Note on comments made by William Poole, president of the Federal Reserve Bank of St. Louis at the Office of Federal Housing Enterprise Oversight Symposium on March 10, 2003.

William Poole gave a speech on March 10, 2002 at an OFHEO symposium, in which he asked several pertinent questions about Fannie Mae and Freddie Mac.* We advise anyone interested in the issue to read Poole’s speech, as well as Fannie Mae’s response.

Poole’s questions, while provocative, have all been asked before. And Fannie Mae’s defense (which also goes for Freddie Mac), is also well-known in the market. FIDAC has reviewed this issue before, and we are on record that the GSEs have had remarkable success over the past decade, but the very size and breadth of their business exposes the financial markets to risks that are unquantifiable and unforecastable. What Poole is saying, and what we are saying, is that just because something has never happened doesn’t mean it never will happen. We agree with Poole: The risks are asymmetric and therefore the GSEs should slow down growth and increase capital.

These remedies, if taken, have and will affect the value of the equity of Fannie Mae and Freddie Mac, but we as MBS investors don’t particularly care about that. We buy Fannie and Freddie MBS not just because of the guarantee they provide, but also because they are perhaps the premier asset-backed security available in the market today: Holders of MBS are protected by the secured structure of mortgage-backed securities. The MBS holder has multiple levels of protection. Besides the guarantee of Fannie Mae and Freddie Mac (which has never failed, and has never needed Treasury assistance), the MBS holder is secured by the actual loan-to-value rating of the home, mortgage insurance, the income verification and maintenance of the homeowner, property/casualty and life insurance, the rights of foreclosure and the settlement process, and the reduction in principal amount from monthly amortization. Any increased scrutiny into the GSEs will not change these facts.

Fannie Mae and Freddie Mac most likely believe that any increased analytical and regulatory scrutiny is a negative in that it is costly to manage, could affect profitability and may result in a change in operations. However, scrutiny that results in policies that ensure the safe and sound operations of Fannie Mae and Freddie Mac, and therefore the American financial system, can’t be a bad thing.

The following excerpts are the sound-bite version of today’s Point/Counterpoint:

Poole: “Given the complexity of [the GSE’s] operations, is the capital standard in the law adequate? Why is the standard so far below that required of federally regulated banks? What will happen to the housing market if Fannie and Freddie become unstable?”

He goes on to ask: “How big does a financial institution have to be, and does it have to be a depository institution, to be ‘too big to fail?’ In this respect, there is tremendous ambiguity about the status of the GSEs. The market prices the GSEs’ debt as if there were a federal guarantee, or a high probability of a guarantee, standing behind their entire outstanding obligations. Yet, there is no explicit guarantee in the law. Actual experience has left the markets with all of these important questions and ambiguities. No one should underestimate the potential importance of the ambiguity over the financial status of the GSEs. Would ‘too big to fail’ be extended to GSEs in a crisis, and if so how would it be effected in the absence of a federal insurance agency with an unlimited line of credit? How quickly could such a rescue be implemented?”

His conclusion is also ambiguous: “If the market value of GSE debt were to fall sharply, because of ambiguity about the financial soundness of GSEs and about the willingness of the federal government to backstop the debt, what would happen? I do not know, and neither does anyone else.”

It is also worth excerpting the response of Fannie Mae.**

“Our minimum capital level reflects the fact that our main asset -- the conventional, conforming mortgage -- is relatively low risk, heavily collateralized by the property and owner’s equity, often backed by mortgage insurance, and geographically dispersed.”

“If Fannie Mae operated and invested in the types of assets banks do, we should be -- and would be -- required under current law to hold additional capital. First, by law Fannie Mae is restricted to one asset class: US residential mortgages. Banks, in contrast, hold a wide variety of assets, including credit card debt, commercial loans and others, many of which are far riskier than mortgages. And even when banks do hold mortgages, their credit losses are 30 times higher than Fannie Mae’s credit losses on mortgages.”

“Mr. Poole’s comment that an unforeseen event poses a systemic risk to the financial system is unremarkable because it could be said about any large financial institution in the United States. Even the OFHEO systemic risk study that Mr. Poole cites states that any systemic risk to the financial system posed by Fannie Mae and Freddie Mac is "remote." And several studies, including a paper just published by a former U.S. Comptroller of the Currency, Eugene Ludwig, have found that our regulatory and capital protections are so rigorous that disaster scenarios that could fatally harm the company are highly improbable.”

On March 11, Moody’s reaffirmed the senior debt rating of Freddie Mac and Fannie Mae at Aaa, indicating that rating reflected “healthy core profitability, leading franchises in the important US housing finance business, excellent asset quality, conservative and well-structured risk management systems, sound liquidity and capital bases that are sufficient to absorb a wide range of market shocks. Moody’s believes that Fannie Mae and Frddie Mac will continue to exhibit excellent business franchise and financial characteristics, within the context of a conservative risk appetite.”

*http://www.stlouisfed.org/news/speeches/2003/3_10_03.html

**http://www.fanniemae.com/media/issues/031003a.jhtml?p=Media&amp ;s=Current+Issues&t=Statements