Thursday, July 10, 2008

Second Round Acute Phase

If these two GSEs, Fannie Mae and Freddie Mac fail, it would most certainly put us int a depression. Poole today said the two entities were insolvent. The entities comprimse 50 percent of all outstanding mortgages in the United States. That's 5 trillion dollars. And they are on the brink.

But Poole warned about this very situation in 2005, time to pay the piper, here are two snippets:

GSE Risks
William Poole
President, St. Louis Federal Reserve
St. Louis Society of Financial Analysts
St. Louis, Mo.
Jan. 13, 2005

GSE Risks
Almost two years ago, in a speech at a conference hosted by the Office of Federal Housing Enterprise Oversight (OFHEO), I argued that Government Sponsored Enterprises (GSEs) specializing in the mortgage market, especially Fannie Mae and Freddie Mac, exposed the U.S. economy to substantial risk, primarily because their capital positions are thin relative to the risks these firms assume.(1) I had a number of specific risks in mind, but did not elaborate the nature of these risks. My purpose tonight is to provide that elaboration. I will concentrate on risks facing Fannie Mae and Freddie Mac, but it should be understood that the Federal Home Loan Banks raise many of the same issues.

Concluding Remarks
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; prepayment risk; interest-rate risk from mismatched duration of assets and liabilities; liquidity risk; operational risk; and political risk. Much more could be said about each of these risks, but I thought it would be useful to discuss each of them briefly in order to have a complete catalog.

I’ve particularly emphasized the importance of facing up to the implications of low-probability events. A low probability must not be treated as if it were a zero probability. Moreover, extensive evidence from many different financial markets, reinforced by similar findings in commodity markets, indicates that price changes in asset markets are characterized by fat tails. The probability of large price changes is much higher than suggested by the familiar normal distribution. In the case of the 10-year Treasury bond, changes of 3.5 standard deviations or more are 16 times more frequent than expected under the normal distribution.

More generally, the probability of shocks of many sorts may be higher than one would think. The accounting problems that surfaced at both Fannie and Freddie would surely have been assigned a very low probability two years ago. Unlike the situation in financial markets, where a wealth of data permits some formal probability estimates, the probability of other sorts of events is much more difficult to judge. For this reason, I believe that the capital held by F-F should be at a level determined primarily by the cushion required should an unlikely event occur rather than by an estimate of the probability itself. It may be that the highly volatile interest rate environment of the early 1980s is extremely unlikely to recur, but I would like to see F-F maintain capital positions that would enable the firms to withstand such an environment anyway.

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 a federal bailout is certain should there be a problem is making a mistake.


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