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Revisiting the Net Benefits of Freddie Mac and Fannie Mae

OTC markets for U.S. dollar interest rates reduce fixed rates by allowing GSEs and others to hedge prepayment risk. Furthermore, the report finds risks associated with the high concentration of dealers to be well managed.

R. Glenn Hubbard, “The Relative Risk of Fannie Mae” (2004). Professor Hubbard, Dean of the Business School at Columbia University and former chair of the Council of Economic Advisors, estimates the probability of default for Fannie Mae using a simulation model tailored to the risks specific to the GSE. He then compares the resulting risk to the corresponding risks of failure for large commercial banks. He finds that Fannie Mae’s likelihood of failure and the expected amount loss given failure are below the levels for most of the banks in his study. He also finds that Fannie Mae’s risk on a “stand- alone” basis is low in absolute as well as relative terms, and he challenges the assumption, made by most analysts of GSE finances, that the low yields on Fannie Mae securities are due to an implicit Federal guarantee rather than a low risk of default independent of whatever Federal support Fannie Mae may have.

Dwight Jaffe, “The Interest Rate Risk of Fannie Mae and Freddie Mac” (2003).This study evaluates the interest rate risk management of the two GSEs and develops public policy proposals. The analysis focuses on the enter- prises’ dynamic hedging and use of derivatives. Professor Jaffe states that the GSEs’ should be commended for the interest rate risk disclosures they now provide. However, he recommends changes to these disclosures and to the OFHEO stress test.

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Appendix: Recent Literature

Paul Kupiec and David Nickerson, “Assessing Systemic Risk Exposure from Banks and GSEs Under Alternative Approaches to Capital Regulation” (2004). Kupiec and Nickerson present a two-period model of financial exchange to investigate whether minimum capital requirements mitigate the potential for systemic risks due to asymmetric information between the financial intermediar- ies and debt holders. The authors find that for comparable mortgage portfolios, banks are more likely to have higher risk of insolvency than GSEs, even though banks hold more capital.

Eugene Ludwig, “Systemic Risk: A Regulator’s Perspective” (2004). Ludwig, a former Comptroller of the Currency, provides his perspective on systemic risk. He begins by stating that the available literature on the topic is limited and contains disagreements about fundamental issues. He believes that unregulated institutions pose greater risk than regulated ones, that the largest institutions do not neces- sarily pose the greatest risk, and that government errors are less likely to lead to crises today than was the case in the past.

Office of Federal Housing Enterprise Oversight, “Systemic Risk: Fannie Mae, Freddie Mac and the Role of OFHEO” (February 2003). This study has sections on systemic risk, including a survey of the literature, a discussion of the operations of the GSEs, and an assessment systemic risk associated with the activities of the GSEs. The sections on GSE operations have detailed coverage of interest rate risk management. The section on systemic risk describes alternative scenarios in which the liquidity or solvency problems strike the GSEs or other parts of the financial system. The report

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