It was another poor showing for U.S. and global equities. For the week, the Dow dipped 2% and the S&P500 declined 3%. The Transports declined more than 1%, and the Utilities were hit for 3%. The Morgan Stanley Cyclical index sank 4% and the Morgan Stanley Consumer index dropped 3%. There was no relief in the broader market, with the small cap Russell 2000 and S&P400 Mid-Cap indices shedding 3%. The technology sector suffered, with the NASDAQ100 declining 3%, the Semiconductors 4%, and the Morgan Stanley Technology index 5%. The Street.com Internet index declined 4%, and the NASDAQ Telecommunications index dipped 3%. The Biotechs dropped 3%. The financial stocks were under pressure, with the Securities Broker/Dealers down 5% and the Banks 4%. Although a volatile bullion price ended the week up $1.40, the HUI Gold index declined another 3%.

Under the circumstances, the Treasury market was again not all too impressive. For the week, the two-year Treasury yield declined eight basis points to 1.62%. The five-year Treasury yield declined four basis points to 2.87%, and the 10-year yield dipped only three basis points to 3.93%. Benchmark mortgage-backs and agencies performed relatively well, with yields generally declining about six basis points. The spread on Fannie's 5 3/8% 2011 note was about unchanged at a narrow 36.5, while the benchmark 10-year dollar swap spread was unchanged at 44.5. Corporate spreads generally widened marginally.

The dollar could not muster back-to-back weekly gains, drifting slightly lower for the week. The CRB index added less than 1%, while trading to the highest level since May 1997. Heating oil futures jumped 21% this week to a 23-year high. Crude prices matched 2-year highs at $35.20 a barrel. Natural gas also traded to a two-year high. The Mexican peso traded to a record low of 11 to the U.S. dollar. The announcement by the Mexican central bank that it was moving to tighten liquidity to support its faltering currency had no impact.

There was $47 billion of U.S. corporate and agency issuance this week. Goldman Sachs sold $2 billion (up from $1.0 billion) of 30-year bonds. Also issuing 30-year bonds, Enterprise Products (oil and gas) raised $500 million. KB Homes raised $300 million (up from $250 million). HCA sold $500 million of bonds, Rite Aid $300 million and Parker-Hannifin $225 million. Interestingly, International Lease Finance, the leasing subsidiary of AIG, was forced to cut the size of its debt offering in half to $500 million. AMG reported about $500 million flowed into junk funds this past week, a reversal from the previous week's outflow.

Broad money supply (M3) expanded $37.7 billion last week to a record $8.54 Trillion, with two-week gains of $69.5 billion. Currency added $1.5 billion, as Demand and Checkable Deposits increased $13 billion. Savings Deposits added $2.2 billion and Retail Money Fund deposits increased $5.2 billion. Institutional Money Fund deposits jumped $20.4 billion and Large Denominated Deposits added $1.3 billion. Repurchase Agreements declined $1.7 billion and Eurodollars dipped $3.2 billion. Broad money supply is up $489 billion, or 7.7% annualized, over the past 41 weeks. Elsewhere, the commercial paper (CP) market turned quiet. For the week, issuance slipped to $500 million, with Financial Sector CP down $3.8 billion and Non-Financial CP up $3.3 billion. Bank Assets were down $16.6 billion, giving back some of the previous week's $53.7 billion expansion. Bank Credit was down $6.1 billion, with Securities holdings declining $13.1 billion. Loans and Leases gained $6.9 billion. Real Estate loans were up $4.5 billion to $2.04 Trillion, and Security loans jumped $6.7 billion to $183 billion. Meanwhile, Commercial and Industrial loans declined $2.5 billion to $960 billion. An annual conference was responsible for this week's minimal ABS issuance.

The Mortgage Finance Bubble blow-off hit week 33, with the Mortgage Bankers Association refi index remaining (despite being down 4% this week) about double the year ago level. The Purchase application index was up 1.5%, about 9% above one year ago. Construction spending was up for the fourth straight month, increasing in December at the strongest pace in ten months. Spending on new single family units was up 12.2% y-o-y, with multi-family spending up 2.6% y-o-y. Spending on Home Improvements was up 7.2% y-o-y. However, non-residential spending was down 14% y-o-y, with Industrial down 35%, Office 23.6%, and Hotels, Motels declining 30.3%. Public sector construction spending was up 4.7% y-o-y, with Educational up 11.4%, Hospital 15.6%, and Military 28.8%.

Manufacturing lost another 16,000 jobs during January, increasing eight-month losses to 330,000. Service Producing employment jumped 143,000, with Retail Trade accounting for 101,000. This reverses December's 99,000 decline, and by subcategory we see that Eating & Drinking establishments added 73,000 jobs after dropping 66,000 in December. Another 6,000 Mortgage Bankers were added, with 39,000 new jobs in five months. Health Services added 18,000 jobs (178,000 in 8 months!) and Government added 4,000. It is worth highlighting that the Labor Department reported total U.S. jobs at 130.8 million. Goods Producing Jobs totaled 23.6 million, with 16.4 million employed in manufacturing. Service Producing jobs accounted for 107.2 million, including Retail Trade at 23.3 million, Business Services 9.3 million, Finance and Insurance 7.8 million, Health Services 10.8 million, and Government 21.4 million. And looking at January's Hours Worked data, we see that Total Private industry Weekly Hours Worked were up 0.1% y-o-y. January Goods Producing Hours were down 2.1% y-o-y (Manufacturing down 2.4%), while Service Producing Hours were up 0.7% (Finance and Insurance up 2.1%, and Services up 1.6%).

And while the media focused on the disappointing report on Non-farm Productivity (down 0.2% vs. expectations of up 0.7%), our eyes caught more indications of germinating inflationary pressures. Compensation per hour increased at a 4.6% annualized rate, this after the third quarter's 5.4%. Today had the ECRI future inflation gauge jumping 2.5 points in January to 119.7, the highest level since August 2000. This is up from January 2002's reading of 97. The ISM Manufacturing index saw the Prices Paid component rise slightly to a strong 57.5, while the ISM Non-manufacturing Prices Paid added 1.7 points to 57.

February 3 - Bloomberg: "U.S. companies generated their biggest revenue gains in almost two years in the fourth quarter, led by companies such as Exxon Mobil Corp., Amgen Inc. and Southern Co. Revenue rose 6.9 percent in the period for the 331 companies in the Standard & Poor's 500 Index that had reported results as of Thursday, according to Bloomberg data. Oil companies benefited from a surge in prices because of concern that a war in Iraq will disrupt supplies, while colder weather boosted demand for heating fuels. Health-care companies are selling more drugs and medical devices as the U.S. population ages." (Further evidence of heightened sectoral inflationary pressures)

February 3 - Dow Jones: "Home equity securitizations will hit $130 billion in 2003, down slightly from the $132 billion record volume recorded the year before, according to a report published by Moody's… The issuance will be driven by subprime borrowers who haven't yet refinanced their loans, said Moody's, adding that much of the new supply will come to market in the first half of the year… subprime lenders, in a continuing effort to entice borrowers with new products, are expected to expand their offerings to appeal to a broader audience this year. " (Poor quality of newly created claims/Credit.)

February 3: "Commercial mortgage originations during the final quarter of 2002 surged to a pace 18 percent above the same period a year earlier and were up 5.2 percent for the year as a whole, according to the quarterly survey of mortgage bankers conducted by the Mortgage Bankers Association of America (MBA)… The 44 MBA members reporting in the survey originated $29.4 billion in mortgages on income-producing properties - up from the revised total of $24.8 billion reported for the same quarter last year. The year-end surge was paced by strong gains in funding by life insurance companies (up 32 percent from a year earlier) and commercial mortgage-backed securities (CMBS) conduits (up 30 percent)."

February 3 - Bloomberg: "Credit-card issuers wrote off an annualized 7.5 percent of uncollectible loans in December, the second-highest loss rate in more than 10 years, according to Standard & Poor's. The average write-off rate, on the rise since September, climbed from 7.1 percent in November and was lower only than the 7.6 percent reported in March 2002, said S&P, which has tracked losses on card loans that back securities since 1992."

February 7 - Bloomberg: "Sales of bonds backed by derivatives more than doubled last year to $281 billion as banks offered new types of the transactions, Creditflux said. J.P. Morgan was the biggest arranger of the instruments known as synthetic collateralized debt obligations, with 12.2 percent as measured by face value. Deutsche Bank AG handled 11.5 percent and Lehman Brothers Holdings Inc. had 10.8 percent, the monthly credit-derivatives magazine said. There were 173 synthetic CDOs last year, compared with 89 in 2001. In 2002, 64 percent were backed by derivatives on investment-grade bonds… The fastest-growing section of the market for synthetic CDOs involved derivatives that use asset-backed and residential-mortgage bonds as collateral…"

February 5 - Fitch: "The ABS market is fighting battles on four major fronts: collateral quality, issuer condition, regulatory environment, and the economic landscape, according… to the latest edition of 'The Fitch Ratings ABS Exchange.' Along with these concerns are the potential impact of the war with Iraq, the threat of a double-dip recession and the destructive forces of fraud. 'While the ABS market has proved its resiliency repeatedly over the past 15 years, it is difficult to imagine a more concerning confluence of events than those facing the market today,' said Kevin Duignan, Managing Director, Fitch Ratings… While collateral quality has deteriorated in virtually all sectors, there are a few places where Fitch is particularly concerned: increasing default rates for nonprime and subprime borrowers, declining used car prices, and deterioration in aircraft values."

February 4 - Dow Jones (Christine Richard): "Moody's Investors Service cautioned Tuesday that it may downgrade a number of asset-backed and residential mortgage-backed transactions because some trustees are falling short on the scrutiny and service they provide to structured transactions. The rating agency said conversations with major trustees over the last couple of months have turned up a difference of opinion over the trustee's role as a watchdog. Also, some trustees have failed to find appropriate back-up servicers for transactions or have passed the cost of back-up servicing on to investors… ' Moody's analysis of ABS and RMBS transactions incorporates an understanding of the responsibilities of the trustees. It now appears that, in some cases, the trustees' own views of their responsibilities differ from Moody's understanding…" Many asset-backed and mortgage-backed transactions carry triple-A ratings. The review of the trustee role, as initially reported by Dow Jones Newswires back in December, was begun by Moody's analysts following the demise of National Century Financial Enterprises… In the NCFE case, funds meant to protect bondholders were diverted without drawing interference from the transaction's trustees, J.P. Morgan and Bank One, according to Moody's. That failure to intervene caused Moody's to undertake a review of how trustees view their role, and the results haven't been encouraging. Moody's found some trustees see their role as purely administrative, which may leave the originator of a transaction policing its own compliance… Moody's examination of some 2,500 transactions in the huge asset-backed and mortgage backed markets follows word from the Securities and Exchange Commission last week that it has concerns about the asset-backed market." (Awfully late in the game for "differences of opinion.")

The stocks of many key "structured finance" Operators have been under recent pressure. The European financial conglomerates are reeling, with the insurance sector especially strained. Here at home, risk behemoth American International Group (AIG) shocked the Street by announcing a $2.8 billion increase in insurance reserves. The Wall Street Journal (Christopher Oster) quoted a property-casualty analyst: "This is an indictment of the entire industry's balance sheet." The same day Chubb took a charge to add to reserves for its directors-and-officers liability business.

Credit Insurer powerhouse MBIA disappointed the Street with expectations of slowing growth. Year-over-year, Net Debt Service increased $59 billion to almost $782 billion. 2002 Global Public Finance Adjusted Direct Premium (ADP) increased 1% to $657.7 million, while Global Structured Finance ADP surged 40% to $546.6 million. Total Assets expanded 16% to $18.9 billion. And leading the list of "50 Largest Structured Finance Credits" is none other than Metris Master Trust at $2.3 billion, followed by Providian Gateway Master Trust at $2.3 billion, European Super Senior Synthetic CDO at $1.8 billion, and Global Structured Finance Vehicle at $2 billion. MBIA wrote $28.7 billion of "net par" CDO (Collateralized Debt Obligations) exposure during the year, ending 2002 with net CDO exposure of $66 billion. An MBIA exec stated to a conference call audience that he did not expect any losses from Metris, with the recent spike up in charge-offs a "seasonal" development. What?

And this today from a Wall Street Journal article (Henny Sender), "Spitzer's Hedge-Fund Inquiry Eyes Credit Derivatives": "Last year, MBIA saw demand for protection (credit default insurance on its debt) go from about $5 million or $10 million a week to 'hundreds of millions of dollars a week by October for us,' said MBIA President Gary Dunton. 'Our view is that the market is too illiquid to be meaningful,' he says. For Several weeks, Mr. Dunton adds, the firm indirectly sold protection on itself in an effort to keep the price from rising in a market sensitive to the sudden surge in demand. But when he became aware that the activity was primarily because of one hedge fund, MBIA withdrew from the market, Mr. Dunton says." An enormously exposed insurance company writing insurance on itself during a period of acute systemic stress? Very bad idea.

February 6 - Washington Post (Daniela Deane): "The White House has announced that it will nominate Mark C. Brickell, an expert on financial derivatives ('a former managing director in the derivatives group at J.P. Morgan & Co.'), to head the federal agency that oversees Fannie Mae and Freddie Mac, the giants of the secondary mortgage market. Sources familiar with the situation said Armando Falcon Jr., head of the Office of Federal Housing Enterprise Oversight, was asked by administration officials for his resignation Tuesday morning. That was just hours before Falcon released the findings of a "systemic risk" study, which laid out a scenario in which Fannie Mae and Freddie Mac could experience severe financial difficulties that then would cause wide-ranging disruptions in the housing and financial markets."

February 5 - Dow Jones (Dawn Kopecki): "Fannie Mae and Freddie Mac officials… dismissed the agency's report. 'This simply, in our mind, is not a serious piece of policy research' said Freddie Mac spokeswoman Sharon McHale. 'It's based on this completely speculative doomsday scenario where we essentially wake up and are insolvent.' Fannie Mae spokesman Chuck Greener agreed: 'The Falcon paper is a review of research on systemic risk and discussion of hypothetical scenarios. The director himself acknowledged these scenarios are hypothetical and quite remote.'"

I disagree vehemently; OFHEO's report should be taken quite seriously and accomplishes much more than simply addressing "quite remote" hypothetical scenarios. Indeed, Mr. Falcon should be strongly commended for courageously formulating the first examination of the GSEs and their critical role in fomenting heightened systemic risk. The 118 page report is comprehensive, thoughtful, independent, formative, and extraordinarily timely. It is by far the most relevant and important "policy research" I have read. I have compiled excerpts attempting to highlight key aspects of OFHEO's analysis, but strongly recommend a thorough reading http://www.ofheo.gov/docs/reports/sysrisk.pdf .

"Introduction: Over the past quarter-century, financial markets in many countries have experienced serious disturbances associated with financial institutions and failures. The period has been one of profound and rapid changes in the financial sector. Those events have heightened awareness of systemic risk - the possibility that a systemic event, a financial crisis that leads to a substantial reduction in aggregate economic activity - will occur… 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. Fannie Mae and Freddie Mac - the two government-sponsored enterprises (GSEs) chartered by the federal government to support the secondary market for residential mortgages - 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…

The large and rapidly growing literature on financial crises, systemic risk, and the role of governments in mitigating that risk includes no detailed analyses of how Fannie Mae and Freddie Mac can affect systemic risk. This report addresses that gap by analyzing how the Enterprises operate in the housing finance system and the financial sector, how their activities affect economic activity, and how they can affect systemic risk in different circumstances.

At the end of 1990, Fannie Mae and Freddie Mac had securitized $604 billion in outstanding mortgage loans and held an additional $136 billion of mortgages in their asset portfolios. The Enterprises combined total book of business - mortgages securitized and held on the balance sheet - represented 25% of outstanding residential mortgage debt. At the end of 2001, the combined mortgage asset portfolios of Fannie Mae and Freddie Mac had risen to over $1.2 trillion, an increase of more than seven-fold, whereas their combined outstanding MBS held by other investors had more than doubled to over $1.5 trillion… The Enterprises' on-balance sheet assets grew rapidly from 1992 to 2001, rising at an annual rate of 18 percent at Fannie Mae and 32 percent at Freddie Mac…

Between 1996 and 2001, foreign holdings of what the Federal Reserve refers to as "U.S. agency securities" (a category that includes the debt and MBS of Fannie Mae and Freddie Mac, Federal Home Loan Bank System debt, MBS guaranteed by Ginnie Mae, and securities of smaller GSEs and federal agencies), have grown about as fast as the Enterprises' debt, and almost twice as fast as their combined debt and mortgage-backed securities. It was not unusual in 2000 for foreign investors to buy 50% or more of a new issue of two- or three-year Enterprise notes or more than 20 percent of a new issue of long-term notes… Importantly, the Enterprises' debt securities make up an increasing share of the portfolios of foreign central banks… At year-end 2000 and 2001, foreign and international monetary authorities held $102.3 billion and $133.1 billion in federal agency securities, respectively…

Fannie Mae and Freddie Mac are each among the largest end-users of financial derivatives. To date virtually all of the derivatives contracts of Fannie Mae, and most of those of Freddie Mac, have been over-the-counter (OTC) contracts, primarily interest rate swaps and swaptions - options to enter into interest rate swaps… The Enterprises enter into foreign currency swaps to fully hedge the exchange-rate risk associated with issuing foreign currency-denominated debt… In volatile markets such as those associated with the Asian currency crisis of 1997 and the Russian default of 1998 - the latter associated with the collapse of Long Term Capital Management - the market values of some derivatives contracts may fluctuate significantly and even be difficult to determine, especially where markets cease to function normally and model-based valuations, which assume liquidity, become invalid… The market for OTC derivatives is highly concentrated among a small number of dealers, primarily brokerage firms and commercial banks that are counterparties for at least one side of virtually all contracts. The largest dealers include JPMorgan Chase, Citigroup (including the large derivative operation in its broker/dealer subsidiary, Salomon Smith Barney), Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley Dean Witter… (Total notional value of Fannie and Freddie derivatives at year-end 2001 was $1.19 Trillion)

Fannie Mae and Freddie Mac also have significant direct interdependencies in the form of credit exposures to private mortgage insurers. Those firms pose credit risk because there is the possibility that they will be unable to meet their contractual obligations to cover credit losses or insured mortgages owned or securitized by the Enterprises. Seven firms provide nearly all primary (loan-level) insurance on single-family mortgages, and there is significant concentration among the coverage provided by that relatively small group… The top four mortgage insurers that provided the most primary insurance for each Enterprise at year-end 2001 accounted for over 70% of each Enterprise's primary coverage…

Finally, government sponsorship contributes significantly to the size and continuing growth of Fannie Mae and Freddie Mac and their major and expanding roles in securities and derivative markets. The perception of an implicit federal guarantee encourages market participants to view the Enterprises' obligations as almost riskless and makes Fannie Mae and Freddie Mac favored counterparties in the market for OTC derivatives. The Enterprises are so large that the direct interdependencies between them and other participants in securities and derivatives markets may exceed those of any other privately owned financial institutions. The magnitude of those interdependencies implies that, if either Enterprise became insolvent or illiquid, investors in its debt and, potentially, its derivatives counterparties could incur losses. Fannie Mae and Freddie Mac are themselves vulnerable to conditions in the market for OTC interest rate derivatives…

Measuring Systemic Risk: Financial regulators and policy makers do not systematically quantify the systemic risk posed by the financial sector or the potential effect of individual financial institutions or markets on that risk. Measuring risk means estimating the probability of the occurrence of specific losses as a result of a specific type of event. Since systemic risk, as used in this report, is the possibility that a financial crisis will lead to substantial losses in aggregate economic output, economists would use macro-econometric models to measure that risk. Unfortunately, current economic models are not suited to measuring the potential effects of large financial institutions such as Fannie Mae and Freddie Mac on systemic risk. The typical economic model represents the financial sector in a highly aggregated fashion, a manner that is ill designed to quantify explicitly the relationships between financial variables such as the supply of credit and interest rates on different types of financial assets and real variables such as output and employment. That aggregation reflects the present state of macroeconomic theory, which generally 'presumes that the financial system functions smoothly - and smoothly enough to justify abstracting from financial considerations"…

Financial history is replete with stories of highly regarded firms that faltered, became illiquid, and failed. In fact, two GSEs - Fannie Mae and the Farm Credit System - had serious solvency problems in the 1980s… The future differs from the past in unexpected ways, and sometimes those differences can be great. The consequence is that unexpected events can cause institutions to suffer losses from exposures that neither they nor their regulators viewed as significant or of which few observes were even aware.

An admittedly imperfect, but increasingly popular, way to circumvent those limitations is to employ scenario analysis - the construction and elaboration of hypothetical, conditional scenarios without the use of econometric models. This is what military planners do with war games. Scenario analysis does not yield numerical estimates of the risk of specific adverse outcomes but generates insights into the potential functioning of the system in question under specific conditions of extreme stress… Scenario analysis is a valuable way to analyze the potential effects on systemic risk of specific institutions or markets…

The three scenarios were selected as generic examples from a broad range of possibilities because they illustrate how the financial health of Fannie Mae and Freddie Mac, and the public and private responses to severe financial difficulties at an Enterprise, could affect the likelihood of macroeconomic losses…

Scenario #1: In a Period of Reduced Liquidity, the Enterprises Help to Mitigate risk…

Scenario #2: One Enterprise Develops Serious Solvency Problems But Remains Liquid, There are few Adverse Economic Effects, and No Systemic Event Occurs…

(For brevity's sake - as well as for the likely irrelevance to unfolding circumstances, details relating to the first two scenarios will be omitted.)

Scenario #3: One Enterprise Suffers Large Losses and Becomes Illiquid and a Systemic Event Results. In Scenario #3 Enterprise A unexpectedly incurs large losses. Some other financial institutions are also in a weakened position. Investors generally do not believe Enterprise A is viable and are uncertain about whether it will default, about the size of any credit losses they may incur, and about the future liquidity of its debt. That uncertainty leads to widespread selling of Enterprise A's debt as well as a large decline in the market prices of its MBS.

Scenario #3 may unfold in different ways that have significantly different consequences for economic activity. How the scenario develops depends largely on 1) how the private and public sectors respond to the sell-off in markets for Enterprise A's obligations and 2) the financial health of Enterprise B.

In some circumstances, investors - including Enterprise B - may respond to falling prices of Enterprise A's MBS and debt by purchasing those obligations, in which case their prices remain depressed but do not collapse and the risk to the banking system is limited. Although Enterprise A is no longer able to compete for new business, if Enterprise B is financially healthy and can convince investors of that fact, the housing finance system may adjust quickly and absorb Enterprise A's business volume with slightly higher mortgage rates, without any major adverse effects on housing activity. In that case, no systemic event occurs in Scenario #3, as in Scenario #2. On the other hand, if Enterprise B cannot expand its activities quickly, a significant short-term decline in mortgage lending, home sales and housing starts occurs, contributing to problems elsewhere in the economy and increasing the likelihood of macroeconomic losses.

In other circumstances, the sell-off of Enterprise A's debt becomes a panic, so that trading in those obligations virtually ceases, at least for a time. The Market for Enterprise A's MBS is somewhat less affected because those securities are backed by mortgage collateral. Illiquidity in the market for Enterprise A's debt and the plunge in the market value of its MBS exacerbate liquidity problems at many banks and thrifts. Those problems increase the risk of contagious illiquidity spreading through the banking system, the markets for the obligations of other GSEs, and the financial sector as a whole, adversely affecting the U.S. and the global economy. In that worst case, the federal government faces difficult choices. Actions to bolster the liquidity of the market for Enterprise A's debt, while reducing systemic risk and protecting the economy in the short run, may cause other problems or prove to be inadequate. If the government does not prevent a financial crisis, the potential decline in aggregate economic activity may be very large.

Subsequent Developments in the Financial Sector: Many market participants have strong doubts about the viability of Enterprise A. Investors in Enterprise A's debt and MBS are aware that federal law neither creates an explicit legal obligation for the government to provide financial assistance to the Enterprise nor provides budgetary resources or establishes a process for doing so… In this scenario those uncertainties lead to widespread selling of Enterprise A's debt. As the prices of those securities fall and their yields rise, more and more investors try to liquidate their position before the market becomes illiquid and they can no longer do so. At the same time, the quality spreads of MBS guaranteed by Enterprise A increase much more than in Scenario #2, and bid-ask spreads in the market for those obligations widen sharply, indicating a significant reduction in liquidity…

The illiquidity of Enterprise A's debt, and the possibility of investors in that debt and that Enterprise's MBS incurring credit losses in the event of default, lead to spikes in the yields of the uninsured deposits of and interbank loans to many depositor institutions whose holdings of GSE obligations are large relative to their capital. Even institutions that do not hold large amounts of the obligations of Enterprise A are affected… Thus, there is heightened uncertainty about the liquidity of all depositories whose holdings of GSE debt and MBS are large relative to their capital, and over sixty percent of all commercial banks, and a significant number of larger banks, experience a sudden, large increase in their marginal funding costs. The spike in funding costs worsens the solvency problems of the subset of those institutions that had recently incurred sizable losses…

Market participants and financial regulators are concerned that a vicious circle may develop in which a large number of those institutions report declines in their net income, have to pay even higher yields on new borrowings, experience losses that create solvency problems, and become illiquid. If a very large bank or a sufficient number of smaller banks become illiquid, there could be a general decline in liquidity in the interbank loan market, which could lead to a breakdown of payment and settlement systems and a disruption in the functioning of the financial sector. Other creditors of Enterprise A may experience difficulties as well. No federal statute or regulation establishes the priority of claimants among an Enterprise's creditors or provides a process for allocating losses among creditors in the event of default…

Among those financial institutions exposed to Enterprise A are derivatives counterparties whose contracts with the Enterprise have a positive market value. The magnitude of each counterparty's loss could depend on the size of its credit exposure to Enterprise A and the severity of a default by Enterprise A. Under some circumstances, such losses could significantly impair the capital of some counterparties…

All of the largest derivative counterparties of Fannie Mae and Freddie Mac are major securities dealers and commercial banks or subsidiaries thereof. If any of those firms incurred credit losses that were large relative to their equity as a result of a default by EnterpriseEven if Enterprise A did not default, perceptions that the risk of a default was higher and uncertainty about how a default could affect the solvency and liquidity of the major derivatives dealers could lead to a temporary spike in the borrowing costs of all of them…

The adverse effects of Scenario #3 on broader financial markets unfold quickly. Observing the illiquidity of Enterprise A's debt, the possibility of credit losses on those obligations, and the effects of financial institutions that hold such debt, many investors become less willing to hold debt and other fixed-income obligations perceived to pose a significant degree of credit risk and liquidity risk. The demand for U.S. Treasury securities increases significantly, and the demand for higher-risk obligations declines, raising quality spreads for all non-Treasury issuers. Quality spreads for Enterprise B and other GSEs rise because increased uncertainty about the perceived federal guarantee of their obligations. Enterprise B also suffers from contagion to the extent it cannot convince investors that it does not suffer from difficulties similar to Enterprise A's. Those developments substantially reduce the desirability of all GSE debt, not just that of Enterprise A, as suitable instruments for use in hedging or as collateral for repurchase agreements, further reducing liquidity in financial markets. Foreign investors, especially monetary authorities, seek to sell their GSE obligations, and dollar-denominated assets generally, which causes a decline in the dollar's exchange-rate value and higher interest rates in the U.S…

If the yields on Treasury securities and other interest rates change markedly during Scenario #3, the interest rate risk exposures of the Enterprises may increase materially. In that event, some derivatives dealers may not write new contracts with Enterprise A, or do so only if that Enterprise agrees to post high-quality, liquid collateral to cover any increases in the market value of the dealer's position… Market turmoil and increased interest rate volatility may raise the cost of new hedges substantially.

As in Scenario #2, how Enterprise B and other sources of mortgage financing respond to Enterprise A's unexpected cessation of new commitments to purchase and securitize mortgages (and, potentially, decision not to honor outstanding purchase commitments) affects the volume of lending in the primary mortgage market in Scenario #3... First, the disruption in the relationships between >Enterprise A and lenders is more serious. Second, the solvency and liquidity problems of some banks and thrifts could limit the volume of newly originated mortgages they could fund with newly issued liabilities… The risk of an increase in mortgage rates and decline in mortgage lending is clearly much greater than in Scenario #2…

Financial market participants are likely to look to Congress and the Department of the Treasury for explicit statements of intent to protect investors in Enterprisemight be made quickly. However, Congress could be in recess: could be concerned about the magnitude of the cost of such assistance, particularly if Scenario #3 occurred at a time of large budget deficits that could be viewed as contributing to the underlying financial market problems; or could be concerned about the consequences for market discipline of other firms that market participants might consider to be "too-big-to-fail…" In the meanwhile, the Treasury could lend either Enterprise A as much as $2.25 billion if asked to do so by the Enterprise. Given the size of the Enterprises, those amounts might not have much effect on their liquidity.

In the short run, a heavy burden of decision might fall on the Federal Reserve System, which has broad authority to purchase the securities of or, in certain circumstances, to make a loan to a GSE. In taking any of those actions, the Federal Reserve could be concerned about the precedent that it would create, the risk that Enterprise A's condition might deteriorate further, and potential complications for the conduct of monetary policy in an already very difficult financial environment.

Effects on Economic Activity: The range of potential effects of Scenario #3 is quite broad. The best case is a modest but short-lived decline in housing activity and no substantial decline in consumption, output, and employment… In the worst case, the market for Enterprise A's debt becomes illiquid and there are adverse consequences throughout the financial sector and economy.

Conclusions: Scenario #3 would not have been possible a decade ago, when the failure of Fannie Mae or Freddie Mac would have posed a much smaller systemic threat to the U.S. economy. If Fannie Mae had failed at year-end 1981, when the Enterprise was insolvent on a mark-to-market basis and had less than $60 billion in outstanding debt and $3 billion in guaranteed MBS, that failure would have imposed losses on investors, mortgage lenders, and related firms but probably would not have seriously threatened a collapse of the housing finance system or a disruption of financial markets generally. At the time the Federal Housing Enterprise Safety and Soundness Enhancement Act of 1992 was enacted, the outstanding debt of Fannie Mae was about one-fifth, and that of Freddie Mac was about one-twentieth, of the levels at year-end 2001. In addition, the Enterprises' debt and MBS were much less important in financial markets, and Fannie Mae and Freddie Mac were just beginning to use financial derivatives. Although OFHEO regulation of the Enterprises has reduced the likelihood of an Enterprise failure, the potential for such a failure, if it occurred, to contribute to disruptions in the housing market and financial system is much greater now than it was then.

We'll take exception to the Freddie exec's reference to Mr. Falcon creating the "doomsday scenario." It would not take a wild imagination to create Scenario #4, with "Big Three" GSE debt and securitization markets dislocating, the dollar in free-fall, the ABS market closed for business, derivatives markets "seized up," the leverage speculating community in chaos, and financial markets faltering in systemic liquidity crisis. But putting disastrous scenarios aside, it is rather clear to us that the entire U.S. financial sector has evolved into one big, unmanageable leveraged speculation; the dollar one historic confidence game. And the GSEs have developed into the epicenter of systemic liquidity with mortgage finance running the financial and economic show. There will be no turning back. Today, the Federal Reserve should be explicitly delegated as the sole GSE regulator - responsibility and accountability. No reason and too much at stake to obfuscate.

And from Wednesday's Wall Street Journal article (Patrick Barta and Dawn Kopecki), New Regulator Is Veteran Finance Man: "'He (Mark Brickell) is no friend of regulation, except for the discipline that market regulation brings upon parts of the marketplace,' said Bob Pickel, the current executive director of the International Swaps and Derivatives Association. Mr. Brickell believes 'the market will bring the greatest discipline to bear on the marketplace. I think he would approach problems with Fannie and Freddie from the same perspective.'

Well, "market regulation" some time ago failed spectacularly. It is today disappointing to read that the new OFHEO director, a position demanding of one of the most diligent and dedicated regulators in world today, is "no friend of regulation." Difficult to believe he will be a friend of the public interest.

"Hats Off" to Armando Falcon, as well as his colleagues Patrick J. Lawler, Brian M. Doherty, Forrest W. Pafenberg, Thomas J. Lutton, David Pearl, Mary Ellen Taylor, and Mark A. Kinsey for their historic document. But, unfortunately, OFHEO has been deliberately placed in a powerless, thankless, and winless situation. They are a paper "regulator," when extraordinary circumstances beckon loudly for Iron. The mighty powerful Fannie and Freddie insist on straw. And, make no mistake about it, there will come a day when the straw man will be morphed into Contrived Scapegoat. The finger-pointers have their target in waiting.

Considering the environment nowadays in Washington, we are especially appreciative of Mr. Falcon's diligence and determination. We see so little of it from our monetary authorities that the whole thing seems rather alien to us. Scenario #3: pondering such realistic potentialities is today invaluable and an important public service, albeit worse than woefully politically incorrect. Telling it like it is has become straight out taboo and rendered self-destructive in our nation's capital. It may have cost Mr. Falcon his job, but we hope very much that demonstrating integrity, a sense of purpose, and commitment to the public interest do not impede his career. We wish you, Mr. Falcon, all the best in your future endeavors.