Revisiting the Net Benefits of Freddie Mac and Fannie Mae
systemic risk is frequently proclaimed during banking and currency crises, its meaning is vague and ambiguous. It means different things to dif- ferent persons, particularly with respect to causa- tion.”29
As best we can determine, the concern over systemic risk arises from a complex set of con- siderations that cannot be fully addressed here.30 The points raised in this regard include the size and growth of the GSEs, their nominally low leverage capital ratios, their use of derivatives to manage prepayment risk, and concern that their counterparties in the debt and derivatives markets would allow their exposure to the GSEs to reach imprudently high levels.31
In our view, these concerns do not, either individually or in combination, suggest the GSEs pose unique threats to financial stability. The GSEs are indeed very large, although neither is as large as the largest depository institutions. More important, the GSEs are a different type of financial enterprise. Through the use of callable debt and with various “swaps,” “swaptions,” and the like, The GSEs are able to hedge against credit and prepayment risk much better than the typical depository.32
The capacity to manage risk is clear in the results of a study completed by the CapAnalysis
Group in 2003.33 Taking the risk-based-capi- tal standards promulgated by OFHEO for the GSEs and applying them to the thrift industry as a whole, CapAnalysis simulated the various risk scenarios OFHEO applies to the GSEs. The study found that even though the GSEs passed the tests, the thrift industry failed—confirming the stringency of the OFHEO test and reinforcing the agency’s conclusion that the GSEs are extremely unlikely to fail.34
Similarly, Paul Kupiec and David Nickerson (2004) conclude, “[h]olding constant asset risks,... intermediaries that issue contingent liabilities may exhibit low or no risk of insolvency while holding significantly less capital than deposit-taking institutions...” In another study of Fannie Mae’s risk of default, Glenn Hubbard, former Chairman of the Council of Economic Advisers (2004) concludes that an upper bound on the likelihood of a Fannie Mae default is one in 1,000, which is lower than the median probability of failure by commercial banks, and the expected loss from failure of large commercial banks is many times that from the failure of Fannie Mae. Likewise, Nobel Prize winner Joseph Stiglitz and two as- sociates (2002) conclude, “The probability of a shock as severe as embodied in the risk-based- capital standard is substantially less than one in 500,000—and may be smaller than one in three
Kauffman (1999), 19. Similar statements can be found in OFHEO (2003), 7, and Ludwig (2004), 1 and 2.
Bear in mind that the first group to suffer should a GSE fail is the company’s stockholders, who thus have a strong incentive to make sure risk is maintained within reason.
See, for example, Greenspan (2005, 2006), Poole (2005) and Eisenbeis, Frame and Wall (2006).
For a discussion of hedging prepayment risk, see OFHEO (2003), 59-61 and Jaffee (2003).
One of the authors (Miller) served as chairman of the CapAnalysis Group at the time.
See OFHEO (2003)
The Policy Debate Over GSE Activities