For the Washington Post, Robert Samuelson writes Fixing Fannie and Freddie. Combined, the debt of government-sponsored enterprises Freddie Mac and Fannie Mae totalled $1.5 trillion at the close of 2002, writes Samuelson. Highly profitable, they continue a history of expansion, enabling the American Dream of home ownership. They buy money cheap (by selling bonds) and sell it dear (by buying bundles of mortgage notes). They make money on the "spread," and protect themselves from fluctuations with derivatives.
Samuelson asks "What if they failed?" This year, discoveries of misleading profit reports shook up Freddie, suggesting that errors, even big ones, can escape the notice of regulators. The failure of either is unlikely, Samuelson admits, but the consequences could be catastrophic. In his editorial, he suggests that a blue-ribbon commission be formed to take an unbiased look at the structure and practices of these financial service giants. (More ... )
Samuelson's editorial brings to mind the failure of Long Term Capital Management (LTCM), a highly leveraged "hedge fund," that owed huge amounts to major players in the U.S. financial system. In 1998, LTCM was caught in an unexpected shift of the financial markets triggered by the Russian government's default on its debt. In the resulting disarray in the global debt markets, LTCM found its spread "inside out," and suddenly went from growing profits to sudden and massive losses. In order to prevent the failure of LTCM (which might trigger further cascades of failure in the U.S. financial system), the Federal Reserve organized a private sector bailout that stopped the landslide, but is controversial still today. In 1999, the General Accounting Office (GAO) reported on its study of the LTCM failure. From the opening summary:
Between January and September 1998, LTCM, one of the largest U.S. hedge funds, lost almost 90 percent of its capital. In September 1998, the Federal Reserve determined that rapid liquidation of LTCM’s trading positions and related positions of other market participants might pose a significant threat to already unsettled global financial markets. Thus, the Federal Reserve facilitated a private sector recapitalization to prevent LTCM’s collapse. Although the crisis involved a hedge fund, the circumstances surrounding LTCM’s near-collapse and recapitalization raised questions that go beyond the activities of LTCM and hedge funds to how federal financial regulators fulfill their supervisory responsibilities and whether all regulators have the necessary tools to identify and address potential threats to the financial system."
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"Federal financial regulators did not identify the extent of weaknesses in banks’ and securities and futures firms’ risk management practices until after LTCM’s near-collapse. * * * [E]xaminations done after LTCM’s near-collapse revealed weaknesses in credit risk management by banks and broker-dealers that allowed LTCM to become too large and leveraged."
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"Regulators for each industry have generally continued to focus on individual firms and markets, the risks they face, and the soundness of their practices, but they have failed to address interrelationships across each industry. The risks posed by LTCM crossed traditional regulatory and industry boundaries, and the regulators would have needed to coordinate their activities to have had a chance of identifying these risks. Although regulators have recommended improvements to information reporting requirements, they have not recommended ways to better identify risks across markets and industries. We are recommending that federal financial regulators develop ways to better coordinate oversight activities that cross traditional regulatory and industry boundaries."
Other studies of the LTCM collapse include Roger Lowenstein's "When Genius Failed: The Rise and Fall of Long-Term Capital Management" and Nicholas Dunbar's "Inventing Money: The Story of Long Term Capital Management and the Legends Behind It."
See also a 1999 speech by FRB Governor Laurence H. Meyer "Lessons from Recent Global Financial Crises"
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