By: Ronald D. Struck
June 26, 2003
EVOLVING
RISK CONCENTRATIONS
IN FREDDIE
MAC & FANNIE MAE
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.
Top
