OFHEO on Systemic Risk

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Peter Spengler drew my attention to the OFHEO report on systemic risk
and Fannie Mae and Freddi Mac.

He reported that the day after the report was present to Congress, the
director of OFHEO, Amando Falcon, was fired and replace from someone
from JPMorgan.

Interesting if true.

Henry C.K. Liu

Note:

Recent analyses of systemic risk have concluded that some non-bank financial
institutions are now so large and integral to the financial sector as a
whole that their failure could
lead to a systemic event.1 Fannie Mae and Freddie Mac—the two
government-sponsored
enterprises (GSEs) chartered by the federal government to support the
secondary market for
residential mortgages2—are among the largest non-bank financial
institutions in the world.
Thoughtful observers have expressed concern that, if either of those
Enterprises experienced
severe financial difficulties, turmoil in the market for GSE debt could
become severe and spread
to other financial markets, substantially increasing systemic risk.3
Factors cited as justifying that
concern include the huge size of the outstanding debt and
mortgage-backed securities4 (MBS) of
Fannie Mae and Freddie Mac, and the fact that, although investors
perceive an implicit federal
guarantee of those obligations, the government has provided no explicit
legal backing for them.5

3 See, for example, W. Poole, “Financial Stability,” Economic Review,
Federal Reserve Bank of St. Louis, Vol. 84,
No. 5 (Sept./Oct. 2002), 1-7 at 5-6. The author is the president and
chief executive officer of the Federal Reserve
Bank of St. Louis.

Poole of course started the press focus on Fannie Mae's inadequate
capital base in a sppech last week.



Full report:
http://www.ofheo.gov/docs/reports/sysrisk.pdf

Section Three: The Effect of Consolidation and Use of Over-the-Counter
Financial Derivatives on Systemic Risk
Traditionally, concerns about systemic risk focused primarily on the
possibility that bank
failures could lead to contagious runs in which retail depositors fled
to currency, triggering a
decline in the money supply, a breakdown in payment and settlement
systems, and an
interruption of bank lending.117 There is much less concern about those
possibilities today
because of the existence of deposit insurance, the track record of
central banks in providing
liquidity to the banking system in times of potential crisis, and the
improvements in banking
supervision since the Great Depression.
Economists, financial regulators, and policymakers now focus more on the
systemic risk
associated with the wholesale activities of financial institutions and
markets. Those activities
include overnight loans among banks, the clearing and settling of
large-value transfers of funds
and securities, and trading in markets for government and corporate debt
and other fixed-income
securities, foreign exchange, and financial derivatives. Recent studies
have addressed the
question of how two trends—consolidation among banks and the rapidly
growing use of overthe-
counter (OTC) derivatives—have affected the systemic risk posed by
wholesale activities.
Consolidation Among Banks
In the 1990s, rapid consolidation in the financial sector reduced the
number of banks in
the U.S. by about one-third.118 During that period, the largest
institutions grew substantially in
terms of total assets, share of banking industry assets, and assets
relative to GDP. For example,
the share of industry assets of the 50 largest banks increased from 49
percent at the end of 1990
to nearly 63 percent at year-end 1998.119 A recent study by the Group of
Ten addressed the
question of how those trends affected risk in the financial sector.120
That study concluded that
diversification gains seem likely to accrue from consolidation across
regions of a given nation
and from consolidation across national borders, as well as from
consolidation across financial
products and services. However, consolidation may also increase
operating risks and managerial
complexities. Moreover, the larger firms that result, in part, from
consolidation have a tendency
either to participate in or otherwise rely more heavily on “market”
instruments, which exposes
them more to rapid declines in market prices and increases the potential
speed at which they may
experience financial declines.121 Overall, the study found that the net
impact of consolidation on
www.federalreserve.gov/pubs/staffstudies/2000-present/ss174.pdf
117 Group of Ten, op. cit., 14-15, 132. For discussions of the changing
nature of systemic risk, see International
Monetary Fund, “Managing Global Finance: Private and Public Challenges
Raised by Last Fall’s Mature Market
Turbulence,” in International Capital Markets: Developments, Prospects,
and Key Policy Issues (September 1999),
118-168; and Schinasi, et. al., op. cit.
118 Rhoades, S.A, Bank Mergers and Banking Structure in the United
States: 1990-1998 (Washington, DC: Board
of Governors of the Federal Reserve System, August 2000), 23-25,
available online at
and Bassett, W.F., and E. Zakrajsek, “Profit and
Balance Sheet Developments at U.S. Commercial Banks in 1999,” Federal
Reserve Bulletin (June 2000), 367-395 at
368, available online at
http://www.federalreserve.gov/pubs/bulletin/2000/0600lead.pdf. For an
analysis of bank
consolidation, see Shull, B., and G. Hanweck, Bank Mergers in a
Deregulated Environment: Promise and Peril
(Westport, CT: Quorum Books, 2001).
119 Rhoades, op. cit., 24.
120 Group of Ten, op. cit.
121 Ibid., 14-15, 128-132.
30
the risk of individual institutions is unclear and must be assessed on a
case-by-case basis. The
study also found that the impact of consolidation on the systemic risk
posed by the financial
sector is uncertain.122
The Group of Ten study also argued that increasing size and the growing
complexity of
the activities of large financial institutions has probably increased
the challenges of identifying
solvency problems and resolving failed institutions in a timely fashion.
The study concluded
that:
It seems likely that if a large and complex banking organization became
impaired,
then consolidation and any attendant increase in complexity may have, other
things being equal, increased the probability that the work-out or
wind-down of
such an organization would be difficult and could be disorderly. Because
such
firms are the ones most likely to be associated with systemic risk, this
aspect of
consolidation has most likely increased the probability that a wind-down
could
have broad implications.
Important reasons for this effect include disparate supervisory and
bankruptcy
policies and procedures both within and across national borders, complex
corporate structures and risk management practices that cut across
different legal
entities within the same organization, and the increased importance of
marketsensitive
activities such as OTC derivatives and foreign exchange transactions. In
addition, the larger firms that result, in part, from consolidation have
a tendency
either to participate in or to otherwise rely more heavily on “market”
instruments.
Because market prices can sometimes change quite rapidly, the potential
speed of
such a firm’s financial decline has risen. This increased speed,
combined with the
greater complexity of firms caused in substantial degree by
consolidation, could
make timely detection of the nature of a financial problem more
difficult, and
could complicate distinguishing a liquidity problem from a solvency
problem at
individual institutions.
The importance of this concern is illustrated by the fact that probably
the most
complex large banking organization wound down in the United States was the
Bank of New England Corp. Its $23.0 billion in total assets ($27.6
billion in 1999
dollars) in January 1991 when it was taken over by the government pale in
comparison to the total assets of the largest contemporary U.S. firms,
which can
be on the order of $700 billion.123
The Group of Ten study also measured the interdependencies among large,
complex
banking organizations (LCBOs) in the U.S. The study found that direct
interdependencies of the
average LCBO in the U.S., as measured by the ratios of short-term
interbank loans to capital and
of the positive market value of derivatives contracts to capital,
increased substantially in the
122 Ibid., 14-15, 131.
123 Ibid. See also the analysis at 132-135.
31
1988-1999 period.124 The same study found that the total (direct and
indirect) interdependencies
of the average LCBO, as measured by the correlations of the stock
returns of sampled banks, also
increased significantly during that period.125 As noted above, an upward
trend in direct
interdependencies, relative to capital, among large financial
institutions implies that when an
adverse shock leads to the failure of one institution, there is greater
likelihood of spillover effects
on other institutions. Likewise, a higher level of indirect
interdependencies among institutions
means a greater likelihood that an adverse shock will result in
correlated losses at those
institutions. It is not clear, however, what level of consolidation, or
level or type of
interdependencies increases the risk of spillover effects and correlated
losses enough to make the
financial sector unacceptably vulnerable to a shock.
A recent paper attempted to quantify the risk of large spillover effects
resulting from
direct interdependencies among banks in the U.S. by simulating the
potential effect of the failure
of a large bank on other institutions that have bilateral credit
exposures to the failed bank arising
from overnight Federal funds transactions.126 The simulations assumed
that counterparties of the
failed bank suffered two rates of loss on their exposures: 40 percent
and five percent. Under the
first assumption of a 40 percent loss rate, the study found that the
failure of the largest bank in
the Fed funds market would cause the failure of two to six other
primarily smaller banks holding
less than 1 percent of total bank assets.127 If the two largest debtor
banks failed, fewer than 10
other banks would fail. Under the second assumption of a five percent
loss rate, which is
consistent with the loss rate of uninsured depositors at Continental
Illinois National Bank, the
initial failure(s) would cause no other banks to fail.128
Those results arguably should be interpreted as lower bound estimates,
as the simulations
did not consider interbank exposures through other channels.129
Aggregate interbank exposures
may be much higher than federal funds exposures alone, however, and the
risk of large losses
from cascading bank failures may be significant. Importantly, the
simulations also illustrate that
the magnitude of credit exposures among interdependent financial
institutions and the expected
losses given default are both important determinants of the degree of
spillover effects and the
potential for contagion.130
Growing Use of Financial Derivatives
The term derivative refers to a variety of bilateral contracts whose
value derives from an
underlying asset, reference rate, or index. The most common derivatives
embody forward
contracts, options, or some combination of those building blocks. Those
instruments either have
http://www.bis.org/publ/work70.pdf
124 Ibid., 137-140. The study’s sample of institutions considered LCBOs
included the largest banking organizations
in the U.S. For a list of which of the largest 50 banking institutions
were considered LCBOs at year-end 1998, see
Study Group on Subordinated Notes and Debentures, op. cit., 29.
125 Group of Ten, op. cit.; and De Nicolo, G., and M.L. Kwast, “Systemic
Risk and Financial Consolidation: Are
They Related?” Journal of Banking and Finance, Vol. 26, No. 5 (May
2002), 861-880.
126 Furfine, C.H., Interbank Exposures: Quantifying the Risk of
Contagion (Basel: Bank for International
Settlements Working Paper No. 70, June 1999), available online at .
127 Ibid., 7.
128 Ibid., 8.
129 Ibid., 12.
130 Ibid., 8-11.
32
standardized terms and are traded on organized exchanges, or have unique
features and are
negotiated privately “over-the-counter” or OTC.
Derivatives give financial institutions and non-financial firms greater
capacity to
unbundled, repackage, and transform financial risks. That increases
firms’ ability to diversify
and hedge risk, price the different types of risks embodied in financial
instruments, and select
those they do not want.131 Overall, derivatives contribute to more
complete markets for trading
and managing risk and facilitate a more efficient allocation of risk.
Banks, securities firms, and other participants in the market for OTC
derivatives play one
or more of three roles. Brokers match buyers and sellers, but avoid
market and counterparty risk
exposures. Dealers make markets, serve as counterparties on at least one
side of virtually all
contracts, and actively manage the risks of the resulting net portfolio
position. End-users—nonfinancial
firms, institutional investors, other financial institutions, and
governments—use OTC
derivatives to manage risk, reduce transactions costs, lower financing
costs, and increase
portfolio yields. End-users could accomplish much the same results by
using exchange-traded
futures, options, and derivative securities, but only at the much higher
cost of establishing a
sophisticated in-house unit capable of continually managing
exchange-traded positions.
Unlike the exchange-traded derivatives markets which are subject to
Federal regulation
by the Commodity Futures Trading Commission, OTC derivatives are
unregulated individual
contractual agreements between the parties involved in the transaction.
Increasingly, trade
practices have resulted in uniform language and standard templates, but
for the most part, there is
no comprehensive system of regulation for these instruments.
The existence of standardized, government-approved commodities futures
and well-
regulated and -capitalized clearing agencies in the exchange-traded
derivatives markets, serve to
reduce, to some extent, the likelihood of a systemic event arising out
of the operation of those
markets. Such comfort does not exist in the case of unregulated OTC
derivatives, where
economic and market forces may, during a period of stress or crisis, be
exacerbated by problems
that arise out of the structure and operation of the unregulated
marketplace.
The market for OTC derivatives is quite large, both in absolute terms
and relative to the
global economy and global financial markets. The Bank for International
Settlements (BIS)
estimates that the notional principal amount of outstanding OTC
derivatives totaled $111.1
trillion at the end of 2001, up from $80.3 trillion at year-end 1998.
Because OTC derivatives
contracts do not specify the exchange of notional principal, gross
market value—an estimate of
the cost of replacing a defaulted contract, typically about 2 to 5
percent of notional principal—is
a better indicator of current credit exposure than notional principal.
BIS estimates that the global
gross market value of outstanding contracts in OTC derivatives markets
was $3.8 trillion at the
end of 2001, up from $3.2 trillion at year-end 1998. Netting
arrangements—written contracts to
combine offsetting obligations between two or more parties reducing them
to a single net
http://www.federalreserve.gov/boarddocs/speeches/2002/20020422/default.htm
131 See, for example, Schinasi, et. al ., op. cit., 41, and Greenspan,
A., New York, New York, April 22, 2002,
available online at .
33
payment or receipt for each party—make the net market value of
outstanding OTC derivatives
less than one-third the gross market value.132
Dealing in OTC derivatives, which is dominated by the major
internationally active
banks and securities firms, is highly concentrated. According to data
compiled by the Office of
the Comptroller of the Currency, at the end of 2001 seven U.S. banks
held nearly 96 percent of
the notional OTC derivatives of the U.S. banking system. Twenty-five
banks held over 99
percent of the notional OTC derivatives outstanding of all U.S. banks.133
OTC derivatives involve credit exposures for the contracting parties.
For example, a
financial institution that finances a long-term, fixed-rate loan with
short-term debt can limit its
exposure to interest rate risk by entering into a pay-fixed,
receive-floating swap—an agreement
to pay interest at a fixed rate at specific intervals for a certain
period in exchange for receiving
interest at a floating rate over that same period. Each party’s payments
are calculated by
multiplying the appropriate interest rate by the notional principal
amount, which is not
exchanged. The contract effectively converts the institution’s long-term
loan into a short-term
asset. If the contract’s reference floating rate is perfectly correlated
with the rate on the
institution’s short-term debt, interest rate risk associated with
financing the loan is eliminated.
Each party is both a debtor and a creditor whose net position varies
over time with changes in the
contract’s reference floating rate. The contract exposes each party to
credit risk—the possibility
that the other party will default on its obligation to pay if the
reference floating rate changes and
it becomes the net debtor in the arrangement.
A key feature of OTC derivatives is that the credit risk of a contract
is correlated with the
underlying market risk exposure being hedged, which may be quite
volatile. Day-to-day shifts in
the prices of financial assets can have a considerable effect on the OTC
derivatives-related credit
exposures of individual financial institutions, as well as the
distribution and concentration of
those exposures across the financial sector.134
In 1994 the U.S. General Accounting Office (GAO) expressed concern that
failure by a
large end-user of derivatives could lead to the following sequence of
events: one or more dealers
who were counterparties could default, causing a chain reaction of
counterparty defaults; the
opaqueness of derivatives and increased uncertainty could result in a
general lack of liquidity or
“freeze-up” of OTC derivatives markets, forcing dealers and others to
use the more liquid
exchange-traded futures and options markets, and leading to “price
breaks” in those markets;
those price breaks could spread to markets for other assets and create
widespread uncertainty
about asset values, which in turn could generate widespread panic
selling, plunging asset values
throughout the world, resulting in real economic losses.135
132 Bank for International Settlement (BIS), Quarterly Review:
International Banking and Financial Market
Developments (Basel, March 2002), A99, Table 19; and BIS Press Release
“Rapid Expansion of OTC Derivatives
Market in the Second Half of 2001,” May 15, 2002.
133 U.S. Office of the Comptroller of the Currency, OCC Bank Derivatives
Report, Fourth Quarter 2001
(Washington, DC, March 2002), 9.
134 Schinasi, et al., op. cit., 3.
135 U.S. General Accounting Office, Financial Derivatives: Actions
Needed to Protect the Financial System
(Washington, DC: Government Printing Office, May 1994).
34
A number of studies counter that GAO overstates the risk exposure of OTC
derivatives
dealers by ignoring three important facts: 1) dealers maintain balanced
portfolios, 2) the greater
diversification provided by the size of dealer portfolios significantly
lowers their counterparty
credit risk exposure, and 3) netting agreements and posted collateral
substantially limit the credit
exposures of dealers and other derivatives counterparties.136 Those
studies argue that derivatives
activity has reduced systemic risk by allowing risks to be actively
traded and efficiently
allocated. They also argue that a lack of liquidity among derivatives
dealers and other market
makers can be handled by the Federal Reserve System and other nations’
central banks. At the
same time, there is acknowledgement that OTC derivatives give banks and
other institutions
powerful tools to increase their risk in ways that are relatively
opaque, and that those instruments
complicate regulatory efforts to monitor the risk of, and set capital
requirements for, financial
institutions that use them.137
136 Darby, op.cit.; Edwards, The New Finance, op. cit.; Hentschel and
Smith, op. cit.; Hunter and Marshall, op. cit.;
and Mackey, op. cit.
137 For example, during a period of volatile interest rates, a financial
institution can increase its exposure to rising
interest rates by entering into a pay-floating, receive-fixed swap. That
transaction synthetically converts a portion of
the institution’s fixed-rate assets into floating-rate assets. If the
notional amount of the contract is large enough
relative to the institution’s assets, the transactions can raise the
institution’s overall interest rate risk exposure quite
substantially. See also, for example, Schinasi, et al., op. cit., 48:
“OTC derivatives activities are relatively opaque.
In traditional banking, when a bank issues a loan the risks are
transparent even if they are not easily quantified and
managed. With OTC derivatives transactions, it can be difficult to
adequately gauge, assess and understand the
distribution and balance of counterparty and other risks, including who
owns which risks.” However, with respect to
the Enterprises, OFHEO’s risk-based capital stress test takes in account
all of the financial derivatives of Fannie
Mae and Freddie Mac on an instrument-level basis, so that each
Enterprise’s risk-based capital requirement reflects
the risk posed by those instruments.
35
Section Four: Difficulties in Assessing Indirect Interdependencies
Financial regulators generally assess risk at the level of individual
institutions, yet such
assessments cannot be aggregated to yield assessments of the systemic
risk posed by the
financial sector as a whole.138 Assessing systemic risk requires
estimation of the
interdependencies among, at least, the largest and most important
institutions and markets. One
economist suggests that, at a minimum, it would be desirable for
regulators to have sufficient
information on the terms of financial contracts to assess the net
position of the financial sector
vis-à-vis the rest of the economy—non-financial firms and households.139
At present such
assessments are not possible, in part because financial institutions are
not required to report
information needed to analyze such interdependencies in detail, in part
because different
regulators are responsible for different types of financial
institutions, and in part because
financial regulators have not committed the necessary resources required
to collect and analyze
such information.
Investors’ and financial regulators’ lack of data to estimate all
indirect interdependencies
limits the effectiveness of market discipline and regulatory efforts to
counter the incentives
created by an underpriced financial safety net to overextend credit,
build up excessive leverage,
or finance asset price bubbles. The weak market discipline of
LTCM—despite the fact that
LTCM required a minimum investment of $10 million and allowed no
withdrawals for three
years, which should have attracted only relatively sophisticated
investors—and the large indirect
interdependencies that developed between LTCM and the banking system and
among bank
counterparties of LTCM illustrate this point.
http://www.bis.org/speeches/sp000921.htm
138 Crockett, A., “Marrying the Micro- and Macro-Prudential Dimensions
of Financial Stability,” remarks before the
Eleventh International Conference of Banking Supervisors (September 21,
2000), available online at
.
139 Hellwig, M., “Systemic Aspects of Risk Management in Banking and
Finance,” Swiss Journal of Economics and
Statistics, Vol. 131 (4/2), 1995, 723-737 at 731.
36