Alan Greenspan, chairman of the Federal Reserve, threw a chill into shares of both Fannie Mae
Now, how something is "almost inevitable" is beyond me, but Chairman Greenspan is not one for using one word when six of varying etymological origin will do. He also said that the risks at present were "virtually negligible," which if I parse means something like "a facsimile of almost nothing."
The combined portfolios of the two federally chartered companies exceed $900 billion. Greenspan added that, "if they continue to grow, continue to have the low capital they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest-rate risk aversion, they potentially create ever-growing potential systemic risks down the road." Greenspan further suggested that the companies could hold onto as many Treasury bills as they choose, but elect not to since there is no spread for them "to exploit." His suggestion is that the two be limited to portfolios of no more than $200 billion.
This is a repeat of the testimony he gave last year, when he claimed that Fannie and Freddie would threaten the economy if they were allowed to continue to grow, and also follows up on a 2003 Federal Reserve study showing that the two enterprises, for all of their activity and dollar shuffling, do precious little to lower mortgage costs for consumers. But this time around, Greenspan stated a palliative -- carve back these portfolios by as much as 85% -- and called on Congress to set limits. As we noted before, accounting scandals at both companies have given legislators the motivation and cover to do just that.
Let me see if I can boil all of this down. Fannie and Freddie can borrow an unlimited amount of money at below-market rates, for all intents and purposes giving them unlimited potential growth. They both have extraordinarily thin slices of capital to back up the debts, so they have to engage in enormous derivatives transactions in order to hedge their own risks.
But Congress didn't create Fannie and Freddie just so they could securitize mortgages in whatever quantities they wished to generate profit. These entities were formed for a greater good -- to provide liquidity to the mortgage business, making it easier for Americans to buy homes.
But in the time since Fannie and Freddie were founded, the collateralized mortgage obligation has grown infinitely more efficient, and the demand for higher-yielding investments among institutional investors like hedge funds and pensions has created outlets for liquidity in the secondary market in competition with Fannie and Freddie. This being the case, there's not much need for these companies to have portfolios of the size they have at present, except to drive profits at the firms.
Greenspan's point is simple: These are government-sponsored entities. While they should not be prevented from profiting to the benefit of their shareholders, the pursuit of such should only take place (a) in so much as it furthers their charters, and (b) not at the expense of the increased risk of creating a financial disaster that they come nowhere close to having the wherewithal to handle in the case of a default.
As I said before, the financial misdeeds at Fannie and Freddie portend nightmares for shareholders and their previously toothless regulator in Washington suddenly finds itself with plenty of friends on Capitol Hill. That might not have been enough to get anything passed, but add in the warnings of America's chief economist and the likelihood of some heavy pruning of their portfolios and activities is much, much higher.
Philip Durell recommended Fannie Mae for Motley Fool Inside Value subscribers. Want to find out why? Take a free, no-obligation trial today.
Bill Mann 's got no ARMs. He holds shares in none of the companies mentioned in this story. The Motley Fool is investors writing for other investors.
