Affordable Housing Institute : US

William Poole, president of the Federal Reserve Bank of St. Louis — and thus, a man who knows whereof he speaks — has written a truly fantastic article (Adobe Acrobat) — clear, concise, even-handed, and devastating in its dispassion — on GSE systemic risks.  Why?  As he says:

 

1.       Investors should be aware of these risks.

2.       Sound public policy decisions depend on such understanding.

 

To reduce the potential for a financial crisis, risks need to be mitigated.

 

 

“Alas, poor Franklin; I knew him, Horatio”

 

Fannie Mae and Freddie Mac face five major sources of business risk:

 

1.       Credit risk [borrowers default on their loans]

2.       Prepayment risk [borrowers prepay when rates fall, leaving the lender exposed with non-callable long-term obligations, now mismatched]

3.       Interest rate risk from mismatched duration of assets and liabilities [rates rise, increasing cost of rolling over obligations while mortgages written remain at the same fixed rate]

4.       Liquidity risk [the need to roll over $30 billion of short-term obligations every week]

5.       Operational risk [accounting irregularities].

 

Poole then observes “the risk of systemic, worldwide financial crisis should Fannie Mae or Freddie Mac become insolvent.  The argument was the same as that stated so clearly by Richard Posner:”

 

The Indian Ocean tsunami illustrates a type of disaster to which policy makers pay too little attention — a disaster that has a very low or unknown probability of occurring, but that if it does occur creates enormous losses. Great as the death toll, physical and emotional suffering of survivors, and property damage caused by the recent tsunami are, even greater losses could be inflicted by other disasters of low (but not negligible) or unknown probability.

 

Poole then adds:

 

The risk of very large events must be identified and carefully analyzed through extensive ’stress testing.’  Then adequate controls must be instituted to mitigate the identified risks.

 

He concludes with a combination of recommendation and warning:

 

I believe that the capital held by F-F should be at a level determined primarily by the cushion required should an unlikely event occur rather than by an estimate of the probability itself.

 

One thing I know for sure is this: An investor who ignores the risks faced by Fannie Mae and Freddie Mac under the assumption that a federal bailout is certain should there be a problem is making a mistake.

 

Read the whole thing.  Print it out and read it several times.  Aside from providing a bone-chilling exposition of things we would rather not worry about, it is also a terrific condensed education in the multi-billion-dollar niceties of the long-term capital markets.

 

To be, or not to be: that is the question:
Whether ’tis nobler in the House to suffer
The slings and arrows of outrageous Fannie,
Or to take arms against a sea of troubles,
And by opposing end them?  To die: to sleep;
No more; and by a sleep to say we end
The heart-ache and the thousand market shocks
That GSEs are heir to, ’tis a consummation
Devoutly to be wish’d.

 

 

“I’m from the government and I’m here to help you” 

 

(A library of my GSE posts may be found here.  Hat tip: Ethan Handelman, Recap Advisors)

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