Government Sponsored Enterprises (GSEs) specializing in the mortgage market, especially Fannie Mae and Freddie Mac, exposed the U.S. economy to substantial risk, primarily because their capital positions are thin relative to the risks these firms assume...I believe that the capital held by [Fannie and Freddie] should be at a level determined primarily by the cushion required should an unlikely event occur rather than by an estimate of the probability itself. It may be that the highly volatile interest rate environment of the early 1980s is extremely unlikely to recur, but I would like to see F-F maintain capital positions that would enable the firms to withstand such an environment anyway.

Although many investors assume that F-F obligations are effectively guaranteed by the U.S. Government, the fact is that the guarantee is implicit only...An investor who ignores the risks faced by Fannie Mae and Freddie Mac under the assumption that a federal bailout is certain should there be a problem is making a mistake.

The risk of financial problems at Fannie Mae and/or Freddie Mac are not as remote as it might seem, because of the fat tails of the distribution of price changes in asset markets. These two observations—enormous potential costs and a probability of failure higher than commonly realized—imply that the risks of very large events must be identified and carefully analyzed through extensive "stress testing."

The Federal Reserve has adequate powers to prevent the spread of a liquidity crisis, but cannot prevent a solvency crisis should Fannie or Freddie exhaust their capital. In the event of a solvency crisis, the market would become unreceptive to Fannie and/or Freddie obligations; they would have difficulty rolling over their maturing debt. Moreover, their outstanding obligations would decline in price and their markets would become less liquid.

An investor who ignores the risks faced by Fannie Mae and Freddie Mac under the assumption that a federal bailout is certain should there be a problem is making a mistake.

The issue of GSE reform goes well beyond the role of housing in the economy. It has far-reaching implications for the entire US financial system.

Most observers believe the GSEs pass some of their implicit subsidy along to homeowners through lower mortgage interest rates...This situation raises concerns over fairness, because the subsidy puts other financial institutions at a disadvantage, but the larger issue is that the subsidy creates a source of systemic risk for the US financial system. The risk arises because the subsidy has allowed the GSEs to become gigantic...

Because the housing GSEs are so large, the risk they face is important for the entire financial system...Even a small mistake in GSE risk management could have ripple effects throughout the economy.

The belief in a government bailout if things go wrong creates an incentive for a company to take on risk and enjoy the associated increase in return...Although there is no way to eliminate the underlying risk, it is possible to reduce it by ensuring that the housing GSEs are overseen by an effective regulator.

Congress needs to create a GSE regulator with authority on a par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear process sanctioned by the Congress for placing a GSE in receivership...[Furthermore,] GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and nonmortgages, that they hold. Fannie and Freddie should be encouraged to continue to expand mortgage securitization, keeping mortgage markets deep and liquid while limiting the size of their portfolios. 

[Fannie and Freddie] are important organizations that, because of their implicit subsidy, are expanding at a pace beyond that consistent with systematic safety. They have made, and should--with less reliance on subsidies--continue to make, major contributions to the financial system of the United States.

I should emphasize that Fannie and Freddie, to date, appear to have managed [their] risks well and that we see nothing on the immediate horizon that is likely to create a systemic problem. But to fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later.

Most of the concerns associated with systemic risks flow from the size of the balance sheets that these GSEs maintain.

The unease [generated by Fannie and Freddie] relates mainly to the scale and growth of the mortgage-related asset portfolios held on their balance sheets. That growth has been facilitated, as least in part, by a perceived special advantage of these institutions that keeps normal market restraints from being fully effective.

In the case of the GSEs, the enormous scale of their liabilities could create a massive problem in the credit markets. If the market value of GSE debt were to fall sharply, because of ambiguity about the financial soundness of GSEs and about the willingness of the federal government to backstop the debt, what would happen? I do not know, and neither does anyone else.