Managing Risk
1. Interest-rate risk.
Interest-rate risk is common in any institution that loans money at fixed rates. When interest rates drop people rush out to refinance to take advantage of lower rates. This pre-payment risk poses problems for Freddie Mac and Fannie Mae's business. If a large portion of their higher-interest loans pay off and are replaced by lower-interest loans, the companies must be able to "match" those new loans with lower-interest debt. If they can't refinance their own debt--in the same way homeowners do--Fannie and Freddie will lose money.
(Linda Spillers -- AP)
|
|
One of the ways Fannie and Freddie reduce exposure to interest-rate risk is using complex financial contracts known as derivatives. In early 2002, PricewaterhouseCoopers, Freddie Mac's auditor, found that Freddie Mac was not accounting for some derivatives properly on its financial statements, causing Freddie Mac to restate three years of results.
An internal company investigation into the earnings restatement led to the firing of David W. Glenn, president and chief operating officer, for allegedly altering documents. The company's chief executive and chief financial officer were also asked to retire and resign, respectively. Following the management shake-up, a formal investigation by the SEC and a criminal probe by federal prosecutors were launched.
2. Default risk
Default on mortgages jeopardizes the financial health of both companies because they have guaranteed hundreds of billions of dollars in mortgage-backed securities. Mortgage-backed securities investors rely on timely mortgage payments by individual homeowners. If homeowners default on their mortgages, Freddie and Fannie are on the hook to make sure mortgage-backed securities investors get their money.
3. Political risk.
Given the recent management shake-up at Freddie Mac, both companies face the possibility that the federal government will impose tighter operating rules that could hurt profitability, such as requiring the companies to set aside more capital to cover risks.
Proponents of tougher regulation on Fannie and Freddie include FM Policy Focus, headed by a powerful former congressman and comprised of large banking industry trade associations. The group lobbies to keep the companies from expanding beyond their congressionally chartered mission of buying home loans.
However, both companies have clout in Washington and a history of success in managing these political obstacles. In the last election cycle, Freddie Mac was the largest corporate contributor of unlimited "soft money" donations to the political parties, according to PoliticalMoneyLine.
Washington Post Business Editor Terence O'Hara contributed to this report
