By James Hamilton, J.D., LL.M.
New House Financial Services Committee Chair Barney Frank has pledged to pass legislation to reform the government-sponsored enterprises in this session of Congress. Chairman Frank said that his bill will substantially increase the ability of the regulator to oversee Fannie Mae and Freddie Mac to that point that the powers of that regulator will equal, if not surpass, the powers of the federal banking regulators.
Against this backdrop, St. Louis Federal Reserve Board President William Poole has emphasized that such legislation must contain three essential reforms in order to eliminate the GSEs’ threat to financial stability. First there must be a limit on their portfolio growth; and second, an increase in their minimal required capital. The third essential element is satisfactory bankruptcy legislation so that, should the worst happen, federal authorities can deal with the problem in an orderly way. There is a glaring need for legislation to clarify the bankruptcy process should a GSE fail, he proclaimed. At present, there is no process and no one knows what would happen if a GSE is unable to meet its obligations. Mr. Poole, who characterized the current period as one of ``uneasy waiting,’’ made his remarks recently to the Chartered Financial Analysts of St. Louis.
There is also the issue of derivatives accounting. Freddie Mac and Fannie Mae both got into trouble with accounting irregularities in part because of the complexities under GAAP rules of accounting for derivatives positions and rules determining which assets should be reported at market and which should be reported at amortized historical cost. In the view of the Fed official, sound risk management requires that GSEs base decisions on market values. The reason is simple, he said, since Fannie Mae and Freddie Mac pursue policies that inherently expose the firms to an extreme asset-liability duration mismatch. They hold long-term mortgages and mortgage-backed securities financed by short-term liabilities. Given this strategy, they must engage in extensive operations in derivatives markets to create synthetically a duration match on the two sides of the balance sheet. In turn, these operations expose the firm to a huge amount of risk unless the positions are measured at market value.
According to Mr. Poole, financial firms should also have an intense interest in reforming the GSEs. One reason is simply that banks and other financial firms, and many non-financial firms, hold large amounts of GSE obligations and GSE-guaranteed mortgage-backed securities. He believes that many risk managers simply accept that GSEs are effectively backstopped by the Federal Reserve without ever thinking through how such implicit guarantees would actually work in a crisis. The view seems to be that someone, somehow, would do what is necessary in a crisis. Good risk management requires that the “someone” be identified, said the Fed official, and the “somehow” be specified. He emphasized that before anyone starts thinking about the Federal Reserve as the “someone,” they should understand that the Fed can provide liquidity support but not capital.