WSJ - Greenspan Sternly Warns Of GSE risks

Thursday, September 15, 2005

I am a bit limited in my blogging at my current location (slow modem connection) but happy not to have overlooked another stern warning of Fed chairman Alan Greenspan about the systemic risks of the Government Sponsored Entities (GSE) Fannie Mae and Freddie Mac. In a letter dated September 2 (pdf) to Republican Senator Robert Bennett Greenspan wrote, "as Fannie and Freddie increase in size relative to the counterparties for their hedging transactions, the ability of these (companies) to quickly correct the inevitable misjudgments inherent in their complex hedging strategies becomes more difficult," the Wall Street Journal reports.
Mr. Greenspan's letter concludes: "In the case of (Fannie Mae and Freddie Mac), excessive caution in reducing their portfolios could prove to be destabilizing to our financial system as a whole and in the end could seriously diminish the availability of home mortgage funds."
Legislation to impose a range of new controls over the congressionally chartered companies, known as government-sponsored enterprises, or GSEs, has been stalled in the House, in part over Mr. Greenspan's concerns that it doesn't go far enough in curbing the growth of the companies' mortgage portfolios.
Many conservatives, who see Fannie and Freddie as a form of government intrusion, also worry that another provision of the bill would strengthen the companies' already substantial political clout on Capitol Hill, by substantially raising the amount of money they dedicate to affordable-housing programs around the country.
The two companies borrow money to buy home mortgages. They either hold the mortgages in their own portfolios or sell them to other investors. Because they can borrow almost as cheaply as the federal government itself, critics worry that there are no effective curbs on their potential growth, and particularly the growth of their portfolios. That is a potential concern because their portfolios of mortgages make the companies extremely vulnerable to interest-rate swings.
The companies try to hedge that risk through complicated strategies involving derivative investments such as interest-rate swaps. But Mr. Greenspan and some others worry that as the companies and their portfolios grow, they could overwhelm the ability of Wall Street banks to act as the counterparties. Already, market participants have reported occasional shocks when sudden zigzags in interest rates have brought the companies - along with other mortgage-market players - into the swaps market suddenly.
Freddie Mac said Mr. Greenspan's comments were consistent with prior statements he has made. The company also sought to play down concerns about systemic risk posed by its portfolio investments. "Our portfolio is very conservatively managed and tightly regulated," said Freddie spokesman David Palombi, pointing to the elaborate tests that federal officials run to measure its safety. He also suggested that the markets themselves would prevent untoward growth of the companies, and warned that "arbitrarily limiting our retained portfolio would decrease over time the availability of the long-term, fixed-rate, prepayable mortgage."
Fannie declined to comment. Both companies have warned investors that the legislation could materially hurt their profits and affect their ability to promote affordable housing.
While holdings of mortgages and related securities by Fannie and Freddie have soared during the past 15 years, so far this year their combined holdings have declined. At the end of July, the combined total came to about $1.449 trillion, down 7 % from the end of 2004. That is partly because Fannie has been shrinking its holdings to meet stiffer capital requirements imposed by the company's regulator in the wake of an accounting scandal.
But critics worry that if the current wave of scrutiny passes without strong new legislative curbs, the companies will be free to start growing again. That concern led Mr. Greenspan to warn earlier this year that passing the House bill would be worse than doing nothing.
Yesterday, the chief proponents of the House legislation sought to improve chances for their bill by amending it to steer more of the companies' profits into affordable housing in the stricken Gulf Coast region. One of the leaders of the effort is Rep. Richard Baker, a Louisiana Republican who represents the Baton Rouge area.
Another proponent, House Financial Services Chairman Michael Oxley (R., Ohio), said the bill is expected to come to a floor vote next week. Still, it isn't clear that the changes will be enough to overcome objections to the House measure among conservative critics.
A shortlist of most threatening risks to the economy:
  • Current account deficit
  • Budget deficit
  • Trade deficit
  • Inflation (new figures due today, seen at 0.5 % monthly change)
  • Medicare
  • Current (Iraq) and looming wars (Iran)
  • GSE's (includes the housing bubble)
  • Stagnant private sector employment
  • Katrina's costs
  • The highway bill
  • Demographics
  • Middle East
This growing pile of current and future debts has only one positive side effect: Anybody heard anything about Bush's plans to privatize social security lately?
Bush and Social Security

NOTE: Full scale blogging will commence on September 20, the day of the next FOMC meeting whose results are highly dependent on today's new inflation figures. Another 0.5 % increase in the headline figure would compound to an annual rate of 6.17 % and could force the Fed to leave the path of "measured" hikes, caught in the conflict of higher prices and slowing growth.

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