GSE's Part III: What's It All About Alfie?
Accounting Methods Used: Fair value is company's assets minus liabilities at current market value, stripping out the effects of volatile earnings from unrealized changes in the values of financial contracts used to hedge swings in interest rates.
Derivatives differences and effects: Freddie's losses were related to derivatives that were bought as part of ordinary trading activity to hedge against interest rate risk. A drop in value of these derivatives is accounted for in the income statement and does reduce income (revenues). Fannie used derivatives as a hedge against fluctuations of assets or liabilities value. A drop in value of these derivatives is NOT accounted for in the income statement.
The key point in both instances: Major banks and investment dealers are the institutions that have sold interest rate protection in the form of derivatives to the GSE's. These derivatives counterparties have priced in a small possibility of interest rate fluctuations, i.e. low volatility.
The Bottom Line: The lessor risk is that the GSE's go bankrupt when rates go up and the value of their fixed income portfolios deflates. The greater risk is that the derivatives counterparties have a problem due to mispricing the risk to insure the GSE's against interest rate volatility. Should the situation get out of hand, it could cause a collapse of the financial system.
Solutions: The GSE's could trim down their trillion dollar portfolios. If they shrank by 30% or so, the systemic risk would be lessened. Problem is there aren’t that many buyers around. FCB's (foreign central banks) have picked up around $75 Billion of the MBS over the past year. But that's a drop in the bucket.
The GSE's could also unwind and retire their derivatives contracts, reducing or eliminating the systemic risk. Then they could liquidate the remainder of the portfolio over time, without preoccupation about volatility in income or valuations.
Derivatives differences and effects: Freddie's losses were related to derivatives that were bought as part of ordinary trading activity to hedge against interest rate risk. A drop in value of these derivatives is accounted for in the income statement and does reduce income (revenues). Fannie used derivatives as a hedge against fluctuations of assets or liabilities value. A drop in value of these derivatives is NOT accounted for in the income statement.
The key point in both instances: Major banks and investment dealers are the institutions that have sold interest rate protection in the form of derivatives to the GSE's. These derivatives counterparties have priced in a small possibility of interest rate fluctuations, i.e. low volatility.
The Bottom Line: The lessor risk is that the GSE's go bankrupt when rates go up and the value of their fixed income portfolios deflates. The greater risk is that the derivatives counterparties have a problem due to mispricing the risk to insure the GSE's against interest rate volatility. Should the situation get out of hand, it could cause a collapse of the financial system.
Solutions: The GSE's could trim down their trillion dollar portfolios. If they shrank by 30% or so, the systemic risk would be lessened. Problem is there aren’t that many buyers around. FCB's (foreign central banks) have picked up around $75 Billion of the MBS over the past year. But that's a drop in the bucket.
The GSE's could also unwind and retire their derivatives contracts, reducing or eliminating the systemic risk. Then they could liquidate the remainder of the portfolio over time, without preoccupation about volatility in income or valuations.
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