For release: Aug. 4, 2002
Contact: Joe Elstner, (314) 444-8902 or (314) 640-3526 (cell); Charles B. Henderson (314) 609-5972 (cell)

Working Through Accounting Problems Will Leave United States in "Much Stronger Position": St. Louis Fed's Poole

Link to speech

NEW ORLEANS -- William Poole, Federal Reserve Bank of St. Louis president, said the U.S. "will come out the other side of our current experience with accounting irregularities in a much stronger position than when we entered it."

Poole, in a speech to the Council of State Governments' Southern Legislative Conference, said that "corporate boards, senior management and audit firms will not take risks on accounting issues lightly." He said that since government action and market discipline have brought some prominent firms down quickly, "everyone involved in corporate governance will remember these events for a long time."

Poole noted that the United States has governmental and market-based mechanisms to impose lasting reforms. As an example, he cited the 1930's bank failures, which led to deposit insurance, but a flaw later led to the failure of scores of savings and loan associations and a $150 billion taxpayer bailout. "But we learned a lesson," said Poole. "Regulatory requirements were strengthened. The most important, in my opinion, was rigorous enforcement of capital requirements for insured depository institutions."

A second example Poole cited was the Penn-Central Railroad bankruptcy in 1970. The commercial paper market, he said, was disrupted as investors wondered what other firms might be suspect. Investors refused to roll over commercial paper of many highly rated companies because they were no longer sure what the ratings meant. "After that experience," Poole said, "companies routinely arranged backup lines of credit at banks. That change prevented any recurrence of the generalized disruption of the commercial paper market that we saw in 1970."

Emphasizing that he was speaking strictly for himself and not for the Federal Reserve System, Poole proposed two vulnerabilities he believes the country faces and that need careful examination. "One is familiar to everyone--the state of the Social Security and Medicare Systems," he said. "The potential problem is huge, and there is great uncertainty about what the government will do. A change in economic conditions could quickly increase the size of the problem and move forward the time when it would become acute."

Poole said the other vulnerability he would like to see more widely discussed concerns Government Sponsored Enterprises (GSEs), including Fannie Mae, Freddie Mac, the Federal Home Loan Bank System and smaller entities. He said that in the United States today, GSE securities and government-related mortgage pool securities outstanding, excluding deposits, exceed the combined total of all other private financial sector firms. "Looked at another way," he said, "the total of GSE direct and guaranteed debt is 40 percent larger than the federal government's debt, what we loosely call the 'national debt'."

Poole noted that financial markets price GSE debt as if there is a federal guarantee, or a high probability of one, standing behind it. Yet, he said, there is no explicit guarantee in the law. "If the market value of GSE debt were to fall sharply because of ambiguity about the financial soundness of GSEs and the willingness of the federal government to backstop the debt, what would happen? I don't know, and neither does anyone else." Poole emphasized that he does not see any immediate risk of a GSE debt problem, "but I'm not willing to assume that in different conditions in the future one could not occur."

Poole "threw out for debate" two steps the federal government might take. "First, various aspects of federal sponsorship that the market reads as providing an implied guarantee of GSE debt should be withdrawn. Second, over a transitional period of several years the GSEs should add to the amount of capital they hold." He said capital is important for the GSEs because their short-term obligations are large. "Capital provides a cushion against mistakes and unforeseeable circumstances," Poole said. He noted that in the private sector, government securities dealers carry capital "in the neighborhood of 5 percent," and other financial firms much more. The core capital requirement at Fannie Mae and Freddie Mac, he said, is 2.5 percent of on-balance sheet assets and 0.45 percent of outstanding mortgage backed securities.

A further item the federal government should consider, Poole said, is "whether federal tax law should continue to encourage substitution of corporate debt for equity." For tax purposes, he said, corporations can deduct interest paid but not dividends paid. "That provision encourages corporations to issue debt instead of equity to finance expansion and acquisitions. But when a large fraction of revenue is devoted to paying interest instead of dividends, firms are more vulnerable to failure when revenues fall. A dividend can be cut or eliminated, but interest payments can't." Poole said tax law could be changed in a "revenue-neutral" way to solve the problem.

Concerning the stock market decline, Poole said "we should not think of the stock market as a direct measure of the nation's wealth. All you have to do is look at charts of the stock market and GDP to realize that there is a long history of stock market fluctuations that are far larger than GDP fluctuations and that the two are not all that highly correlated. I'm not trying to say that the stock market doesn't matter, but I am trying to put the matter in proper perspective. It's reasonable to expect that the economic recovery will continue and that the stock market will in time settle down."

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