Professional Documents
Culture Documents
William Poole
This article was originally presented as a speech to the St. Louis Society of Financial Analysts,
St. Louis, Missouri, January 13, 2005.
Federal Reserve Bank of St. Louis Review, March/April 2005, 87(2, Part 1), pp. 85-91.
A
lmost two years ago, in a speech at a A second reason to understand the risks is
conference hosted by the Office of that sound public policy decisions depend on
Federal Housing Enterprise Oversight such understanding. To reduce the potential for
(OFHEO), I argued that government- a financial crisis, risks need to be mitigated.
sponsored enterprises (GSEs) specializing in the Fannie Mae and Freddie Mac face five major
mortgage market, especially Fannie Mae and sources of business risk: credit risk, prepayment
Freddie Mac, exposed the U.S. economy to sub- risk, interest rate risk from mismatched duration
stantial risk, primarily because their capital posi- of assets and liabilities, liquidity risk, and opera-
tions are thin relative to the risks these firms tional risk. A sixth risk, so-called political risk,
assume (Poole, 2003). I had a number of specific arises from the possibility of regulatory or statutory
risks in mind, but did not elaborate the nature of revisions that could adversely affect those who
these risks. My purpose here is to provide that hold the firms’ debt or equity. I’ll discuss these
elaboration. I will concentrate on risks facing risks in turn, devoting much more time to some
Fannie Mae and Freddie Mac, but it should be than others. Along the way, I will also discuss an
understood that the Federal Home Loan Banks extremely important point concerning the fre-
raise many of the same issues. quency of occurrence of large interest rate changes.
An understanding of the risks facing Fannie This issue is critical to understanding the risks of
Mae and Freddie Mac—which I will sometimes any strategy involving incomplete hedging.
refer to as “F-F” to simplify the exposition—is
important from two perspectives. First, investors
should be aware of these risks. Although many CREDIT RISK
investors assume that F-F obligations are effec- Credit risk occurs because homeowners can
tively guaranteed by the U.S. government, the and do default on mortgage loans. Even though
fact is that the guarantee is implicit only. I will default rates on mortgages in the United States
not attempt to forecast what would happen should are low, in recent years less than 1 percent, they
either firm face a solvency crisis, because I just are not zero and vary considerably across regions.
do not know. What I do know is that the issue is Credit risk on mortgages can be handled, as in fact
a political one, and political winds change in Fannie and Freddie do very effectively, through
unpredictable ways. a policy of geographic diversification and of not
William Poole is the president of the Federal Reserve Bank of St. Louis. The author appreciates comments provided by colleagues at the
Federal Reserve Bank of St. Louis. Robert H. Rasche, senior vice president and director of the Research Division, Hui Guo, senior economist
in the Research Division, and William R. Emmons, senior economist in the Bank Supervision Division, provided extensive assistance. The
views expressed are the author’s and do not necessarily reflect official positions of the Federal Reserve System.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W M A R C H / A P R I L , PA R T 1 2005 85
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buying a significant number of high loan-to-value interest rate obligation. Historically, the exercise
mortgages, as well as through the use of mortgage of this option was constrained by relatively high
insurance and guarantees. transaction costs. In recent years, however, trans-
In assessing credit risk, it is important not to action costs have fallen considerably so that the
focus just on national average conditions. For call option in the typical fixed rate mortgage
example, although average house prices in the instrument comes in-the-money with relatively
United States have not declined year to year since small declines in mortgage rates. Such refi activity
the Great Depression,1 prices have declined in has been substantial in recent years.
particular significant markets. Some examples When Fannie and Freddie issue MBSs to be
would be Boston 1989-92, Los Angeles 1991-96, held by the investing public, buyers of the bonds
San Francisco 1991-95, and Texas 1987-88. More assume the prepayment risk. Fannie and Freddie
formally, the dispersion of changes in house prices service the MBSs and guarantee them, thus assum-
and not just the national average is relevant for ing the credit risk.
judging mortgage default risk. However, for many years F-F have been accu-
Given that house prices do sometimes decline mulating a portfolio of their own MBSs and
in particular markets, it is possible that a geograph- directly owned individual mortgages. For the two
ically diversified portfolio of mortgages could firms together, these portfolios are very large,
suffer significant losses. Therefore, to determine amounting to over $1.5 trillion at the end of 2003.
the capital a firm needs to hold against credit risk Thus, F-F assume prepayment risk by holding
requires not only analysis of the geographical these assets.
diversification in the portfolio but also an analysis Under the most conservative financial strategy,
of risks and likely losses given foreclosure in Fannie and Freddie could mitigate completely their
various housing markets. From everything I know, prepayment risk by issuing long-term callable
Fannie and Freddie do a fine job of managing bonds to finance their holdings of long-term mort-
credit risks, but I am not one who believes credit gage assets. With such a strategy, the cash inflow
risks can be ignored. from the assets matches exactly the cash outflow
required to service the liabilities, and interest rate
and prepayment risk are perfectly hedged.
PREPAYMENT RISK
Fannie Mae and Freddie Mac issue mortgage-
backed securities (MBS) against pools of conform- A DIGRESSION ON FINANCIAL
ing mortgages—mortgages with dollar value at ENGINEERING
or below the conforming limit that qualifies the In practice, both Fannie and Freddie make
mortgages for F-F operations. All such mortgages limited use of long-term callable bonds. Rather,
have no prepayment penalties and are therefore they issue non-callable long-term bonds and a
subject to prepayment risk. significant amount of short-term debt. Doing so
In finance lingo, these fixed-rate mortgages exposes F-F to prepayment risk and interest rate
carry a call option. In the event that interest rates risk from a mismatch of duration of assets and
fall during the life of the mortgage, the homeowner
liabilities. They then use various devices to man-
can exercise the option to refinance the mortgage,
age the risks created.
effectively calling the outstanding high interest
Before discussing the ways F-F manage pre-
rate mortgage and replacing it with a new lower
payment and interest rate risk, it is worth noting
1
that the more elaborate portfolio policy has noth-
This statement may or may not be strictly accurate. Annual data on
national average new home prices from the U.S. Census start in ing whatsoever to do with the mortgage market
1963 and show small declines in the late 1960s and early 1990s. per se. Consider this analogy: An investment
Annual data for the median sales price of existing single-family
homes from the National Association of Realtors start in 1968 and
company could own a portfolio of long-term cor-
do not exhibit any annual declines. porate bonds, most of which become callable at
86 M A R C H / A P R I L , PA R T 1 2005 F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W
Poole
some point before maturity. When interest rates tively creates a cash flow obligation that mimics
fall, corporations call such bonds and refinance that of a long-term bond. They also use options—
with lower-rate bonds. The phenomenon is exactly in particular, swaptions—to hedge the prepayment
the same as that observed in the mortgage market, risk.
except that corporate bonds have a certain number Finally, like many large financial firms,
of years of call protection when issued and pay a Fannie Mae and Freddie Mac employ a strategy
call premium when called. of imperfect dynamic hedging, which involves
As far as I know, there are no closed-end three steps: “(1) Maintain very complete hedges
investment companies that hold a portfolio of against the likely, near-term, interest rate shocks;
corporate bonds, financed by their own issues of (2) Use less complete hedges or even no hedges for
short and long debt. The reason, I conjecture, is longer-term and less likely rate shocks; (3) Imple-
that there is no implied federal guarantee on such
ment additional hedges as interest rate levels
obligations, which means that an investment
change, and the unlikely becomes likely” (Jaffee,
company could not earn a satisfactory spread
2003, pp. 16-17). The term “dynamic hedge” refers
from holding a portfolio of marketable corporate
to a strategy that involves continuous rebalancing
bonds financed by its own obligations.
of the firm’s portfolio in an attempt to maintain
The GSEs, however, have the benefit of the
implied federal guarantee, which makes their acceptable risk exposures. A dynamic hedging
financial engineering profitable. Because of the strategy can be quite successful when prices move
implied guarantee, F-F can operate with a small continuously, in small steps, but is increasingly
capital position and issue their own obligations ineffective the larger are price discontinuities, or
at rates that are little above those paid by the U.S. price jumps.
Treasury. The spread over Treasuries is smaller at The advantage of using derivatives and
the short end of the maturity structure than at the imperfect dynamic hedging to manage interest rate
long end, which is why F-F issue large amounts risk is that these strategies are less costly than the
of short-term debt. This financial engineering has perfect hedge and perform equally well when the
little to do with the mortgage market, except that interest rate volatility is moderate. The disadvan-
F-F are authorized to hold mortgages rather than tage is that potential losses associated with the
corporate bonds in their portfolio. The financial unlikely risks can be very large.
engineering has nothing to do with the mortgage
• Because of imperfect dynamic hedging, F-F
market per se and everything to do with the
implied federal guarantee. may suffer a significant loss whenever there
are unexpected and large interest rate move-
ments in either direction. Formal models of
INTEREST RATE RISK dynamic hedging assume price continuity
and do not work well when prices jump
Fannie and Freddie create interest rate risk for discretely by large amounts.
themselves by financing their portfolio through
a mixture of long-term non-callable bonds and • Fannie Mae and Freddie Mac are exposed
short-term obligations. Both firms have obligations to the counterparty default risk in their
due within one year in the neighborhood of 50 derivative contracts. The counterparty
percent of total liabilities. default risk per se may be small because
Having created prepayment and interest rate both firms require all counterparties to post
risk by not matching the characteristics of their collateral on a weekly basis. However, at a
obligations to the characteristics of their mortgage time of disrupted financial markets, it would
assets, F-F must then pursue sophisticated hedging be very costly to replace the swap positions
strategies. They employ debt and interest rate of a defaulting counterparty because the
swaps to create synthetic long-term obligations— other counterparties are likely to have
a short-term obligation plus a fixed-pay swap effec- similar problems.
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W M A R C H / A P R I L , PA R T 1 2005 87
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88 M A R C H / A P R I L , PA R T 1 2005 F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W
Poole
Figure 1
Trading Day Percentage Changes in On-the-Run 10-Year Treasury Note
Percent change
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98
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86
90
82
84
92
02
78
04
96
94
80
ay
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Fannie Mae or Freddie Mac become insolvent. installing warning systems. In the case of the risk
The argument was the same as that stated so of financial crisis, the key policy intervention is
clearly by Richard Posner in his recent Wall Street to reduce the probability of the event, by such
Journal op-ed article (Posner, 2005, p. A12) on methods as increasing the amount of capital firms
the Indian Ocean tsunami. Posner writes: hold.
I am also arguing that the risk of financial
The Indian Ocean tsunami illustrates a
problems at Fannie Mae and/or Freddie Mac are
type of disaster to which policy makers
not as remote as it might seem, because of the fat
pay too little attention—a disaster that
tails of the distribution of price changes in asset
has a very low or unknown probability of
markets. These two observations—enormous
occurring, but if it does occur creates
potential costs and a probability of failure higher
enormous losses…The fact that a catas-
than commonly realized—imply that the risks of
trophe is very unlikely to occur is not a
very large events must be identified and carefully
rational justification for ignoring the risk
analyzed through extensive “stress testing.” Then,
of its occurrence.
adequate controls must be instituted to mitigate
Of course, the loss of scores of thousands of the identified risks.
lives in the tsunami is not to be compared to the This is exactly the approach that Mandelbrot
losses from a financial crisis. Nevertheless, the and Hudson recommend: “So what is to be done?
two disaster cases illustrate another important For starters, portfolio managers can more fre-
point about risk management. In the case of the quently resort to what is called stress testing. It
tsunami, nothing can be done about the probabil- means letting a computer simulate everything that
ity of occurrence; loss mitigation depends on could possibly go wrong, and seeing if any of the
F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W M A R C H / A P R I L , PA R T 1 2005 89
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90 M A R C H / A P R I L , PA R T 1 2005 F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W
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fact bail out F-F. Many observers, myself included, required should an unlikely event occur rather
believe that a bailout would not be a good idea. than by an estimate of the probability itself. It may
The bottom line is that there is substantial be that the highly volatile interest rate environ-
uncertainty over the future regulatory structure ment of the early 1980s is extremely unlikely to
that will apply to Fannie Mae and Freddie Mac recur, but I would like to see F-F maintain capital
and over the likely behavior of the government positions that would enable the firms to withstand
should the solvency of either firm come into such an environment anyway.
question. 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
CONCLUDING REMARKS a federal bailout is certain should there be a prob-
lem is making a mistake.
My purpose has been to provide an outline of
all the risks facing Fannie Mae and Freddie Mac.
There are six risks to consider: credit risk, pre-
payment risk, interest rate risk from mismatched
REFERENCES
duration of assets and liabilities, liquidity risk, Engle, Robert. “Risk and Volatility: Econometric
operational risk, and political risk. Much more Models and Financial Practice.” American Economic
could be said about each of these risks, but I Review, June 2004, 94(3), p. 405-20.
thought it would be useful to discuss each of
them briefly in order to have a complete catalog. Jaffee, Dwight. “The Interest Rate Risk of Fannie Mae
I’ve particularly emphasized the importance and Freddie Mac.” Journal of Financial Research,
of facing up to the implications of low-probability 2003, 24(1), pp. 5-29.
events. A low probability must not be treated as
Mandelbrot, Benoit and Hudson, Richard L. The
if it were a zero probability. Moreover, extensive
(Mis)Behavior of Markets. New York: Basic Books,
evidence from many different financial markets,
2004.
reinforced by similar findings in commodity
markets, indicates that price changes in asset Poole, William. “Housing in the Macroeconomy.”
markets are characterized by fat tails. The proba- Federal Reserve Bank of St. Louis Review, May/June
bility of large price changes is much higher than 2003, 85(3), pp. 1-8.
suggested by the familiar normal distribution. In
the case of the 10-year Treasury bond, changes Poole, William. “The Risks of the Federal Housing
of 3.5 standard deviations or more are 16 times Enterprises’ Uncertain Status.” Panel on Government
more frequent than expected under the normal Sponsored Enterprises and Their Future. In
distribution. Proceedings: 40th Annual Conference on Bank
More generally, the probability of shocks of Structure and Competition, May 2004, Federal
many sorts may be higher than one would think. Reserve Bank of Chicago, pp. 464-69.
The accounting problems that surfaced at both
Fannie and Freddie would surely have been Posner, Richard A. “The Probability of a Catastrophe...”
assigned a very low probability two years ago. Wall Street Journal, January 4, 2005, p. A12.
Unlike the situation in financial markets, where
a wealth of data permits some formal probability U.S. General Accounting Office. Government
estimates, the probability of other sorts of events Sponsored Enterprises: Federal Oversight Need for
is much more difficult to judge. For this reason, Nonmortgage Investments. GAO/GDD-98-48.
Washington, DC: 1998.
I believe that the capital held by F-F should be
at a level determined primarily by the cushion
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92 M A R C H / A P R I L , PA R T 1 2005 F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W