By: Ronald D. Struck June 26, 2003


From the time of its establishment in 1968 as a government-sponsored enterprise (GSE) through 1980, Fannie Mae's operating structure was nothing more than that of a giant S&L. It raised deposits on Wall Street via government-backed accounts (its agency-quality bonds) and made mortgage loans to borrowers, albeit indirectly through the mortgage banking industry. Like S&Ls, for most of the 1970s, Fannie Mae made a great deal of profit by borrowing heavily in the short-term securities market at low rates and lending in the long-term mortgage market at higher rates. However, when rates spiked in late 1979, and the yield curve quickly inverted, like the S&L industry, Fannie Mae's mismatch between its assets and liabilities got it into trouble. In fact, on a mark-to-market basis, at one point it was technically bankrupt.

The primary reason for Fannie Mae's recovery was its adoption in the 1980s of Freddie Mac's operating structure. While Fannie Mae had been operating as a giant S&L for the mortgage banking industry, Freddie Mac, a second GSE established in 1970, had been operating as a giant mortgage banker for the S&L industry. Like a mortgage banker, Freddie Mac bought mortgage loans from S&Ls, sold them as mortgage-backed securities on Wall Street, and retained a small "interest rate spread" fee for its MBS servicing and guarantee services. This operating structure is conservative because it does not involve undertaking mismatches between asset and liability maturities, however it does not support the rapid growth of Fannie Mae's original higher-risk S&L operating structure, therefore, in the 1970s, Freddie Mac's growth was slower than Fannie Mae's.

During the 1980s, the conservative mortgage-banker operating structure served both Fannie Mae and Freddie Mac well. However, during the 1990s, to increase growth and compete with one another, both Fannie Mae and Freddie Mac established operating structures that went far beyond the conservative mortgage-banking operating structure. In fact, they went far beyond Fannie Mae's higher-risk S&L operating structure of the 1970s, which had gotten it into trouble. With the clout over Wall Street their size and capital markets activities gave them, their ability to raise unlimited amounts of capital on Wall Street at near-treasury rates, and their access to virtually every kind of sophisticated portfolio management tool, they proceeded to become hedge fund managers.

Now, in the 2000s, as operating structures, not only are Fannie Mae and Freddie Mac giant hedge funds, they are the largest mortgage bankers, S&Ls, and portfolio managers in the world. This creates a unique concentration of risks in highly diverse and extremely complex operating areas. It is dangerous to assume that the professionals within Freddie Mac and Fannie Mae have the expertise and capability to understand and manage the huge risks to which they are exposed. As we saw with the giant hedge fund, Long-Term Capital Management, in 1998, even with highly experienced and respected hedge-fund managers and Nobel prize-winning economists on board, they were unable to manage their risks, resulting in the near-collapse of the fund that helped trigger a global banking crisis.

The best brains on Wall Street were unable to analyze and understand the evolving risks in Long-Term Capital. Freddie Mac and Fannie Mae's risks exceed those of Long-Term Capital, therefore to efficiently regulate Freddie Mac and Fannie Mae, uniquely capable professionals are required with exceptional expertise in housing, mortgages, asset/liability structuring, and securities portfolio risks. It is unlikely that the Office of Federal Housing Enterprise Oversight has the expertise required to monitor the changing risk exposures of the GSEs. In fact, because of their size and diversity, it is unlikely that such expertise exists in any department within the federal government, or anywhere else for that matter.

The founding fathers of Freddie Mac never envisioned that it would become the second largest mortgage lender in the world, one of the biggest issuers of agency debt, or have one of the largest and most complex portfolio structures in the capital markets. Preston Martin, its first chairman, Tomas Bomar, its first CEO and second chairman, William Popejoy, its second CEO, and Victor Indiek, its first CFO and third CEO were all great visionaries. When I was with Freddie Mac from 1972 to 1977, participating in setting up its asset/liability management and capital markets programs, I often heard them make public comments about the purpose they envisioned for Freddie Mac, which was simply to improve the operating structure of the secondary market for residential mortgages, and then turn the benefits of these improvements over to the private sector to enable it to operate more efficiently. It is too bad that Freddie Mac lost sight of the founding fathers' vision because, if it had not, today risks would be dispersed throughout many smaller, private "Freddie Mac-like" companies, and we would not be facing a dangerous mortgage market, a market with one of the greatest concentrations of credit, financial and operating risk ever aggregated.

The mortgage market should hope and pray that the management and regulators of both GSEs are unusually efficient - and lucky - especially lucky. With their enormous risk concentrations, a "big-bang" event (an unexpected and/or uncontrollable major event) could be deadly for Fannie Mae and Freddie Mac. If something is not done soon to reduce their risk concentrations, it is just a question of when, not if, their luck will eventually run out, and there could be major negative, perhaps catastrophic, consequences.


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