Voluntary Cooperative Action—It Works for Fannie and Freddie

A couple of years ago, I worked with Freddie Mac on a group of voluntary public disclosures it was adopting. The main purpose of the disclosures was to indicate the interest rate risk of Freddie Mac’s mortgage portfolios. Fannie Mae, somewhat reluctantly, went along with the voluntary program.

Recently, investors and the media have kicked up a good deal of fuss about the interest rate risk taken by Fannie Mae, the largest government-sponsored mortgage purchaser. Fannie’s monthly disclosure of its interest rate risk (measured by the match between its assets’ and liabilities’ maturity datesu00e2u20ac”the so-called duration gap) showed that it was at a historical high. Fannie Mae’s normal gap does not exceed six months, but it was reported at 14 months.

Investors in both the equity and debt markets reacted immediately, sending Fannie Mae’s stock price down sharply and thus increasing its borrowing costs.

The importance of timely Fannie Mae disclosures is that the market worked. Fannie Mae’s management moved quickly to change its overall risk profile. Some weeks later, Fannie announced that its duration gap had narrowed considerably, down to six months, thereby reducing the market’s penalties. Because the monthly disclosure triggered market discipline, governmental regulatory action was not required. The new voluntary disclosure system was effective.

(Incidentally, the duration gap for the more conservative Freddie currently stands near zero.)

Fannie and Freddie are the only two large financial institutions in the world that publish this type of frequent, real-time financial disclosure to provide early warning signals to the market. Moody’s Investors Service was so impressed with this voluntary disclosure that it commented at the time: “These financial and disclosure commitments by Fannie Mae and Freddie Mac set new standards not only for them, but also for the global financial market. The leadership shown by Freddie Mac and Fannie Mae could prove difficult for other firms to ignore….”

So far, Moody’s was a bit too optimistic. Other large financial institutionsu00e2u20ac”and their regulatorsu00e2u20ac”have not followed the example set by Freddie and Fannie. To my knowledge, no other major financial institution provides a monthly report disclosing interest rate risks. That means that today, a major bank, insurance, or financial company could be experiencing similar interest rate risk problems, though the institution would be under no obligation to disclose these problems to the markets until some time next year. Because they have not followed Fannie’s and Freddie’s example, these institutions may see regulatory or legislative action in the future.

Also, Freddie and Fannie set a good example of how voluntary action can avoid more complicated government regulation. As the new Congress meets, it appears that privacy will be high on its agenda. The question of what financial institutions can do with a customer’s personal financial information is one of large financial and political importance. Voluntary agreements by credit grantors could result in less complicated and restrictive government rules and regulations being enacted in the future. Freddie and Fannie provide a good example of the benefits of voluntary cooperation. But then, when have any large number of our independent-minded financial institutions ever agreed on much of anything?