Fannie Mae CEO Frank Raines Addresses the Brookings Institute
December 15, 2000
Remarks Prepared for Delivery By Franklin D. Raines Chairman and Chief Executive Officer, Fannie Mae
"New Frontiers in Financial Institution Risk Management"
December 15, 2000
Financial policy makers the world over are grappling with new challenges to maintain global financial stability, mitigate systemic risk and modernize financial oversight for the Internet Age.
This clearly is a good thing. Financial supervision must keep pace with the changes brought by financial modernization and technology. Financial companies are growing larger, more diversified, more global, more interconnected and more creative in the tools, products and strategies they use.
To illustrate the size and scope of large financial companies today, the two largest banks in America now hold 15 percent of all bank assets in this country. They operate dozens of different businesses, from consumer banking to asset management to commercial banking, including credit cards, auto loans and student loans as well as home mortgages. And they do business in over one hundred countries. And those are just the top two US banks.
As many have suggested, the Internet Age gives us more reason to worry about the so-called "butterfly effect" ? the concept that a butterfly flapping its wings in, say, Taiwan, could touch off a hurricane in Trinidad and Tobago. We have seen how localized financial disturbances can touch off widespread turmoil in rapid and unpredictable ways. Who knew at the time that the collapse of a hedge fund in Connecticut would combine with turmoil in Russia and Asia to create the global credit crunch two years ago?
The stability of the global financial system is not of passing or academic interest to Fannie Mae. We are the sixth largest financial organization in the world in terms of market value, behind Citigroup, AIG, HSBC in the United Kingdom, Wells Fargo and the Allianz Group in Germany. More importantly, Fannie Mae operates at the pivotal center of the American housing finance system. Our job ? what Congress chartered us to do ? is to harness the capital markets to expand mortgage credit and lower mortgage costs so that more Americans can afford a home.
This country is united in support of the policy that homeownership is good for families, communities, society and the economy. Fannie Mae is one of Congress? chosen instruments to deliver this public policy with private sector management, capital and efficiency. The best proof that Congress has made a wise choice is the spread between jumbo and conventional mortgage rates. Right now, Fannie Mae?s work saves the average home buyer nearly $25,000 on their mortgage.
Thus, as you might imagine, Fannie Mae is keenly interested in a smoothly operating financial system. Moreover, in these times of constant change, great ferment and often turmoil in financial services, we ? as a major financial institution ? have both the opportunity and the responsibility to take leadership to enhance the safety, soundness and stability of the financial system. And this we have done.
For the past seven years, Fannie Mae has operated under one of the toughest capital and examination regimes of any financial company in America, thanks to measures that Congress adopted into our charter in 1992. These measures put Fannie Mae out at the cutting edge of safety and soundness protections, and made us a stronger company for it.
But we entered a new realm entirely when, on October 19th, Freddie Mac Chairman Leland Brendsel and I joined Chairman Leach, Chairman Baker and a bipartisan group of members of Congress who oversee the nation?s financial institutions to make an important announcement. Fannie Mae and Freddie Mac would be adopting a package of voluntary initiatives that would enhance the liquidity, transparency and market discipline of our two companies.
I want to recognize and compliment Chairman Baker?s leadership. These initiatives will set the standard not only in the United States, but also around the world. And not only for Fannie Mae and Freddie Mac, but also for all types of large financial institutions. Indeed, Moody?s recently said that the initiatives "could usher in a wave of enhanced financial risk disclosure. This may prove to be one of the more important ramifications of the GSEs? initiatives." And for this, Chairman Baker deserves a great deal of credit.
These new measures are at the vanguard of safety and soundness protections, the kind of advances that the G-7?s Basel Committee and others are recommending for all major financial institutions. Now Fannie Mae is even farther out in front of our industry.
What we now have is an unparalleled, multi-layered approach to safeguarding our financial strength, an overlapping system with fail-safe redundancies. As a result, Fannie Mae is not only one of the financially strongest companies in the world. Our safety and soundness regime is unmatched by any financial institution in the world, a new global standard if you will.
If every financial company had Fannie Mae?s regime of capital standards, regulatory supervision and market transparency, we could all be a lot more confident in the stability of the financial system going forward. We invite ? we encourage ? all financial supervisors, policy makers, and industry participants to take a close, fresh look at Fannie Mae?s cutting-edge safety and soundness regime.
Let me offer a glimpse today.
To start off, let me concede an important point. Fannie Mae has an enormous advantage over most other financial institutions when it comes to safety and soundness. Fannie Mae focuses on one business, managing one asset type, in one country. All we do is manage risk on US residential mortgages.
Unlike some of these diversified financial services companies, for example, Fannie Mae does not have consumer banking, commercial banking, insurance, investment services, brokerage houses and other diverse lines of business to juggle. Fannie Mae does not have to worry about consumer marketing and service. We do not have to worry about shifts in foreign business environments and exchange rates. We do not have to hedge all the different kinds of risks that others do. Unlike these "financial supermarkets," Fannie Mae has one strong product on our shelves.
We don?t even originate or sell this product to consumers. We do not make, process or service home loans. We simply purchase mortgages from lenders or package their loans into securities for the lender to sell. Then we manage and mitigate the credit risk and interest-rate risk on the loans and MBS.
This single asset in our portfolio also happens to be one of the safest, most credit-worthy assets in the world. Studies show that if a homeowner gets into a financial squeeze, she makes the mortgage payment first ? before the credit cards, before the other debt. And behind each mortgage is a rock-solid, tangible asset ? the home and the land it sits on.
And when it comes to managing risk on mortgages, we have another crucial advantage. We do it in volume. We manage millions of mortgages, geographically diversified across the country. This gives us unrivaled experience, expertise and economies of scale. Using automated underwriting technology, we collect and analyze more loan performance data than any other mortgage holder in the market.
As the economist Irving Fisher noted, "risk varies inversely with knowledge." With our scale of data, nobody has more power to reduce mortgage risk than Fannie Mae does.
In short, Fannie Mae?s mono-line business model vastly simplifies our risk management equation. We would agree with Mark Twain when he challenged the conventional wisdom that you should avoid putting all your eggs in one basket. It is actually wiser, he said, to "Put all your eggs in the one basket ? and watch that basket." That is what we do.
The results speak for themselves. Over the past decade, Fannie Mae has steadily advanced our housing mission and business results throughout a wide variety of risk environments. We managed through wide swings in interest rates. We managed through recessions in California, New England and Texas that crippled many banks and thrifts.
Did we get through these tough times by pulling back? Quite the contrary. We have steadily increased our service to lenders and home buyers, grown our portfolio and expanded our affordable housing mission.
We have vastly expanded our low-down payment lending. We have systematically expanded our credit tolerances for the mortgages we will back, helping lenders approve borrowers that used to be rejected, even those with minor credit issues. We have even committed a total of $3 trillion to purchase or guarantee the so-called "hard-to-do" loans and expand homeownership among lower-income families, minorities and other underserved consumers.
Has this made Fannie Mae more "risky"? Again, quite the contrary. Over the past decade, we have actually reduced our sensitivity to interest-rate and credit risk. Our credit losses have reached their lowest level in a generation, even as we have expanded credit tolerances. And when it comes to the bottom line, Fannie Mae has produced a total of 51 consecutive quarters ? nearly 13 year?s worth ? of increasing operating earnings.
The fact is, Fannie Mae is a very low-risk financial intermediary. We take less risk than any major financial institution investing in mortgages. About half of our liabilities are callable, and our credit book is both very high grade and it is enhanced through extensive use of mortgage insurance and other credit enhancements.
Virtually all of Fannie Mae and Freddie Mac?s competitors take much greater levels of risk. They have little or no callable debt and much less credit enhancements. They tend to buy and own mortgage risk. We tend to share mortgage risk with others. Thus, we can pass highly stringent risk-based capital stress tests while others fail them. And we can report stable earnings when others report earnings disappointments.
In its strength, Fannie Mae has even helped to pull the housing finance system through the various economic shocks of the nineties, including the regional recessions and the global credit crunch of 1998. While other financial institutions were struggling and some even failed, we kept low-cost mortgage credit flowing through the system to home buyers. In turbulent times, Fannie Mae has been a shock absorber.
What about the future? In recent years, we have been asking ourselves, as we continue to expand mortgage credit and homeownership, can we also further strengthen our safety and soundness?
We were not alone in asking this question. Bank regulators, academics, policy makers and others who watch the financial markets have raised various questions about the safety and soundness of all financial institutions, and various solutions have been offered. At the same time, many observers generally do not agree which problem ranks as the most important one.
For example, some have pointed to poor management and systems for decision making as the greatest threat to safety and soundness.
Others have focused on problems raised by deposit insurance. You hear about "moral hazard," whether the option of a bailout actually encourages risky behavior. Or you hear about "master-servant" issues, whether a regulator can become captive to the institutions it regulates. The solution to these problems, some observers say, is to require higher capital levels.
Others have said that it is not the level of capital that matters, but whether the capital regulation itself provides incentives for companies to either mitigate their risk or take on additional risk when they run into financial difficulties.
Still others have said that companies can arbitrage any type of capital regulation, so we need to use market discipline to prevent companies from adapting their behavior, even in perverse ways, to any given set of government-imposed rules.
In response to these problems, regulators and market-watchers have articulated varying solutions.
Those who fear poor management want rigorous supervision.
Those who think that supervision is not always quick enough to correct bad practices want high minimum capital levels.
Those who think that minimum capital levels may encourage risky behavior by a failing institution ? the "go-for-broke" scenario ? want stress test-based capital regulations that tie capital levels to the specific types and changing levels of the risks that companies are taking.
And there are those who think that government regulation is not sufficient to ensure a safe and sound system, and that we need to take advantage of the market?s expertise in measuring whether companies are well-managed and capitalized. Some of those who hold this opinion tend to think that we should use the rating agencies to give a market view of a company?s financial position.
But others may think that the rating agencies are not the right conduit for this information, and they support using a more direct signal of the whole market?s view of a company through the pricing of subordinated debt issuances.
Fannie Mae?s approach was not to pick and choose among these various solutions. We will have them all. Since 1992, we have had the first three: rigorous supervision by a regulator, minimum capital levels set in statute, and a risk-based capital test based on a stress test.
On that strong foundation, we added the other two approaches when we adopted our voluntary initiatives to enhance our transparency and market discipline ? most notably, external ratings and subordinated debt.
Now, if there is any question about the significance of our new initiatives, Chairman Baker, who has been very focused on the matter, voiced an unambiguous view of what we had adopted. He said, "This proposal does plow new ground for a cutting-edge model for financial institutions. In my opinion it exceeds any standard for any domestic or international financial model anywhere."
Indeed, it is now safe to say that Fannie Mae has the most comprehensive configuration of protections against risk and loss of any financial institution in the world, with all five of the approaches recommended by regulators and market-watchers.
Let?s call the five elements "risk mitigators." Some of them, of course, are common to other financial institutions. Others ? as Chairman Baker noted ? are at the cutting edge. But Fannie Mae and Freddie Mac are the only major financial institutions in the world that have all five of these risk mitigators.
Let me expand on each of the five.
First, we have supervision by an examiner, like every regulated institution. Our exams closely resemble those done by the OCC and the Fed. What?s different is that our regulator ? OFHEO ? has some distinct advantages.
We have relatively more examiners on the job. OFHEO has 26 examiners looking at two companies ? us and Freddie Mac. That?s a 13-to-1 ratio. The OCC has about 1,900 examiners for 2,500 entities, less than a one-to-one ratio. The FDIC has about 1,800 examiners for 5,800 entities, meaning that, on average, each examiner has to watch three banks.
Now, the number of examiners assigned to the largest financial institutions is about on par with the number assigned to Fannie Mae. But again, others tend to have multiple lines of complex businesses all over the world. Our examiners are watching a single, relatively simple line of business in one country.
The biggest difference, though, is that bank exam results are not made public. Fannie Mae?s exam results are public information. Our financial regulator reports its findings to Congress, puts them on the Internet and puts out a press release. If there is anything wrong, everybody in the world knows about it, and the market can impose its discipline.
The second of our five risk mitigators is our minimum capital requirement.
Again, most financial institutions ? particularly depository banks ? have this requirement. Fannie Mae must hold 250 basis points of capital against our on-balance sheet assets to cover our interest-rate and credit risk. And we hold an additional 45 basis points against the mortgage-backed securities we guarantee but do not own, to cover the credit risk.
Over the past year, we?ve heard discussion over whose minimum capital standards are higher and who has better quality capital. It is not an easy issue to parse, since everybody has different assets with different risks to hold capital against. For example, our single asset ? US home mortgages ? is secured by real estate and mortgage insurance, while bank credit card debt is unsecured. Our minimum capital requirement was proven to be more than adequate through all of the economic gyrations of the past decade.
Nevertheless, as I will explain later, we have agreed to increase our capital to 4 percent of on-balance sheet assets through the issuance of subordinated debt.
What makes Fannie Mae?s capital requirements exceptional, in any event, is that our minimum capital standard is bolstered by a risk-based capital standard with a stress test ? the third of our five risk mitigators.
Recently, I read the speech by the Basel Committee chairman, William McDonough, to banking supervisors in Basel, Switzerland last September. And I was struck by his depiction of the shortcomings of the current bank capital. "One significant weakness," he said, is that the leverage ratio banks use "may provide banks with the unintended incentive to take on higher risk exposures without requiring them to hold a commensurate amount of capital."
To repair that flaw, the Basel Committee is looking at a new way for banks to weigh risk and hold capital against loss, an internal "ratings-based" approach. Essentially, you weigh the actual risk of each individual loan and borrower. You then determine the severity of your losses if the loan should default. Then you take this data, add it up on all your loans, and use that to establish how much capital to hold. The more risk and loss you project, the more capital you hold.
That is almost precisely the way Fannie Mae has managed our risk and set our capital holdings for almost a decade.
In 1992, Congress beefed up our financial regulation by providing a new risk-based capital model. Through our underwriting technology and other means, we constantly weigh the actual risk of each individual loan we hold or securitize. Then, instead of holding a simple ratio of capital against our assets, like banks do against their deposits, we have to hold enough capital to withstand a severe financial stress test.
Essentially, we must ask, "what if interest rates rose or fell by as much as 600 basis points and stayed that way for ten years?" Then we ask, "what if the oil-patch recession of the eighties, and all the credit losses from that, also hit the whole country during that same ten-year period?"
But we're still not done. Then we have to add 30 percent more capital for management and operations risk. So we must hold 130 percent of the capital necessary to survive the ten-year test.
As you might imagine, very few financial institutions could survive this stress test. As former FDIC Chairman William Seidman has noted, "The risk based capital standard set forth in the 1992 GSE Act creates a very stringent capital standard, one that could be devastatingly stringent if applied to most other financial institutions."
Indeed, according to one study, if the dire scenario in our stress test ever came to pass, most thrifts would deplete their capital base in five to seven years and become insolvent. After ten years of this scenario, Fannie Mae and Freddie Mac may well be the only major holders of mortgage assets in America still standing.
Our regulator is still finalizing our risk-based capital rule. But we have been operating under the model since 1993. And under our voluntary initiatives, we will also begin to self-administer the stress test every quarter. And we will issue the results ? as well as the underlying assumptions ? to the public. After the OFHEO rule is adopted our regulator will announce the results on a quarterly basis.
If you sense a pattern here, there?s more. We believe ? as the Basel Committee does ? that transparency is a powerful tool for making a financial company more safe and sound through market discipline. Having a strong regulator is one good way to provide discipline. But as Chairman Greenspan said last month, "regulators are being pressed to depend increasingly on greater and more sophisticated private market discipline, the still most effective form of regulation."
Fannie Mae is taking extra measures ? going beyond our requirements and beyond the norm ? to open our books and invite the market to scrutinize, judge and react to our risk profile, capital adequacy and financial health. We are inviting the market to look at us from several sources and angles on a regular, ongoing basis.
That is what our fourth risk mitigator is also about. We are going to commission annual reviews by an independent, external ratings agency, and make the results public.
This has been done a couple of times. In 1997, after our financial regulator asked Standard & Poor?s to rate Fannie Mae?s risk to the government, we received a AA- rating. In this rating, S&P cited our consistently strong profitability and our improvements in hedging, especially our ability to weather changing market conditions and interest rate environments.
Let me emphasize that the S&P study did not assess our risk assuming our debt was guaranteed by the government. S&P looked at the likelihood that the government would have to step in. By giving us the AA-minus rating, the S&P indicated that our risk to taxpayers was very low. In fact, our AA-minus rating is higher than 99 percent of banks in America.
As part of our voluntary initiatives, we are now going to have this kind of independent rating on a regular basis. We are going to commission a nationally recognized statistical rating organization to examine our books, judge our overall financial strength, give us a rating and make it public.
On top of disclosing our stress-test results and our external rating, Fannie Mae will also report every month on the impact that changes in interest rates could have on our financial condition, and quarterly on the impact of changes in home prices on our guarantee business.
We already have a regular report looking back. It is our earnings record, which again shows long-range, stable growth even during sharp changes in interest rates and home prices. Now we will keep the market posted on how the economy is affecting our interest rate and credit risk profile, as we go forward.
Finally, rounding out our voluntary initiatives as our fifth risk mitigator, Fannie Mae will begin issuing subordinated debt, which will be externally rated and publicly traded.
This will promote market discipline even more. In the event that our core capital were to fall below a certain level, our subordinated debt holders would have their interest payments automatically suspended. Essentially, sub-debt investors are the "canary in a coal mine."
As the FDIC has recognized in the case of sub-debt issued by banks, the market tends to constantly assess the issuer?s conditions and prospects, and adjust the price of the sub-debt accordingly. And every time you issue new sub-debt, the market re-evaluates your condition.
But there is a crucial difference between bank sub-debt and Fannie Mae?s sub-debt. Ours will be a lot tougher on us. Here?s why.
Sub-debt exacts market discipline only if the debt holders are subject to real risk. The canary has to die when there are fumes in the mineshaft, well before the explosion. However, the majority of sub-debt issued by banks to the public has no provision for the suspension of interest payments. And for the few that do, the bank decides when to trigger the suspension. Theoretically, the bank could simply hold off triggering the suspension to avoid alarming the market.
Not so with Fannie Mae?s sub-debt. If our capital falls below a certain level, our sub-debt holders stop receiving interest payments.
Another crucial element for sub-debt to work is that investors have to know it is subordinated. Sub-debt holders have to know they?re the canaries. And you can be sure investors will be able to tell the difference between our senior debt and our sub-debt.
The offering documentation for our sub-debt issues will make the extra risk very well known. But if there is any confusion about that, the market will tell you the difference. No matter what some observers might say, investors know that the government does not guarantee our senior debt. That?s why our Benchmarks always trade with significantly higher interest rates than Treasuries. Market analysts are estimating that our sub-debt initially will trade with interest rates 20 to 30 basis points higher than our senior Benchmark securities.
But if the market is confident in Fannie Mae, the performance of our sub-debt might improve over time and this differential to our senior debt may narrow, but not disappear. We believe the market will be confident in Fannie Mae because this is a company with a consistent, unassailable record of financial safety and soundness.
We?ve all heard the old joke that goes, "how many Chicago School economists does it take to change a light bulb?" And the answer is, "none ? if the bulb needed changing, the market would have already done it." You don?t have to be from the Chicago School to put your faith in the market. And clearly, the market has a lot of faith in Fannie Mae.
When the market looks at us, it sees a strong, well-capitalized company in a growing, healthy industry. It sees a company with a simple, efficient business model managing risk on a single, safe, well-collateralized asset, in one country. The market sees a financial company that has one of the strongest safety and soundness regimes in the industry, with an exceptional capital and examination regime.
And now when the market sees Fannie Mae, it sees a financial company that is willing to go above and beyond what is required in terms of transparency and market discipline.
If any market participant should wonder how Fannie Mae is doing, they have more ways to tell than ever. You can look at the report on our supervision exams. You can look at our capital levels. You can look at our regular stress test results. You can look at our external rating reports. You can look at our reports on how interest rates and home prices are affecting our business. You can also look at the value of our subordinated debt. No financial company in the world will tell you more about its financial condition than Fannie Mae does.
With our five-sided safety and soundness regime ? supervision by examiners, minimum capital requirements, risk-based capital with a stress test, review by rating agencies, voluntary disclosure and subordinated debt ? the market has even more reason to be confident in Fannie Mae than ever.
Fannie Mae has now responded to the best thinking in the world about financial safety and soundness. If everyone in the financial system adopted Fannie Mae?s five-part safety and soundness regime, it is certain that risk in the global financial system in the Internet Age would be dramatically lower.
We are happy to be a model for others to emulate, and if any other financial institution wants to join us at the vanguard and adopt our safety and soundness regime, we would applaud them and share our experience.
Source: Fannie Mae