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Fed's Poole Says Crisis Is Possible for Fannie Mae, Freddie Mac
By Craig Torres

Washington, March 10 (Bloomberg) -- Government-sponsored mortgage lenders such as Fannie Mae and Freddie Mac may not be adequately capitalized to weather a financial shock and pose a risk to the financial system and U.S. economy, St. Louis Federal Reserve President William Poole said.

``Fannie Mae and Freddie Mac are not'' backed by the credit of the U.S. government ``and hold capital far below that required of regulated banking institutions,'' said Poole said in the text of speech to an Office of Federal Housing Enterprise Oversight.

``Should either firm be rocked by a mistake or by an unforecastable shock, in the absence of robust contingency arrangements the result could be a crisis in U.S. financial markets.''

The government should withdraw an implied sponsorship for the institutions that financial market participants read as an implicit guarantee that the U.S. would bail out the firms in time of trouble, Poole said. Both institutions should also boost their capital to levels more similar to that required for banks and other regulated institutions.

Poole did not speak about the direction of interest rates or the state of the U.S. economy in the text of his remarks.

The risks to the economy of problems at Fannie Mae or Freddie Mac are magnified by the fact that mortgage debt represents 30 percent of all debt issued by nonfinancial companies in the U.S., up from just 5 percent at the end of World War II.

``Any serious instability in the financing of residential capital stock has the potential for significant effects not only on the housing industry but also on the entire economy,'' Poole said.

Contagion and History

An event involving one firm would likely bring the other closer to crisis as well, he said. ``It is not sufficient for any single GSE to argue that its own financial condition is sound. If one GSE comes under a cloud, others may also,'' Poole said. ``It is the process economists call `contagion' whereby uninvolved or innocent firms are affected because the market has difficulty distinguishing solid firms from those at risk.''

Poole said that both Fannie Mae and Freddie Mac use models to measure the quantifiable risks of changes in credit quality and interest rates. He said the danger resides in nonquantifiable risks and ``unpredicted crises,'' which, he said, occur far more often than is recognized. He cited the failure of the Penn-Central railroad, the hedge fund Long Term Capital Management, Continental- Illinois bank, Enron Corp. and Worldcom Inc.

``There is tremendous ambiguity about the status of the'' government-sponsored enterprises, Poole said. ``The market prices the GSE's debt as if there were a federal guarantee, or a high probability of guarantee, standing behind their entire outstanding obligations. Yet there is no explicit guarantee in the law.''

Poole also criticized the capital levels of the mortgage lenders, especially since their liabilities are dependent on short- term instruments. Any short-term funding squeeze could turn into a crisis in financial markets ``very quickly,'' Poole said.

Balance Sheets

A 1992 law states that Fannie Mae and Freddie Mac have a core capital requirement of 2.5 percent of on-balance-sheet assets and 0.45 percent of outstanding mortgage-backed obligations. Government securities dealers carry capital of around 5 percent.

Fannie Mae and Freddie Mac have capital of about 4 percent of their on-balance sheet assets, he said.

``Capital on the books of Fannie Mae and Freddie Mac is well below the levels required of regulated depository institutions,'' the St. Louis Fed president said. ``My sense is that the firms are vulnerable to nonquantifiable risks, because their capital position is low.''

Should either firm be rocked by a mistake or by an unforecastable shock, ``in the absence of robust contingency arrangements the result could be a crisis in U.S. financial markets that would inflict considerable damage on the housing industry and the U.S. economy.''

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