Revisiting the Net Benefits of Freddie Mac and Fannie Mae
million.” In other words, as long as the GSEs meet OFHEO’s risk-based-capital standard, the chance of failure is exceedingly small, certainly less than for other major financial institutions.
The Federal Reserve’s view of the GSEs’ threat to financial stability, as articulated by Alan Greenspan, focuses on the concern that the GSEs may run into supply or liquidity problems in the over-the-counter derivatives market when interest rates change suddenly and “vast reversal transactions are required to rebalance portfolio risks.”35 This argument is related to the GSEs’ use of “dynamic hedging” to reduce some of the prepayment risk in their mortgage portfolios.36
by the GSEs, so the supply of these derivative securities may be vulnerable in a crisis. However, a study by the Federal Reserve System found that “Dealer concentration in the interest rate options markets is fairly high, but the risks resulting from that concentration seem to be reasonably well managed.”37
Third, concern has been expressed about a possible reduction in liquidity in the over-the- counter markets that the GSEs utilize. On this point, an OFHEO study of systemic risk concludes that “most Enterprise derivatives are simple instruments, the market for which is likely to remain liquid in all but the most extreme circumstances.”38
We can offer three points in response to this concern. First, the GSEs use this type of hedging for less than half of their prepayment risk. Most of their portfolios is hedged with callable debt and other techniques that do not require re- balancing. Indeed, the GSEs rely more on call- able debt than other mortgage investors. Thus, although Greenspan has stated that he would prefer that holdings of fixed-rate mortgages be more widely dispersed across investors with less leverage than the GSEs, it is not clear that dispersal would result in less rebalancing activity when interest rates changed.
Second, available information does not indicate that the GSEs’ activity in the derivatives markets is a likely threat to market stability. One expressed concern is that there are only a few dealers in the over-the-counter swaps and options used
Benefits from the Retained Portfolio
The error in the critics’ other premise—that GSE portfolio investments do not benefit home- owners—is eloquently rebutted by Roll (2003). Roll’s main point is that although the GSEs’ mortgage-backed securities have expanded the investor base for conventional mortgage loans, the difficulty in managing prepayment risk puts MBS off-limits for many investors. By purchasing mortgages and mortgage securities for their own portfolios and funding those purchases with unsecured debt that has either no call risk or more predictable call risk than mortgage prepayments, the GSEs further expand the investor base for mortgage loans.
Greenspan (2005). See also Eisenbeis, Frame and Wall (2006) and Jaffee (2003).
For a description of dynamic hedging, see Ferguson (2002).
Staff of the Federal Reserve Board of Governors and the Federal Reserve Bank of New York (2005).
OFHEO (2003), 66.
The Policy Debate Over GSE Activities