YOU ARE HERE: LAT HomeCollections

Fannie Mae, Freddie Mac Face New Scrutiny Over Derivatives

Securities: Critics including Greenspan question the use of such complex contracts by the two mortgage giants.


NEW YORK — Enron Corp.'s extensive use of derivatives has been widely blamed for masking financial problems at the Texas energy trading company, which collapsed late last year. Now some are criticizing the use of these complex contracts in another business, the mortgage market.

Federal Reserve Chairman Alan Greenspan last week took aim at the use of derivatives by the two government-sponsored behemoths of mortgages: Fannie Mae and Freddie Mac.

The Federal National Mortgage Assn., created by Congress during the Depression, and later the Federal Home Loan Mortgage Corp. were given access to emergency lines of credit from the government and exemptions from some securities regulations. Their mission is to create a secondary market in mortgages to make it easier for Americans to buy homes.

Though backed by the government, Fannie Mae and Freddie Mac are private companies with shares trading on the New York Stock Exchange. They have grown so large that they are involved in nearly half the mortgages written in the country.

Greenspan long has opposed government subsidies for private business, arguing that they give the recipients unfair advantages and distort the free market.

He expanded on his concerns last week, saying in a video address to the Institute of International Finance that even the perception of government support might induce institutional investors in the mortgage companies "to apply less vigorously some of the risk controls that they apply to manage their over-the-counter derivatives exposure."

Fannie Mae and Freddie Mac buy mortgages written by banks, brokers and mortgage companies. They then "package" them and sell investors securities based on the mortgage packages. The process keeps money flowing into the mortgage market.

Derivatives come into play for mortgages that Fannie Mae and Freddie Mac purchase and hold in their own portfolios. Derivatives are contracts--generally with money-center banks and large institutional investors--whose value is based on the performance of an underlying asset, and they are used to hedge, or reduce the risk from, interest rate fluctuations.

Both Fannie Mae and Freddie Mac were quick to respond to Greenspan's criticism.

Jayne Shontell, Fannie Mae's senior vice president for investor relations, said in a statement that the companies involved in the hedges "are large, sophisticated, leading financial institutions." She added that "we see no evidence that our derivatives counterparties are applying anything less than careful credit judgment in their transactions with us."

Freddie Mac spokesman David Palombi emphasized that derivatives were used to reduce interest rate risk, not for speculation. Big investors "evaluate us very thoroughly--just as much as we evaluate them," he said.

This is not the first time the issue of derivatives in the mortgage market has arisen. In spring 1999, an alliance of banks, brokerages and mortgage companies that were alarmed at the increasing dominance of Fannie Mae and Freddie Mac came together as FM Watch.

Its Web site,, rails against what it sees as "risky hedging in the derivatives market" by Fannie Mae and Freddie Mac and other activities it believes undercut competition in the mortgage market.

Charles A. Gabriel Jr., an analyst at Prudential Financial in Washington, said critics would have a tough time getting Congress to act because the companies have been so successful in helping millions of families obtain mortgages. Two-thirds of Americans own their homes.

"Even the critics can't dispute the fact that Fannie and Freddie have made the mortgage process more efficient and cut the cost of a mortgage by at least a quarter of a percentage point for the average American," Gabriel said. "This system is the envy of the world."

He argued that the companies were able to do this with an "implicit government subsidy," which requires no cash outlay. Take away the credit lines and other concessions, he said, and the government might have to support housing with cash subsidies--something it would be loath to do at a time of deepening budget deficits.

Fannie Mae and Freddie Mac also have good reputations for financial soundness.

Moody's Investors Service, which long has rated the companies' debt securities, earlier this year gave them each a "bank financial strength" rating of A-minus, making them among the highest-rated financial firms globally.

Los Angeles Times Articles