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GSE Risks
St. Louis Society of Financial Analysts
St. Louis, Missouri
January 13, 2005
Published in the Federal Reserve Bank of St. Louis Review, March/April 2005, 87(2, Part 1), pp. 85-91

A

lmost two years ago, in a speech at a
conference hosted by the Office of
Federal Housing Enterprise Oversight
(OFHEO), I argued that governmentsponsored enterprises (GSEs) specializing in the
mortgage market, especially Fannie Mae and
Freddie Mac, exposed the U.S. economy to substantial risk, primarily because their capital positions are thin relative to the risks these firms
assume (Poole, 2003). I had a number of specific
risks in mind, but did not elaborate the nature of
these risks. My purpose here is to provide that
elaboration. I will concentrate on risks facing
Fannie Mae and Freddie Mac, but it should be
understood that the Federal Home Loan Banks
raise many of the same issues.
An understanding of the risks facing Fannie
Mae and Freddie Mac—which I will sometimes
refer to as “F-F” to simplify the exposition—is
important from two perspectives. First, investors
should be aware of these risks. Although many
investors assume that F-F obligations are effectively guaranteed by the U.S. government, the
fact is that the guarantee is implicit only. I will
not attempt to forecast what would happen should
either firm face a solvency crisis, because I just
do not know. What I do know is that the issue is
a political one, and political winds change in
unpredictable ways.
A second reason to understand the risks is
that sound public policy decisions depend on
such understanding. To reduce the potential for
a financial crisis, risks need to be mitigated.
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Fannie Mae and Freddie Mac face five major
sources of business risk: credit risk, prepayment
risk, interest rate risk from mismatched duration
of assets and liabilities, liquidity risk, and operational risk. A sixth risk, so-called political risk,
arises from the possibility of regulatory or statutory
revisions that could adversely affect those who
hold the firms’ debt or equity. I’ll discuss these
risks in turn, devoting much more time to some
than others. Along the way, I will also discuss an
extremely important point concerning the frequency of occurrence of large interest rate changes.
This issue is critical to understanding the risks of
any strategy involving incomplete hedging.

CREDIT RISK
Credit risk occurs because homeowners can
and do default on mortgage loans. Even though
default rates on mortgages in the United States
are low, in recent years less than 1 percent, they
are not zero and vary considerably across regions.
Credit risk on mortgages can be handled, as in fact
Fannie and Freddie do very effectively, through
a policy of geographic diversification and of not
buying a significant number of high loan-to-value
mortgages, as well as through the use of mortgage
insurance and guarantees.
In assessing credit risk, it is important not to
focus just on national average conditions. For
example, although average house prices in the
United States have not declined year to year since
the Great Depression,1 prices have declined in

This statement may or may not be strictly accurate. Annual data on national average new home prices from the U.S. Census start in 1963 and
show small declines in the late 1960s and early 1990s. Annual data for the median sales price of existing single-family homes from the
National Association of Realtors start in 1968 and do not exhibit any annual declines.

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FINANCIAL MARKETS

particular significant markets. Some examples
would be Boston 1989-92, Los Angeles 1991-96,
San Francisco 1991-95, and Texas 1987-88. More
formally, the dispersion of changes in house prices
and not just the national average is relevant for
judging mortgage default risk.
Given that house prices do sometimes decline
in particular markets, it is possible that a geographically diversified portfolio of mortgages could
suffer significant losses. Therefore, to determine
the capital a firm needs to hold against credit risk
requires not only analysis of the geographical
diversification in the portfolio but also an analysis
of risks and likely losses given foreclosure in
various housing markets. From everything I know,
Fannie and Freddie do a fine job of managing
credit risks, but I am not one who believes credit
risks can be ignored.

However, for many years F-F have been accumulating a portfolio of their own MBSs and
directly owned individual mortgages. For the two
firms together, these portfolios are very large,
amounting to over $1.5 trillion at the end of 2003.
Thus, F-F assume prepayment risk by holding
these assets.
Under the most conservative financial strategy,
Fannie and Freddie could mitigate completely their
prepayment risk by issuing long-term callable
bonds to finance their holdings of long-term mortgage assets. With such a strategy, the cash inflow
from the assets matches exactly the cash outflow
required to service the liabilities, and interest rate
and prepayment risk are perfectly hedged.

PREPAYMENT RISK

In practice, both Fannie and Freddie make
limited use of long-term callable bonds. Rather,
they issue non-callable long-term bonds and a
significant amount of short-term debt. Doing so
exposes F-F to prepayment risk and interest rate
risk from a mismatch of duration of assets and
liabilities. They then use various devices to manage the risks created.
Before discussing the ways F-F manage prepayment and interest rate risk, it is worth noting
that the more elaborate portfolio policy has nothing whatsoever to do with the mortgage market
per se. Consider this analogy: An investment
company could own a portfolio of long-term corporate bonds, most of which become callable at
some point before maturity. When interest rates
fall, corporations call such bonds and refinance
with lower-rate bonds. The phenomenon is exactly
the same as that observed in the mortgage market,
except that corporate bonds have a certain number
of years of call protection when issued and pay a
call premium when called.
As far as I know, there are no closed-end
investment companies that hold a portfolio of
corporate bonds, financed by their own issues of
short and long debt. The reason, I conjecture, is
that there is no implied federal guarantee on such

Fannie Mae and Freddie Mac issue mortgagebacked securities (MBS) against pools of conforming mortgages—mortgages with dollar value at
or below the conforming limit that qualifies the
mortgages for F-F operations. All such mortgages
have no prepayment penalties and are therefore
subject to prepayment risk.
In finance lingo, these fixed-rate mortgages
carry a call option. In the event that interest rates
fall during the life of the mortgage, the homeowner
can exercise the option to refinance the mortgage,
effectively calling the outstanding high interest
rate mortgage and replacing it with a new lower
interest rate obligation. Historically, the exercise
of this option was constrained by relatively high
transaction costs. In recent years, however, transaction costs have fallen considerably so that the
call option in the typical fixed rate mortgage
instrument comes in-the-money with relatively
small declines in mortgage rates. Such refi activity
has been substantial in recent years.
When Fannie and Freddie issue MBSs to be
held by the investing public, buyers of the bonds
assume the prepayment risk. Fannie and Freddie
service the MBSs and guarantee them, thus assuming the credit risk.
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A DIGRESSION ON FINANCIAL
ENGINEERING

GSE Risks

obligations, which means that an investment
company could not earn a satisfactory spread
from holding a portfolio of marketable corporate
bonds financed by its own obligations.
The GSEs, however, have the benefit of the
implied federal guarantee, which makes their
financial engineering profitable. Because of the
implied guarantee, F-F can operate with a small
capital position and issue their own obligations
at rates that are little above those paid by the U.S.
Treasury. The spread over Treasuries is smaller at
the short end of the maturity structure than at the
long end, which is why F-F issue large amounts
of short-term debt. This financial engineering has
little to do with the mortgage market, except that
F-F are authorized to hold mortgages rather than
corporate bonds in their portfolio. The financial
engineering has nothing to do with the mortgage
market per se and everything to do with the
implied federal guarantee.

INTEREST RATE RISK
Fannie and Freddie create interest rate risk for
themselves by financing their portfolio through
a mixture of long-term non-callable bonds and
short-term obligations. Both firms have obligations
due within one year in the neighborhood of 50
percent of total liabilities.
Having created prepayment and interest rate
risk by not matching the characteristics of their
obligations to the characteristics of their mortgage
assets, F-F must then pursue sophisticated hedging
strategies. They employ debt and interest rate
swaps to create synthetic long-term obligations—
a short-term obligation plus a fixed-pay swap effectively creates a cash flow obligation that mimics
that of a long-term bond. They also use options—
in particular, swaptions—to hedge the prepayment
risk.
Finally, like many large financial firms,
Fannie Mae and Freddie Mac employ a strategy
of imperfect dynamic hedging, which involves
three steps: “(1) Maintain very complete hedges
against the likely, near-term, interest rate shocks;
(2) Use less complete hedges or even no hedges for

longer-term and less likely rate shocks; (3) Implement additional hedges as interest rate levels
change, and the unlikely becomes likely” (Jaffee,
2003, pp. 16-17). The term “dynamic hedge” refers
to a strategy that involves continuous rebalancing
of the firm’s portfolio in an attempt to maintain
acceptable risk exposures. A dynamic hedging
strategy can be quite successful when prices move
continuously, in small steps, but is increasingly
ineffective the larger are price discontinuities, or
price jumps.
The advantage of using derivatives and
imperfect dynamic hedging to manage interest rate
risk is that these strategies are less costly than the
perfect hedge and perform equally well when the
interest rate volatility is moderate. The disadvantage is that potential losses associated with the
unlikely risks can be very large.
• Because of imperfect dynamic hedging, F-F
may suffer a significant loss whenever there
are unexpected and large interest rate movements in either direction. Formal models of
dynamic hedging assume price continuity
and do not work well when prices jump
discretely by large amounts.
• Fannie Mae and Freddie Mac are exposed
to the counterparty default risk in their
derivative contracts. The counterparty
default risk per se may be small because
both firms require all counterparties to post
collateral on a weekly basis. However, at a
time of disrupted financial markets, it would
be very costly to replace the swap positions
of a defaulting counterparty because the
other counterparties are likely to have
similar problems.

JUDGING THE SCALE OF
INTEREST RATE RISK
Without highly detailed information about the
hedging strategies pursued by F-F, it is impossible
to offer a quantitative assessment of the scale of
interest rate risk to which the firms are exposed.
However, the fact that hedging is incomplete raises
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FINANCIAL MARKETS

Figure 1
Trading Day Percentage Changes in On-the-Run 10-Year Treasury Note
Percent change
6
Days when on-the-run bond changed are omitted

3

0

–3

04
M
ay
1

1

M

ay

M
ay

02

00

98
1

M
ay

96
1

M
ay
1

ay

94

92
M
1

M
ay
1

ay

90

88
M
1

86

M
ay
1

M
ay
1

ay

84

82
M
1

80

M
ay
1

M
ay
1

1

M

ay

78

–6

NOTE: Dashed lines show a range of ± 3.5 standard deviations.

warning flags. The reason is that standard hedging
strategies rely on the assumption that changes in
securities prices follow a normal distribution—
the familiar bell-shaped curve. The Black-Scholes
formula for pricing options assumes, for example,
that asset prices follow a normal distribution.
To judge risk, we start by computing the standard deviation from a long history of price changes
in some particular market. The normal distribution is the baseline case. What we in fact observe
are “fat tails,” by which we mean that there are
many more large price changes—changes out in
the tails of the distribution—than expected with
a normal distribution of the calculated standard
deviation. Failure to take adequate account of fat
tails is responsible for many failures of financial
firms over the years, such as the 1998 failure of
Long Term Capital Management.
A key security in the context of the mortgage
market is the 10-year on-the-run Treasury bond.
Long-term mortgages are priced off the 10-year
Treasury, and Treasury bonds themselves, because
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they are traded in a highly liquid market, are
employed extensively in hedging strategies. Price
changes for the Treasury bond for about 25 years
are shown in Figure 1. The vertical axis measures
the daily percentage price change, and the dashed
bands define a range plus and minus 3.5 standard
deviations from the mean.
The first thing to note in this figure is the frequency of large changes. Roughly 0.75 percent of
the Treasury bond price changes in the sample are
greater in absolute value than 3.5 standard deviations, more than 16 times the number of such
outliers that would be expected from a normal
distribution of price changes. Let me repeat—
there are 16 times more price changes in excess
of 3.5 standard deviations than expected with the
normal distribution. Assuming 250 trading days
in a year, on average bond price changes of this
or greater magnitude in absolute value occur twice
per year instead of once every 8 years. The normal
distribution provides a grossly misleading picture
of the risk of large price changes. Really large

GSE Risks

changes of 4.5 or more standard deviations—the
ones that can break a highly leveraged company—
occur only 7 times in a million under the normal
distribution, but there are 11 such changes in the
6,573 daily observations in the figure.
A second point to note from the figure is that
large changes tend to cluster together. It appears
that markets go through periods of relative volatility and other periods of relative tranquility.
Clustering is important because a firm may be
rocked several times in quick succession by large,
unanticipated price changes. Incomplete hedges
against large price changes expose a firm to cascading failure.
The fat tails phenomenon has been documented for a wide range of financial instruments
over many different sample periods. Benoit
Mandelbrot and Richard Hudson refer to these
features as “wild randomness” (Mandelbrot and
Hudson, 2004, p. 32). They conclude:
Extreme price swings are the norm in
financial markets—not aberrations that
can be ignored. Price movements do not
follow the well-mannered bell curve
assumed by modern finance; they follow
a more violent curve that makes the
investor’s ride much bumpier. A sound
trading strategy or portfolio metric
would build this cold, hard fact into its
foundations.
Robert Engle characterizes returns in financial
markets this way: “Returns are almost unpredictable, they have surprisingly large numbers of
extreme values, and both the extremes and quiet
periods are clustered in time. These features are
often described as unpredictability, fat tails, and
volatility clustering” (Engle, 2004, p. 407).

MANAGING INTEREST RATE RISK
In my speech to the OFHEO conference
almost two years ago, I emphasized the risk of
systemic, worldwide financial crisis should either
Fannie Mae or Freddie Mac become insolvent.
The argument was the same as that stated so

clearly by Richard Posner in his recent Wall Street
Journal op-ed article (Posner, 2005, p. A12) on
the Indian Ocean tsunami. Posner writes:
The Indian Ocean tsunami illustrates a
type of disaster to which policy makers
pay too little attention—a disaster that
has a very low or unknown probability of
occurring, but if it does occur creates
enormous losses…The fact that a catastrophe is very unlikely to occur is not a
rational justification for ignoring the risk
of its occurrence.
Of course, the loss of scores of thousands of
lives in the tsunami is not to be compared to the
losses from a financial crisis. Nevertheless, the
two disaster cases illustrate another important
point about risk management. In the case of the
tsunami, nothing can be done about the probability of occurrence; loss mitigation depends on
installing warning systems. In the case of the risk
of financial crisis, the key policy intervention is
to reduce the probability of the event, by such
methods as increasing the amount of capital firms
hold.
I am also arguing that the risk of financial
problems at Fannie Mae and/or Freddie Mac is
not as remote as it might seem, because of the fat
tails of the distribution of price changes in asset
markets. These two observations—enormous
potential costs and a probability of failure higher
than commonly realized—imply that the risks of
very large events must be identified and carefully
analyzed through extensive “stress testing.” Then,
adequate controls must be instituted to mitigate
the identified risks.
This is exactly the approach that Mandelbrot
and Hudson recommend: “So what is to be done?
For starters, portfolio managers can more frequently resort to what is called stress testing. It
means letting a computer simulate everything that
could possibly go wrong, and seeing if any of the
possible outcomes are so unbearable that you want
to rethink the whole strategy” (Mandelbrot and
Hudson, 2004, p. 267).
By this criterion, incomplete hedging of
longer-term and less likely interest rate shocks is
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FINANCIAL MARKETS

not an adequate risk management strategy for
GSEs. Capital ratios that are not tested against
extreme events do not adequately mitigate the
interest rate risk faced by such institutions.

LIQUIDITY RISK
Fannie Mae and Freddie Mac must roll over
roughly $30 billion of maturing short-term obligations every week. At a time of disrupted financial
markets, the credit markets might refuse to accept
the F-F paper. “Fannie Mae and Freddie Mac
recognize this risk and both firms indicate they
maintain sufficient liquidity to survive for some
time (3 months or longer) without access to
rollover markets…[However,] the U.S. General
Accounting Office (1998) has also pointed out that
holding securities in their investment portfolios
for liquidity purposes represents a highly profitable arbitrage for [both firms], since the return on
the assets exceeds the cost of the agency bonds
used to fund the positions” (Jaffee, 2003, p. 16).
Therefore, if Fannie Mae and Freddie Mac are
unable to sell new debt, then they may also be
unable to carry out sales of the “liquid” securities
from their investment portfolio.
I discussed liquidity risk at some length in a
speech last spring (Poole, 2004). I won’t repeat
that analysis, but the bottom line is simple: The
Federal Reserve has adequate powers to prevent
the spread of a liquidity crisis, but cannot prevent a solvency crisis should Fannie or Freddie
exhaust their capital. In the event of a solvency
crisis, the market would become unreceptive to
Fannie and/or Freddie obligations; they would
have difficulty rolling over their maturing debt.
Moreover, their outstanding obligations would
decline in price and their markets would become
less liquid. Beyond that, it is hard to say exactly
what else might happen.

OPERATIONAL RISK
In the past two years, there have been surprising news reports of accounting irregularities, first
at Freddie and more recently at Fannie. In both
6

cases senior executives have left the firms and
audit attestations have been questioned. Both firms
have been required to restate earnings for a number
of years. Investigations by OFHEO, the SEC, and
the Department of Justice are ongoing.
Accounting problems were not on my radar
screen when I first became concerned about GSE
risk. The recent revelations are another example
of our inability to predict shocks that will impact
our financial system. Even though the assets F-F
hold are relatively simple—residential real estate
mortgages and mortgage-backed securities—the
firms themselves are complex organizations
because of their scale and the financial engineering they employ. The accounting problems provide
an example of operational risk; other aspects of
F-F operations, such as the automated underwriting procedures, are also subject to operational
risk. It remains to be seen how the accounting
restatements will affect the market’s view of F-F
earnings and capital adequacy. Clearly, though,
F-F need to hold capital against operational risk.

POLITICAL AND REGULATORY
RISK
From a narrow market perspective, a key issue
is whether the federal government would bail out
Fannie Mae and/or Freddie Mac should the solvency of either firm be threatened. But that is too
narrow a perspective, even for a holder of F-F
obligations.
If there were a solvency crisis, the outcome
would certainly involve extensive changes in the
powers and characteristics of the firms. Institutions holding F-F obligations, direct or guaranteed,
would most likely have to alter their portfolio
practices. Moreover, even if the federal government bailed out F-F, their obligations might be
redeemed eventually but cease to trade actively
in liquid markets. Finally, there is of course no
guarantee that the federal government would in
fact bail out F-F. Many observers, myself included,
believe that a bailout would not be a good idea.
The bottom line is that there is substantial
uncertainty over the future regulatory structure

GSE Risks

that will apply to Fannie Mae and Freddie Mac
and over the likely behavior of the government
should the solvency of either firm come into
question.

CONCLUDING REMARKS
My purpose has been to provide an outline of
all the risks facing Fannie Mae and Freddie Mac.
There are six risks to consider: credit risk, prepayment risk, interest rate risk from mismatched
duration of assets and liabilities, liquidity risk,
operational risk, and political risk. Much more
could be said about each of these risks, but I
thought it would be useful to discuss each of
them briefly in order to have a complete catalog.
I’ve particularly emphasized the importance
of facing up to the implications of low-probability
events. A low probability must not be treated as
if it were a zero probability. Moreover, extensive
evidence from many different financial markets,
reinforced by similar findings in commodity
markets, indicates that price changes in asset
markets are characterized by fat tails. The probability of large price changes is much higher than
suggested by the familiar normal distribution. In
the case of the 10-year Treasury bond, changes
of 3.5 standard deviations or more are 16 times
more frequent than expected under the normal
distribution.
More generally, the probability of shocks of
many sorts may be higher than one would think.
The accounting problems that surfaced at both
Fannie and Freddie would surely have been
assigned a very low probability two years ago.
Unlike the situation in financial markets, where
a wealth of data permits some formal probability
estimates, the probability of other sorts of events
is much more difficult to judge. For this reason,
I believe that the capital held by F-F should be
at a level determined primarily by the cushion
required should an unlikely event occur rather
than by an estimate of the probability itself. It may

be that the highly volatile interest rate environment of the early 1980s is extremely unlikely to
recur, but I would like to see F-F maintain capital
positions that would enable the firms to withstand
such an environment anyway.
One thing I think I know for sure is this: An
investor who ignores the risks faced by Fannie
Mae and Freddie Mac under the assumption that
a federal bailout is certain should there be a problem is making a mistake.

REFERENCES
Engle, Robert. “Risk and Volatility: Econometric
Models and Financial Practice.” American Economic
Review, June 2004, 94(3), pp. 405-20.
Jaffee, Dwight. “The Interest Rate Risk of Fannie Mae
and Freddie Mac.” Journal of Financial Research,
2003, 24(1), pp. 5-29.
Mandelbrot, Benoit and Hudson, Richard L. The
(Mis)Behavior of Markets. New York: Basic Books,
2004.
Poole, William. “Housing in the Macroeconomy.”
Federal Reserve Bank of St. Louis Review, May/June
2003, 85(3), pp. 1-8.
Poole, William. “The Risks of the Federal Housing
Enterprises’ Uncertain Status.” Panel on Government
Sponsored Enterprises and Their Future. In
Proceedings: 40th Annual Conference on Bank
Structure and Competition, May 2004, Federal
Reserve Bank of Chicago, pp. 464-69.
Posner, Richard A. “The Probability of a Catastrophe...”
Wall Street Journal, January 4, 2005, p. A12.
U.S. General Accounting Office. Government
Sponsored Enterprises: Federal Oversight Need for
Nonmortgage Investments. GAO/GDD-98-48.
Washington, DC: 1998.

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