The charts show inflation''s in the cards

Alarm bells sound for Fannie and Freddie

By John Dizard
Financial Times
Sunday, February 29, 2004

a href=http://news.ft.com/servlet/ContentServer?http://news.ft.com/servlet/Cont...
pagename=FT.com/StoryFT/FullStoryamp;c=StoryFTamp;cid=1077690777355

Ordinarily, Alan Greenspan's testimony to Congress gives
Prozac serious competition for medicating the over-anxious.

Last week, though, the Federal Reserve chairman's warnings
about Fannie Mae and Freddie Mac, the government-sponsored
enterprises, or quot;Sodom and Gomorrahquot;, as one friend of mine
calls them, came as something of a shock. He said that quot;we
assess [systemic risk] as likely if GSE expansion continues
unabated.quot;

Mr. Greenspan's warning was accompanied by one from
Gregory Mankiw, the chairman of the President's Council of
Economic Advisors, who warned: quot;Even a small mistake in
GSE risk management could have ripple effects throughout
the economy.quot;

What's most odd about these warnings is that they appeared
to come out of the blue. Over the past two or three years
there has been a stream of articles, speeches, conference
calls, and tedious op-ed columns by people such as yours
truly about the potential systemic risk posed by Fannie and
Freddie.

Since Mr. Greenspan is the master of acting hyper-political
while posing as non-political, and since Mr. Mankiw is on a
very short leash held by the White House's political operators,
one has to wonder the following:

What do they know that we don't know?

Is some buttress in the financial system going to fail soon?
Why are the pilot and co-pilot putting on their parachutes?
Should we buy some more canned food and ammunition for
the country house?

Not that I don't agree with everything both men said. They
were entirely correct. However, there is no chance at all
that there will be limits placed on housing finance in an
election year. These are ass-covering memos.

There is also a red herring buried in Mr. Mankiw's remarks.
He said: quot;The [GSE] charters do not require the federal
government to bail out a troubled GSE.quot; This is true.
Furthermore, the GSEs themselves say they do not need
a backup federal bailout. Their derivatives book, they say,
enormously reduces their risk from a rapid increase or
decrease in interest rates.

Both statements are subtly deceptive because they don't
identify the parts of the financial system that would truly be
at risk in the event of a serious quot;rate shock.quot;

I don't believe the GSEs will have to be rescued by the Fed
in a crisis. Nope.

THE PEOPLE WHO SOLD THEM PROTECTION WILL HAVE TO BE BAILED
OUT. And, sorry Mr. Mankiw, but the Fed does have an
obligation to take care of them.

Let's go back to the GSEs' own defences against more
regulation and limits on their growth. The real threat posed by
the GSEs, in the view of Mr Greenspan and Mr Mankiw and
their staffs, is that they're just getting too darn big.

Mr. Greenspan would like to limit Fannie and Freddie to
repackaging mortgages and redistributing them through the
financial system.

This function gives a quot;liquidity discountquot; to mortgage
interest costs. What he doesn't like is their trillion-dollar
purchases of their own paper and the tiny equity bases on
which they do that.

In the central banking equivalent of a scrawled insult on a
bathroom wall, Fannie Mae publishes a series of Fannie
Mae Papers, an quot;occasional series on policy issues.quot; These
pour contempt on warnings such as Mr. Greenspan's. In one
such paper from last October, one of Fannie's distinguished
contributors, Christopher Culp, wrote about quot;mythsquot; he cited
as a quot;concern of central bankers.quot; (No names, please.) One
was that quot;Fannie Mae's use of derivatives poses systemic
riskquot;. Mr. Culp, the author of the recent quot;Art of Risk
Management,quot; trivializes the risks imposed by the $811
billion of notional derivative principal Fannie had on its books
last June.

He does touch on Mr. Greenspan's real concern: that the
counterparties for those derivative contracts are too highly
concentrated among a small number of securities houses
and banks. But he does so only to dismiss the problem,
writing that quot;these concerns play much more on fear than
on any actual empirical evidence legitimating the concern.quot;

The problem with Fannie and Freddie's party line is that
there is no quot;empirical evidencequot; because history has no
precedent for their risk concentration. The failure of Drexel
Burnham or Long Term Capital Management's problems,
which Mr. Culp cites, are two or three orders of magnitude
smaller than the mountains of GSE paper.

Mr. Greenspan and Mr. Mankiw don't think they'll have to
bail out Fannie and Freddie. They think they'll have to bail
out the half dozen largest swaps and derivatives dealers
-- the big banks and investment dealers. In a rapidly rising
interest rate environment, the quot;gamma,quot; or the rate of the
rate of increase in their hedging of their obligations to the
GSEs, could, or, if you believe the chairman, will, require
the Fed to act as the derivatives counterparty of last resort.

The math tells him this could be seriously inflationary.

Why the warning now?

Here's a thought: the GSEs' purchases of their own
mortgage-based securities peaked last summer and have
been gently declining since, reducing requirements for
derivatives purchases. However, Fannie has privately been
telling bank fixed-income securities analysts that it intends
to start to increase its purchases, and to achieve
double-digit portfolio growth for 2004.

I think that talk set off the alarm bells at the White House
and the Fed.

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