For release: March 10, 2003

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Unforeseen Shock to GSEs Could Bring Crisis To U.S. Financial Markets: Says St. Louis Fed's Poole

WASHINGTON, D.C — Should Fannie Mae or Freddie Mac be rocked by a mistake or unforecastable shock, the result, without strong contingency arrangements, could be a crisis in U.S. financial markets that would inflict considerable damage on the housing industry and the U.S. economy.

That was the chief viewpoint of William Poole, president of the Federal Reserve Bank of St. Louis, as he spoke at an Office of Federal Housing Enterprise Oversight (OFHEO) seminar."Today, our housing finance system is heavily concentrated," Poole said. "Just three firms—Fannie Mae, Freddie Mac and Ginnie Mae—account for over 40 percent of the residential mortgage market. Ginnie Mae is backed by the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac are not so backed, and hold capital far below that required of regulated banking institutions." If either firm suddenly faces an unexpected shock, Poole said, the result could be a crisis reaching far into the economy.

"Given the enormous importance of housing and housing finance to the U.S. Economy," said Poole, "I think we do need to carefully examine the potential for financial instability and consider steps to reduce the risk." Poole commended OFHEO for its recent report, "Systemic Risk: Fannie Mae, Freddie Mac and the Role of OFHEO." Poole said the report shows "an impressive depth of scholarship" in reviewing literature on the subject and that it deserves careful study by economists and policymakers.

Poole mentioned two steps the federal government might consider to resolve the ambiguity he sees as a fundamental risk to our financial system's stability. "First, various aspects of federal sponsorship that the market reads as implicitly guaranteeing GSE debt should be withdrawn," Poole said. Noting that the Secretary of the Treasury has authority to buy up to $2.25 billion of Fannie Mae and Freddie Mac obligations, Poole said "eliminating that authority would provide a signal that the government is serious when it says there is no governmental guarantee of GSE debt.

Second, Poole said, over a transitional period of several years, GSEs should add to the capital they hold. "Capital is critical because when there is a securities market crisis, financially strong firms can stand the pressure without lasting damage." Poole added that capital is especially important for GSEs because their short-term obligations are large. Fannie Mae and Freddie Mac have debt obligations due within one year of about 45 percent of their debt liabilities. Any problem in the capital markets affecting these firms could become very large, very quickly."

Poole noted that "the issue with Fannie Mae and Freddie Mac is not primarily one of disclosure. Their annual reports disclose quite well the complexity of their operations and the small amount of capital they carry above what is required by law. My questions are these: Given the complexity of their operations, is the capital standard in the law adequate? Why is the standard so far below that required of federally regulated banks? What will happen to the housing market if Fannie and Freddie become unstable?"

In his judgment, Poole said, "the only way for financial institutions to insure stability in the event of nonquantifiable shocks is to maintain a substantial extra capital cushion above that deemed necessary by quantifiable risks."

Poole also discussed long-run trends in housing and housing finance. The United States is "well housed," he said, and the housing finance system has been working efficiently in recent years. "Our aim must be to sustain and extend this progress," he said.

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