St. Louis Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac face five major sources of business risk: credit risk, prepayment risk, interest rate risk from mismatched duration of assets and liabilities, liquidity risk and operational risk, according to William Poole, president of the Federal Reserve Bank of St. Louis.
Poole's comments were part of a speech to the St. Louis Society of Financial Analysts.
Concerning liquidity risk, Poole said Fannie Mae and Freddie Mac must roll over roughly $30 billion of maturing short term obligations every week. At a time of disrupted financial markets, the credit markets might refuse to accept Fannie Mae and Freddie Mac paper. The two GSEs recognize this, and both firms indicated they maintain sufficient liquidity to survive for some time - three months or longer - without access to rollover markets. However the U.S. General Accounting Office in 1998 pointed out that that holding securities in their investment portfolios for liquidity purposes represents a highly profitable arbitrage for both firms, since the return on the assets exceed the cost of the agency bonds used to fund the positions. Therefore, if Fannie and Freddie are unable to sell new debt, they may also be unable to carry out sales of the liquidity securities from their investment portfolios.
Poole cited accounting difficulties faced by Fannie Mae and Freddie Mac as examples of operational risk. Accounting problems were not on my radar screen when I first became concerned about GSE risk, he said. The recent revelations are another example of our inability to predict shocks that will impact our financial system. It remains to be seen how their accounting restatements will affect the markets view of their earnings and capital adequacy. Clearly, though, Fannie and Freddie need to hold capital against operational risk.
Regarding political and regulatory risk, Poole said that from a narrow perspective, a key issue is whether the federal government would bail out Fannie Mae or Freddie Mac if the solvency of either firm is threatened. If there were a solvency crisis, said Poole, the outcome would certainly involve extensive changes in the powers and characteristics of the firms. Portfolios relying on Fannie and Freddie obligations, direct or guaranteed, would most likely have to alter their portfolio practices. Moreover, even if the federal government bailed out Fannie and Freddie, their obligations might be redeemed eventually but cease to trade actively in liquid markets. There is of course no guarantee that the federal government would bail them out. Many observers, myself included, believe that a bailout would not be a good idea.
Poole noted that many of the risks faced by GSEs are of low probability. However, he said, A low probability must not be treated as a zero probability. I believe that the capital held by Fannie and Freddie should be at a level determined primarily by the cushion required should an unlikely event occur rather than by the estimate of the probability itself.
Poole said One thing I think 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.
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