are two or three orders of magnitude smaller than the mountains of GSE paper.
Mr Greenspan and Mr Mankiw don't think they'll have to bail out Fannie and Freddie. They think they'll have to bail out the half dozen largest swaps and derivatives dealers who are the big banks and investment dealers. In a rapidly rising interest rate environment, the "gamma", or the rate of the rate of increase in their hedging of their obligations to the GSEs, could, or, if you believe the chairman, will, require the Fed to act as the derivatives counterparty of last resort. The math tells him this could be seriously inflationary.
Why the warning now? Here's a thought: the GSEs' purchases of their own mortgage-based securities peaked last summer and have been gently declining since, reducing its requirements for derivatives purchases. However, Fannie has privately been telling bank fixed income securities analysts that they intend to start to increase their purchases, and to achieve double-digit portfolio growth for 2004.
I think that talk set off the alarm bells at the White House and the Fed.
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