Magazine article Insight on the News

Fed Wizard's Policies Not Economic Magic

Magazine article Insight on the News

Fed Wizard's Policies Not Economic Magic

Article excerpt

Byline: Christopher Whalen, SPECIAL TO INSIGHT

In February testimony before the U.S. Senate Banking Committee, Alan Greenspan said "the Federal Reserve is concerned about the growth and scale" of the swelling mortgage portfolios of Fannie Mae and Freddie Mac. Created by Congress in 1938 and 1970, respectively, Fannie and Freddie are privately held corporations that facilitate mortgage lending in the United States but benefit greatly by the market's assumption that Uncle Sam stands behind their obligations. Since the two giants function by purchasing residential mortgages from originating banks and reselling those loans as mortgage-backed securities, the rate they are charged to borrow money is reduced by the effective subsidy accorded by the U.S. Treasury.

"Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage risk by holding greater capital," Greenspan warned, and raised the possibility that a financial hiccup by one or both of these highly leveraged entities could pose a "systemic risk" to the global financial system. He explained in a nationally televised appearance that government supports for such government-sponsored enterprises (GSEs) as Fannie Mae and Freddie Mac are the equivalent of subsidies which might be leading investors to underestimate the risk of dealing in their securities. Indeed, in the third week in April, Greenspan confirmed that the European Central Bank in July 2003 responded to an unfolding accounting scandal at Freddie Mac by planning to shed holdings of all Fannie Mae and Freddie Mac debt.

Echoing Greenspan's warning, U.S. Treasury Secretary John Snow said on April 22 that continued growth of the giant government-sponsored enterprises Fannie Mae and Freddie Mac could pose a threat to financial markets. "There are clear systemic risks in the continued growth of entities this large relative to the whole financial system," Snow said at a meeting of the Bond Market Association.

Though the most recent warnings of Greenspan are welcome and indeed overdue, it is worth noting that the Fed under his leadership has encouraged the creation of gigantic institutions that pose just as great a "systemic risk" to the U.S. financial system as do Fannie or Freddie, several close observers of the Fed say. Since the last U.S. banking crisis in 1991, it has been the policy of the Fed to encourage big banks to merge and embrace derivatives as a primary source of profitability, not just for risk reduction.

Of the 575 U.S. bank holding companies and single-unit institutions active in the derivatives market in the fall of 2003, 138 held notional value positions in excess of their weighted risk-based capital (RBCW), as reported to the Federal Deposit Insurance Corp (FDIC). At the top of the pile was J.P. Morgan Chase (JPM) with $34.3 trillion in notional contracts outstanding, some 49.8 percent of total positions held by banking institutions. JPM is also the least profitable a relatively small realized loss in the notional position, a mere 15 basis points, would create a loss equivalent to JPM's entire RBCW. Significantly, the Top 20 institutions represent 97.6 percent of the notional contracts held by banks involved in derivatives, some $67. …

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