Fannie, Freddie May Still Pose too Much Risk to System

N.Y. Federal Reserve president comments on GSE risks

May 19, 2004

By PATRICK CROWLEY

Geithner accurately pointed out that Fannie and Freddie alone “dominate the government securities business,” according to a written transcript of the speech he gave during the New York Bankers Association’s Annual Financial Services Forum.

The impact of Fannie and Freddie on the nation’s financial system cannot be overstated. Combined, the Government Sponsored Enterprises, or GSEs, own or guarantee about 70 percent of the country’s $7.3 trillion mortgage market.

But the GSEs have grown so large that a rising interest rate environment could lead to problems for the nation’s entire financial system.

“The growth in the size of government-sponsored mortgage entities creates a high degree of concentration in a market with very large systematic implications,” Geithner said. “Concentration has benefits, but it necessarily increases the vulnerability of the system to an operational or financial disruption.

“This concentration can also give rise to linkages between markets that are not apparent in normal circumstances and that could potentially affect how the financial system functions in conditions of acute stress,” Geithner said.

Geithner’s comments follow a similar warning given in February by Fed Chairman Alan Greenspan.

Testifying before the Senate Banking, Housing and Urban Affairs Committee, Greenspan said the Fed is so concerned with the growth and reach of Fannie and Freddie that both should be privatized. Greenspan also said that breaks given the GSEs by the government, including tax breaks and low borrowing costs, should end.

Doing so would force the GSEs to operate more as businesses instead of government agencies, he said.

“The Federal Reserve is concerned about the growth and scale of the GSEs mortgage portfolio,” Greenspan said according to a written transcript of his testimony.

“Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage … risk by holding greater capital. Instead, they have chosen heightened leverage, which raises interest rate risk,” Greenspan said.

Greenspan said that interest rate volatility combined with the ability of homeowners to prepay mortgages without penalty “means that cash flows associated with the holding of mortgage debt directly or through mortgage-backed securities are highly uncertain, even if the probability of default is low.”

Greenspan emphasized that Fannie and Freddie do appear to be managing their risks “and that we see nothing on the immediate horizon that is likely to create a systemic problem.

“But to fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner or later,” Greenspan said.

Yet rising rates could actually benefit the GSEs, the investment firm of Credit Suisse First Boston (SCAB) says in a new report.

“The GSEs retained portfolios should benefit significantly from a flatter yield curve, as the ‘carry trade’ becomes less profitable and depositories begin to shed their mortgage holdings,” the investment firm said in its written report.

Banks and others are likely to “lighten their mortgage holdings by $200-$300 billion over the next year, which could lift GSE retained portfolios (by) 15%,” CSFB said.

The firm also reviewed the GSEs’ margins and found them “to be relatively insulated to rising short-term interest rates,” the firm said.

Patrick Crowley is a political reporter and columnist and former business writer for The Cincinnati Enquirer. Email Patrick at: pcrowley@enquirer.com