Banks may be busy trying to get rid of risk, but two huge American institutions cannot get enough of it. The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, known affectionately as Fannie Mae and Freddie Mac, have become arguably the two most worrying concentrations of risk in the global financial system. This is because of their portfolio of mortgages and securitisations, their use of derivatives and the habit of many other borrowers, including hedge funds, of using their debt as collateral.
At the end of 2001, Fannie had a total credit risk of $1.56 trillion (a $705 billion mortgage portfolio and guarantees on securitised mortgages of $859 billion). Freddie’s was $1.14 trillion ($492 billion plus $646 billion), adding up to a combined exposure of $2.7 trillion, nearly double the 1996 figure of $1.45 trillion. Bert Ely, an economist, calculates that the current level amounts to a hefty 13.9% of the total credit risk in the non-financial sector of the American economy, and 49.8% of home-mortgage credit risk.
Worries about Fannie and Freddie owe more to concerns about corporate governance and sheer size than to any evidence of poor risk-management. The two were set up to ensure that the poor had access to affordable mortgages. They are “government-sponsored”, a vague status that allows them to maximise profits for their private-sector shareholders. It also earns them a subsidy from the markets worth an estimated $10 billion a year, because despite official insistence that there is no federal guarantee, Fannie and Freddie are so big, and so plugged into the Washington establishment (their boards are rest-homes for former government officials), that it is hard to imagine them being allowed to fail.
What might go wrong? They do not appear to be making the common error of using short-term finance to back long-term liabilities — though, as with any big derivatives user, it is hard to be sure. They stress-test their portfolios, for instance to see what would happen if the Texas real-estate crisis 15 years ago were repeated nationwide: say, a 25% fall in house prices, no home equity left, people defaulting on mortgages. They think they could survive that. The biggest danger may be counterparty risk: Fannie and Freddie are heavily dependent for their risk-management programmes on a handful of big banks. If there were an unexpected sharp rise in interest rates, those banks might be unwilling or unable to provide the derivatives Fannie and Freddie need to hedge their risks. The chance of this is small, but if it ever came to pass, the consequences would be huge.