Warnings Shadowed Firms' Rapid Growth

Could they get into trouble?

Fannie Mae nearly did in the 1980s. It borrowed money short-term at low rates, bought long-term mortgages that carried higher rates, and made a profit off the difference.

When interest rates shot up, the company found itself holding a big block of mortgages with rates that were far below market. Homeowners clung to those loans, and Fannie Mae, forced to refinance its own debt at higher and higher rates, plunged into the red. At one point the company was losing $1 million a day.

But a combination of timely easing of rates and the leadership of then-Chairman David O. Maxwell allowed the company to survive. It adapted, including by developing mortgage-backed securities, a technique pioneered by Freddie Mac in which purchased loans are pooled and securities based on them are sold to other investors, shifting interest-rate and other types of risks to them.

And both companies began using various hedging techniques to offset interest-rate movements. The techniques ranged from issuing "callable" debt that can be prepaid if interest rates fall, to using derivatives that are supposed to move in the opposite direction of interest rates.

Those devices have been put through "stress tests," designed to measure what would happen if interest rates move dramatically, and both firms say they work.

But the revelation last year that Freddie Mac had been employing improper accounting methods to smooth earnings sharpened criticism and undermined the confidence in the two organizations.

"In the case of Freddie Mac, this huge company basically outran its internal controls," Stanton said. "If that happens, you begin to lose control over a huge volume of transactions," which can cause damage to a wide range of other parties.

The risks posed by the two giants, should one or both get into trouble, fall into different categories, said Peter Wallison of the American Enterprise Institute.

First, there is "taxpayer risk," the risk that taxpayers "will be required to pony up the money necessary to fill up a hole of some kind from losses" the companies suffer.

Then there is "systemic risk," he said. That derives first from the fact that Fannie Mae and Freddie Mac securities "form a major investment for many banks throughout the financial system, especially small banks. But even large ones have very substantial portions of their capital in Fannie and Freddie debt." A reduction in the value of that debt might limit their ability to lend and result in "a restriction on the growth of economy," he said.

Additionally, Wallison said, the two companies "are absolutely integral to the residential finance market, so that an inability of Fannie Mae and Freddie Mac to borrow, or a sharp increase in the interest rates they have to pay, would make it very difficult for people to buy homes."

Housing is a $6 trillion to $8 trillion market, and a slowdown would ripple beyond real estate transactions into "everything people buy when they buy homes," he added.

So how worried should people be?

There were no major problems in the financial system after Freddie Mac's disclosure of similar problems.

"It very, very hard to gauge," Wallison said. Five years ago, he said, he would have thought it unlikely that either company would get into trouble. "Now, since what happened with Freddie Mac, I don't think anyone can be confident that he or she understands the underlying financial condition of these companies."