The Systemic Risk Debate

Systemic risk is an issue to which the Administration has devoted considerable attention. Thus, it may be useful to look at the very recent work of the President's Working Group on Financial Markets that set forth broad principles for use by the financial regulators in mitigating potential systemic risks posed by "private pools of capital" (e.g., hedge funds). Hedge funds differ from GSEs in critical ways. Unlike the GSEs, hedge funds are unregulated, loosely capitalized and opaque; they are not required to publicly disclose their portfolio holdings, trading strategies or even their financial performance. They also invest in a wide range of asset classes while we are generally restricted to investing in high-quality mortgage related assets.

That said, and even though we present much less risk to counterparties than a typical hedge fund, many of the Working Group's findings are applicable. For example, in its two "overarching principles," the Working Group argues, first that "public policies that support market discipline, participant awareness of risk, and prudent risk management are the best means of protecting investors and limiting systemic risk" and second, that "supervisors should use their existing authorities" to foster market discipline." We agree wholeheartedly with these two principles and believe that market discipline and strong supervision are the most effective way to manage the systemic risks posed by large financial institutions. As for GSE supervision, over the past three years we have seen just how tough a safety and soundness regulator OFHEO can be. H.R. 1427 would make that oversight even stronger. We are also very confident in the federal banking agencies' abilities to monitor their institutions' counterparty risks. With regard to market discipline, we have made important efforts, such as our issuance of subordinated debt, to enhance the degree of market discipline.

Moreover, in the context of the debate regarding the GSEs, systemic risk is routinely used as shorthand for the view that these institutions somehow present a special degree of risk to the U.S. financial system (or even the world's financial markets). The simple fact is that while the GSEs are large financial institutions, they are only two of a group of large financial institutions within the U.S. Our financial system is quite resilient and innovative – the subject of constant changes and improvements. Further, the nation's system for financing residential real estate mortgages is the envy of the world – as is shown by the investments in it from various sources around the globe. While we agree that the system could be stronger, we strongly disagree that the GSEs represent a unique, large looming problem waiting to happen, particularly given the intense scrutiny we have received.

GSE Assets Among the Safest

The assets the GSEs own are considered to be among the safest financial products, evidenced by the reduced level of capital called for by the Basel II accord for high quality residential mortgages. A mortgage in our portfolio is no riskier than a mortgage held in the portfolio of a bank, insurance company, hedge fund, or central bank – the risks are exactly the same. As a means of allocating capital, regulatory capital requirements for a particular asset should be comparable regardless of whether the asset is held by a bank, an insurance company, a central bank or a GSE, taking into account the risk management capabilities of the institution holding the asset.

A Track Record of Managing Risks Effectively

Freddie Mac has a demonstrated track record of managing the risks of mortgages very effectively over many years. As shown in the table below, Freddie Mac's credit-related losses have averaged only one basis point annually throughout this decade. Compare this to the credit losses of the commercial banking sector, which from 2001-2005 averaged 83 basis points for all loans and 14 basis points for residential mortgages.

Freddie Mac Has Lower Charge-Offs and Charge-Off Volatility Than Banks
Note: Freddie Mac 2006 data is an estimate as of December 31, 2006 and is a subject to change. Source: FDIC, OFHEO, Freddie Mac.

Our management of interest-rate risk has been equally effective. We do not retain all of the interest-rate risk in our portfolio – we disperse most of it into the capital markets through the use of callable debt and derivatives. The record refinancing boom of 2003 provides a prime example of how we do this. During 2003, we financed nearly $835 billion in new mortgages, as borrowers refinanced to take advantage of historically low mortgage rates. During this time, more than half of our total mortgage portfolio prepaid. To manage the effect of this boom on our retained portfolio, we also called and refinanced much of our debt. This is the type of shift in the market to which our critics assert that we are uniquely vulnerable. In fact, our reported risk measures were consistently low, and our fair value of net assets increased by 19 percent. These same disclosures show that our duration gap – which contrasts the expected life of our assets and liabilities – has been at zero months in every month but one since January 2004. A duration gap of zero months indicates that assets and liabilities are expected to mature at the same time, demonstrating they are properly matched. All of this can be verified by reviewing our monthly disclosures.

None of this is meant to suggest that there are no risks involved in GSE mortgage investment. Ensuring that we manage these risks well should be key to the new regulatory regime. But the risks of the GSEs investing in mortgages, as opposed to other investors, are not unique, nor are they uniquely difficult to manage.