The document discusses the Futures & Options Expo 2000 conference which covered regulatory changes in the futures industry, including proposed legislation to modernize regulation. It also discusses the Chicago Mercantile Exchange's new business-to-business initiative and partnerships, as well as issues facing the managed futures sector. The conference showed the ongoing transformation in the futures industry driven by globalization, technology changes, and deregulation.

1. FEDERAL RESERVE BANK
OFOiICAGO
CAPITAL MARKETS NEWS
December 2000
The Futures &: Options Expo 2000
T
he Futures & Options Expo, held
each fall in Chicago, is the largest
futures industry event in the
world. It attracts international exchanges
and clearinghouses, traders, technology
and data vendors, and global financial
institutions as well as accounting, law
and consulting firms that support the
futures industry.
This year's conference once again offered
a rich program, with sessions on industry
issues, online markets, and trading strate-
gies running in three parallel venues.
Regulatory reform, B2B markets, and
virtual trading dominated most sessions,
while other more narrowly defined topics
like retail products, exchange-traded
funds, and managed funds received
heightened attention as well.
New Regulation
Bill H .R. 4541, known as "The
Commodity Futures Modernization Act
of2000," which reauthorizes the CFTC'
and amends the Commodity Exchange
Act (CEA), has passed the House but
awaits Senate approval. The bill addresses
the following four broad categories:
• granting legal certainty to bilateral
swap transactions;
• clarifying the ambiguities contained in
the Treasury Amendment;'
. • repealing the Shad-Johnson prohibi-
tion on trading single stock futures; and
• endorsing the regulatory reform pack-
age proposed by the CFTC.
Repeal of the Shad-Johnson jurisdic-
tional accord' and the new regulatory
framework proposed by the CFTC
received considerable attention in the
program. The section ofthe bill on single
stock options is a modified version ofthe
agreement reached between the
Chairmen ofthe CFTC and the SEC to
repeal the Shad-Johnson Accord, over-
coming turf considerations between the
two agencies and rendering the validity of
the product acceptable. The new legisla-
tion permits US exchanges to offer single
stock futures and certain "narrow-based"
indexes subject to joint SEC-CFTC reg-
ulation, though the details required to
bring a level of parity between single
stock futures and options based on trans-
action fees, margins and taxes have yet
to be worked out. General trading may
begin a year after enactment of the bill;
options on single stock futures, however,
may not trade until jointly permitted by
the SEC and CFTC.
From a public policy standpoint, the pro-
hibition ofsingle stock futures was ques-
tionable anyway given that they can be
created synthetically.• With the repeal of
the accord, single stock futures offer a
more efficient alternative to their func-
tional equivalents, and should prove par-
ticularly appealing both to the arbitrage
community and to hedge funds as an
attractive alternative to borrowing stock.
It is expected that the majority of hedge
fund participants will roll their equity
loan books into single stock futures.
Single stock futures can also become a
retail vehicle; depending on how the
product is regulated in the US for retail
customers. CFTC Chairman William J.
Rainer joined the US exchanges and
FCMs in stressing the importance to
repealing the Shad-Johnson Accord this
year, as any delay would place the US
markets at a considerable competitive dis-
advantage. The most eminent threat
comes from LIFFE, which will offer
equity futures in 15 leading equities in
January 2001.'
The new regulatory proposal by the
CFTC provides for three-tiers oftrading
facilities. Exchanges can organize them-
selves as Recognized Futures Exchanges
Capital Markets News is published quarterly by the Capital Markets Group of the
Supervision and Regulation Department. Its primary intention is to further
examiners' understanding of topical issues pertaining to derivatives and other
capital markets subjects. Articles are not intended as exhaustive commentaries of
the subject matter; rather, they are summaries meant to convey a basic under-
standing of the issue and to serve as a foundation for further analysis. Readers
who would like further information on any ofthe articles may contact the author
directly. For additional copies of back issues of the newsletter, please contact
Joe Cilia at 312-322-2368.
Any opinions expressed are the authors' alone and do not necessarily reflect
the views ofthe Federal Reserve Bank ofChicago or the Federal Reserve System.

2. CAPITAL MARKETS N E W S - - - - - - - - - - - - - - - - - - - - - - - - - -
1111111
The futures & Options Expo 2000 continued
("RFEs"), Derivatives Transaction
Facilities ("DTFs") or Exempt
Multilateral Trade Execution Facilities
("MTEFs"). Of these new facilities,
RFEs will be open to any trader and any
futures product, and will be subject to the
greatest degree of CFTC oversight. (US
futures exchanges as they are organized
now fall under the RFE category). DTFs
will offer contracts on underlying com-
modities that have a nearly inexhaustible
deliverable supply or no underlying cash
market, and operate as institutional markets
or'commercial markets limited to users'
ability to make or take delivery. This tier
will be subject to lighter regulatory over-
sight. (The Eurodollar contract traded at
the CME would fall under this category).
Exempt MTEFs will be limited to institu-
tional traders trading as principals only
and not as agents, and to markets where
there is not a finite supply in the underly-
ing product. There would be little need
for a regulator to intervene in such an
environment. The three trading facilities
will be required to adhere to core princi-
ples specific to each category. In this way,
the CFTC has moved from "hands-on"
regulation to a more flexible approach,
whereby regulation is less prescriptive.
The CME's New B2B Initiative'
James J. McNulty, President and CEO of
the CME, delivered a thoughtful and
well-structured presentation of how the
CME, a traditional brick-and-mortar
exchange, has moved into the large and
revolutionary B2B marketspace to take
advantage oftremendous new opportuni-
ties.' Mr. McNulty identified three general
patterns evident in B2B marketplaces:
• they are being created by industry
experts teamed up with technology
experts;
• they are attracting buyers and sellers by
providing industry specific content
and flexible multi-format trading plat-
forms; and
• they match buyers and sellers in easily
understood transactions for near-term
physical delivery.
Mr. McNulty predicts consolidation,
within the B2B marketplace, of one or
two primary exchanges in each industry
that will achieve a critical mass ofliquid-
ity. Having said that, technology is not
the sole prerequisite ofliquidity. In order
to attain and maintain liquidity profitably,
marketplaces need to assemble "a com-
plete ecosystem of users, products and
services." Currently, most B2B markets
are, in essence, front-end engines only,
matching buyers and sellers. The CME,
he maintains, is able to deliver value-
added products and services that "com-
plete the market ecosystem" in a manner
that is superior and more expedient than
building such services from scratch or
acquiring them elsewhere.
A complete market ecosystem consists of
the spot and derivatives markets, with a
clearinghouse in place to allow for the
netting ofrisks and payments. The evolu-
tion ofthe system calls for the presence of
a spot market with its purchasers, suppli-
ers and contracts for delivery, and a clear-
inghouse with escrow services, letters of
credit, and guaranteed payments and
delivery, thereby allowing market prices
to be free of credit spreads. The deriva-
tives market, with a clearinghouse in
place that removes credit risk and provides
collateral and credit management ensur-
ing payment and settlement, develops in
response to a need to hedge transactions in
the spot market. The derivatives market
attracts professional liquidity providers
(market makers) and speculators (traders),
while arbitrage opportunities between the
spot and derivative markets attract arbi-
trageurs. All these entities and market
participants together create "a complete
market ecosystem."
The CME articulates its core competen-
cies as market making know-how, efficient
clearing, error-free transaction processing,
and trading instrument innovation. It
hopes to achieve economies of scale by
developing an infrastructure that can be
generalized easily and plans to market to
"verticals" in pursuit of a "horizontal
strategy." The exchange moved decisively
2
into the B2B marketplace . S
in epte b
when it signed an agre Ill er
ement ·
CheMatch.com, a B2B Int With
ernet-has d
marketplace for bulk commodity che e_
cals, plastics and fuel products t . .nu-
, o Joint]
develop and market a co-brand d Y
e COtn.
plex of chemical futures and op · -
t1ons
products. The new derivative prod
ucts
will trade exclusively on GLOBEX2, the
electronic trading system of the
exchange, and will clear at the CME
clearinghouse with a clearing member
firm. The plan calls for a seamless link
between the CheMatch trading platform,
where physical products currently trade,
and GLOBEX2 via the Internet, giving
simultaneous and direct trading access to
both the physical and derivative products.
The Future ofManaged Futures
The session on managed futures sought to
delineate reasons behind the sector's poor
performance' and offered solutions for
the future. Investment in managed futures
has dropped significantly from a decade
ago, when it comprised 18% ofthe alter-
native asset class, to its current level of7-
8%.' Moreover, in the last 24-30 months
the managed futures sector has had the
lowest return-on-risk-adjusted basis
within the alternative asset class. On the
surface, the sector appears to possess the
necessary characteristics to remain viable.
Managed futures encompass a diversified
pool of products, have the unique
attribute of leverage, are riskless invest-
ments from a credit standpoint,10
and
afford an investor the ability to go long or
short. Those factors driving poor perfor-
mance are characterized as both internal
and external to the markets.
When viewed internally, markets have
witnessed considerable change. Until
recently, the performance of managed
futures manifested itself within the
financial markets, particularly foreign
exchange and fixed income. With the
conversion to the euro, significant dealing
potential was lost when euroland moved
to a smaller universe of currencies. On

3. the fixed income side, the convergence of
EMU interest rates in preparation for the
euro offered attractive trade opportunities
that have since gone away, while the
Treasury buybacks in the US have
impacted the long bond market, distort-
ing historical patterns. There are fewer
opportunities in the agricultural markets
where improvements in farming technol~
ogy have resulted in controlled trading
ranges for these products. The metals
market has moved from a store value and
inflation hedge to an industrial market; as
a result, metal markets trade only as carry
markets and provide little opportunity for
profit. External factors have also
impacted the performance of managed
futures. Technology has enabled large
volumes of information to be dissemi-
nated quickly, making markets more effi-
cient and collapsing trends on which to
trade. Capital and liquidity have dimin-
ished as money has continually drifted to
the equities markets; NASDAQ, for
example, has attracted a lot ofspeculative
capital. Additionally, the futures industry
in general has failed to attract day-traders,
as its electronic trading technology fell
behind equities. There is also a scarcity of
talent in the industry, as gifted individuals
have moved into the hedge arena or other
alternative classes.
These changes are having a lasting, serious
impact on both the industry as awhole and
the managed futures sector. Nevertheless,
CTAs and CPOs can prosper again ifthey
redirect their efforts to research infrastruc-
ture, better methodologies, and the retail
market potential. It was noted that the
industry has now moved from static allo-
cation models to dynamic models which
focus on frequent portfolio rebalancing
and weighting. Technical analysis has
become more challenging as the nature of
trends, once bigand sustained, has changed.
Noise and volatility in the markets have
increased substantially, requiring the use of
filters and more sophisticated statistical
techniques to identify and substantiate the
onset of trends and trading patterns.
Competition in the fund offunds market
remains stiff but opportunities exist for
the managed futures industry in the retail
arena, where investors do not have access
to hedge fund products. The industry
will need to develop products with an
inherent return component in order to
capture the retail market.
Conclusion
Panel sessions with new entrepreneurs and
representatives from traditional exchanges
sitting side-by-side symbolically captured
the ongoing transformation within the
futures industry. Globalization, rapid
changes in technology, and deregulation
have created a new environment among
exchanges and products alike. Traditional
brick-and-mortar futures exchanges have
clearly lost their monopoly position and
are searching for a new future as the
CFTC moves decisively to reshape the
regulatory landscape, enabling competi-
tion to determine winners and losers.
11
Time is ofessence, and legislative finality
to the CEA amendment is critical.
-Gloria Ikosi
1 The CFTC was created by Congress through the
enactment of the Commodity Futures Trading
Commission Act of 1974 as an amendment to the
Commodity Exchange Act, and is subject to periodic
review and reauthorization by Congress. In 1995,
Congress authorized the CFTC for a period ending
September 30, 2000.
'The Treasury Amendment to the Commodity
Exchange Act excludes the interbank market in for-
eign currency and the dealer market in government
securities from the provisions of the Act. It was
adopted by Congress in 1974 in response to concerns
by the Department of the Treasury that the CFTC
might gain jurisdictional authority to regulate tradi-
tional areas oftrading among banks and dealers.
'The Shad-Johnson jurisdictional accord of 1982
defined the jurisdiction ofeach agency over certain
security-based derivatives. The CFTC was authorized
to permit trading in stock-index futures on futures
exchangesas longas these were basedonabroadorsub-
stantialsegmentofthe equityordebt market. Futureson
individual securities were prohibited. All such contracts
were first subject to initial review by the SEC.
•This can be accomplished by going long a call and
short a put on the same stock with the same strike
3
price and expiration time. In addition, single stock
futures already exist in equity sw.ips that tr.1de primar-
ily in Switzerland and London.
'L!FFE will initially list fifteen futures on Continental
European, UK and US srocks that will tr.1de in euro,
sterling and dollars respectively. The single stock
futures will be on the following stocks: Nokia OYJ
1:r.1ded on the Helsinki Exchanges, Aleatel SA tr.1ded
on the Paris Bourse SBF, Deutsehe Bank AG and
Deutsche Telekom listed on Deutsehe Boerse, the
Royal Dutch Petr0leum Company traded on the
Amsterdam Exchanges, AstraZeneca pie, BP Amoco
pie, Glaxo Wellcome pie, HSBC Holdings pie and
Vodafone Group pie listed on the London ~tock
Exchange, Cisco Systems Inc. tr.1ded on NASDAQ
and Citigroup Inc., Exxon Mobil Corporation, and
Mere & Co Inc. listed on the NYSE. See the press
release posted on the Exchange's website
(www.liffe.com).
•Thanks to Mr. McNulty for a copy ofhis slides.
7 According to Mr. McNulty, the 700 B2B sites that
exist today are projected to increase to 5,000 by 2002,
while the value of transactions conducted online
between companies is expected to reach SS-7 trillion
by year 2004.
' This analysis was presented by David J. Vogel of
Salomon Smith Barney, who moderated the session
entitled "The Future ofManaged Funds."
'According to the Commission, funds committed to
professional management for futures trading have
grown dramatically from $115 million in 1975 to
nearly $44 billion in 2000 (Statement of William J.
Rainer, CFTC Chairman before the House
Appropriations Committee, Subcommittee on
Agriculture, Rural Development, FDA and Related
Agencies, March 24, 2000). The CFTC regulates
commodity pool operators ("CPOs") and commod-
ity trading advisors ("CTAs').
"Through the use ofclearinghouses which removes
direct counterparty risk
11 "Developing a New Regulatory Framework for the
Commodity Futures Trading Commission", Speech
by William J. Rainer, CFTC Chairman at the
International Regulators' Meeting in Burgenstock,
Switzerland, September7, 2000. The CFfC has taken
the stance that "competition is the regulator's ally:•

4. CA PIT AL MA R KET S NE WS- - - - - - - - - - - - - - - - - - - - - - - - -
GLB and the Merchant Banking Competency Center
T
he Gramm-Leach-Bliley Act
("The GLB Act"}, enacted on
November 12, 1999, is considered
by many to be the most significant
change in federal banking law since the
Glass-Steagall Act. The Act permits
banks, insurance companies, securities
firms, and other financial institutions to
affiliate under common ownership, and
to offer their customers a complete range
of financial services that were previously
prohibited. The Act also authorizes bank
holding companies ("BHCs") and for-
eign banks that meet certain eligibility
criteria to become financial holding
companies ("FHCs"). To become a
FHC, a BHC must file a declaration with
the Federal Reserve Bank and the Board
ofGovernors (BOG) certifying that all of
its depository institution subsidiaries are
well capitalized and well managed. The
Federal Reserve has been assigned the
responsibility ofsupervising FHCs similar
to its existing responsibility regarding
BHCs and, to that end, the Fed oversees
the organization's consolidated risk man-
agement activities. In addition, the Act
places certain limits on supervisory pow-
ers with respect to functionally regulated
subsidiaries of a BHC. The Act further
authorizes FHCs to engage in a broad
array of financial activities, including
securities underwriting and dealing,
insurance agency and underwriting activ-
ities, and merchant banking activities.
The merchant banking provisions of the
GLB Act provide additional authority to
FHCs to make equity investments in
non-financial companies. While equity
investments in non-financial companies
can contribute substantially to earnings,
these investments often entail significant
market and liquidity risks, and can also
give rise to increased volatility ofearnings
and capital. It is not uncommon for orga-
nizations to allocate a very small portion
ofconsolidated assets (frequently less than
one percent} to equity investments, yet
the earnings contribution can be as high
as 30 percent ofconsolidated net income.
In all cases, it is the responsibility ofabank-
ing organization's senior management and
board of directors to ensure that the risks
associated with private equity investments
and merchant banking activities do not
adversely affect the safety and soundness of
the banking organization and any affiliated
insured depository institutions.
The Chicago Fed was designated as the
merchant banking Competency Center
for the Federal Reserve System by the
Board of Governors in June 2000. Over
the past several years the Chicago Fed has
developed a team of examiners with a
high level of private equity merchant
banking ("PEMB") expertise. The team's
skills have been utilized by several
Reserve banks seeking help in carrying
out safety and soundness reviews offinan-
cial institutions engaged in private equity
investments. The team is led by Jeno
Majerszky and includes Marge Kerr and
John Wenaas. Jeno will coordinate the
activities of the PEMB Competency
Center and, in addition to Marge and
John, Steve Durfey, Dean Gartelos, Jane
Frost, and Bill Mark will assist him. Steve
and Dean joinJeno, Marge, and John in
the field, while Jane and Bill will be
responsible for the coordination ofindus-
try trend analyses and emerging issues, as
well as information management and
knowledge sharing. The Competency
Center is also in the process of establish-
ing a PEMB website, and Jane Frost has
been instrumental in this endeavor.
Information available on the website will
include data on institutions engaged in
merchant banking activities as well as note-
worthy articles and other points ofinterest.
The objectives of the Competency
Center will be to work closely with
Reserve Bank CPCs (central points of
contact, or institution relationship man-
agers), portfolio managers, and other staff
to develop on-going supervisory strate-
gies and coordinate the most effective
means of deploying Competency Center
specialists for the review ofPEMB activi-
ties. These efforts will also include pro-
:iding periodic updates to and receiving
input from LCBO Coordinator John
Yorke. One of the primary responsibili-
ties of the Competency Center, and a
4
core activity of the PEMB su .
fu . ill . Perv1sory
nct1on, w mvolve knowled
ge transfi
throughout the System. The C er
. 0 mpetency
Center, in collaboration w· h
It Othe
Reserve Banks and the BOG will r
d • • ' create
an mamtam a central monitorin f: ..
r. PEMB . . . g acility
ror act1v1t1es undertaken by FI-I
and BHCs. This monitoring f .
1
_Cs
ac1 lty
would be used to provide a r15
·k r
. . -,ocused
assessment of institutions all
• Ocate
resources, and identify emerging trends.
A BOG issued administrative policy or
AD letter, expected to be released in the
near future, will address issues such as ini-
tial risk management assessments, the
establishment of supervisory plan and
monitoring programs, and ongoing
supervision and monitoring.Both onand
off-site initial assessments will play akey
role in ensuring the continued safety and
soundness offinancial organizations initi-
ating or expanding PEMB activities, as
well as the development of appropriate
risk-focused supervisory strategies. The
System will schedule an initial assessment
within 30 days of receiving the risk-
focused scheduling process; the CPC or
responsible staff member should contact
the banking organization reporting
PEMB activity to obtain preliminary
information for determining the timing
ofan initial assessment. The CPC and the
Competency Center will evaluate specific
information requested of the banking
organization in order to jointly identify
the appropriate timing, scope, and level of
staffing for an initial assessment. Written
. fth . 'tial ents willbesummaries o e lill assessm
maintained by the Competency Center.
1 merchantOver the past severa years, .
banking related activities such as inveSt1ng
· · sts of non-in equities and eqmty mtere .
1 di t privatepublic companies and en ng O d
equity-financed companies have emerge
. . . rces ofearn-as mcreasmgly important sou .
nkin ganizaoons-ings at a number ofba gor
h. •cally been
These activities have !Stan •
gh small bus1-
conducted primarily throu ) d
· (SBICs anness investment corporanons nk
b 'di . fbanks and baEdge Act su s1 anes O • h se
. L'k wise, t eholding companies. 1 e

5. GLB and the Merchant Banking
cornpetency Center continued
activities have been conducted via the
authority granted to BHCs to make
investments in up to five percent of the
outstanding voting shares of any com-
pany. Banking organizations within the
Seventh District involved in private
equity investment activities range in size
from firms holding small equity interests
to those maintaining rather substantial
portfolios. Organizations with various
degrees of activity include, but are not
limited to, BANC ONE, Bankmont,
ABN-AMRO, Heller, Comerica, Irwin
Union, and First Busey.
-John Wenaas
Land of the GSE Giants
F
annie Mae and Freddie Mac have
oflate, been the subject of consid~
erable scrutiny resulting from com-
ments made earlier this year by Gary
Gensler, the senior advisor to Treasury
Secretary Lawrence Summers, as well as
by members of the Administration and
Congress. Critics claim that the agencies
may be taking unnecessary risks in an
effort to increase profitability. Moreover,
many charge that Fannie and Freddie are
undercapitalized compared to rival financial
institutions such as banks.' The overriding
concern is one of systemic risk, namely
that the downfall ofone or both ofthese
prodigious firms would not only spill
over into the US banking system but like-
wise sock taxpayers with a bill even
greater than the $160 billion S&L crisis of
the 80's.2
The agencies, frequently referred to as
government sponsored entities or GSEs,
in their role as buyers ofmortgages in the
secondary market effectively act to fulfill
their government charter by providing
the capital that keeps the housing market
rolling. Ifthey hold mortgages in portfolio,
the firms make money on the spread
between the mortgage rate and its resultant
funding rate; in 1999, for instance, Fannie
realized about $5 billion in investment
income. If they sell these loans into the
marketplace as mortgage backed securi-
ties (MBS), the firms receive a fee for
guaranteeing principal and interest pay-
ments; in this regard, Fannie earned fees
ofover $1 billion.3
In addition, the GSEs
enjoy exemption from state and local cor-
porate income taxes, which the Treasury
estimates saved them a combined $690
million last year. Moreover, they are
exempt from SEC registration, an added
savings of$280 million in fees and related
expenses, and have a $2.25 billion line of
credit with the Treasury.' It is important
to note the perception, in the eyes of
some, that "the GSEs, despite their sub-
sequent privatization, continue to have
government missions which confer a spe-
cial status upon them."' While the idea
exists that the government would act to
5
"bail out" one or both of the firms if it
ever came to that, in reality each prospec-
tus for new Fannie and Freddie debt
clearly states that it is under no obligation
to do so.•
No one can dispute the agencies' impact
on the financial marketplace. Combined,
both GSE's either owe or guarantee
about $1.4 trillion of debt; by contrast,
the Treasury today has around $2.7 bil-
lion in outstanding public debt. Sources
portend that, by 2007, the combined
GSEs will overtake the Treasury as the
largest issuers ofdebt in the US. To illus-
trate this projection last year, according to
Bloomberg, the Treasury paid off about
$100 billion in debt while the GSEs sold
$268 billion. Fannie has been actively
promoting its debt as liquid and deep
enough to become a viable alternative
benchmark to Treasuries in the US.7
Freddie, for its part, announced a plan
this past August to issue at least $18 billion
of bonds into the European debt market
each year, offering investors there an
alternative to government bonds and,
perhaps, establishing a benchmark-type
status abroad for its debt as well. It is the
size of this debt that is of concern to
Treasury officials and others, especially
given Fannie Chief Executive Franklin
Raines' goal to double 1998 earnings of
$3.26 per share by 2003, and achieve
13.6% or greater annual earnings growth
over the next 5 years.•
In an effort to accomplish these ambi-
tious objectives both firms are taking on
more risk, with correspondingly high
stakes, notes John Gibbons, Freddie's for-
mer CEO. Former Fannie board member
Vance Miller is also concerned that the
"companies are reaching for too much
business and going for some much more
risky loans".• Both Fannie and Freddie
are embarking on an aggressive bid to
purchase subprime mortgages; last year
Fannie bought about $4 billion, up sig-
nificantly from about $100 million in
1990. Critics like Peter Wallison, a fellow
at the American Enterprise Institute,

6. CAPITAL MARKETS N E W S - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
"Earlier this year I took
my daughters to the
congressional hearings at the
House Banking Committee.
Chairman Leach invited
my eight-year-old to sit up
at the witness table with me
while 20 to 30 members
of Congress werefiring
questions at me. My
eight-year-old kept passing
me notes, and I had to do
everything not to laugh.
They were pictures she drew
of the congressmen, going
'Blah, blah, blah."'
Gary Gensler, The SmartMoney 30,
SmartMoney Magazine
Land ofthe GSE continued
note that the firms have little experience
in this sector of the market where credit
histories are less than stellar.
10
Additionally, both GSEs are buying up
more and more of their own mortgage
securities, largely fueled by the fact that
they can borrow at more attractive rates
than competing banks given their
implicit government guarantee.
According to the Wall Street Journal
between 1992, when the firms first began
buying up their own securities in great
numbers, and 1999 their combined profits
rose by 173% while the mortgage market
grewby61%.
In the GSE's defense, their risk manage-
ment and hedging practices are well
established and robust. According to
Bloomberg, for most of the 1990's,
Fannie lost only $5 for every $10,000 of
mortgages it held while the banking
industry lost around $86. In the 80's,
however, as rates rose and borrowing
costs were increasing, the firm was losing
about $1 million a day for a stretch of
time. Both GSEs extensively utilize
callable debt as well as swaps, swaptions,
and other derivative instruments to miti-
gate risk. Last year, the firms issued $182
billion in callable debt at relatively favor-
able rates.11
While such risk management
practices may be deemed sufficient for
now, the Office of Federal Housing
Enterprise Oversight (OFHEO), the
GSEs' regulator, questions whether they
would hold up in a severe recession.
OFHEO notes that the risks ofsubprime
lending are still not fully understood and
also questions the sufficiency ofthe firms'
capital. Last year OFHEO conducted
stress tests scenarios on the firms to deter-
mi~e if they could maintain solvency
durmg a 10 year period ofeconomic tur-
moil. It concluded that, while Freddie
was adequately capitalized, Fannie fell
short by about $3.7 billion.12
Richard Baker, a Republican Congress-
man from Louisiana, has referred to the
GSEs as "the biggest potential threat
to our financial system today" .u As
Chairman of the House Subcommittee
6
on Capital Markets, Securities, and GSEs
he introduced H.R. 3703 th· '15 past
February. Called the Housing F'inance
~egulatory Improvement Act, the bill
aims to:
• Consolidate the regulation of F .anrue
Mae, Freddie Mac, and the Federal
Home Loan Banks into a new 1· dn e-
pendent agency, and
• Make a number of amendments to th
GSEs' charters, which address safe;
and soundness and systemic risk issues."
Baker notes that "when you're buying
back your own securities, there's no
explanation for it other than bottom line
profit...buying back securities doesn't
create home ownership". His bill would
remove the companies' Treasury line of
credit and limit their activities in what he
refers to as "non-mission" related invest-
ments. In an address to the American
Enterprise Institute at their May confer-
ence on the GSEs, Baker cited his request
to Chairman Greenspan for comment on
the potential for systemic risk to the
economy, as well as the effect on the
housing and mortgage market, posed by
the GSEs. The Chairman concurred that
the GSE's "clearly benefit from govern-
ment sponsorship, particularly from their
ability to borrow at a lower cost than
comparable private sector borrowers".
15
The bill, calling for a repeal ofthe GSE's
line of credit, would eliminate the per-
ception that the government stands ready
to bail Fannie and Freddie out.
Recently, both firms seem to have gar-
nered a political as well as a market
reprieve. This past October, Chairmen
Leland Brendsel of Freddie and Franklin
Raines of Fannie, along with Represen-
tative Baker and other members of
Congress, appeared at a press conference to
announce several new measures that the
firms have mutually agreed upon, namely:
• Enhanced public disclosure of intereSt
rate sensitivity analyses; .
• Issuance of $15 million of publicly
traded, externally rated subordinated
debt over the next three years; and
<

7. • Maintaining more than three months
worth of liquidity, thereby increasing
their capital base
These initiatives, analysts feel, go a long
way towards addressing the safety and
soundness issues raised by Baker and
other critics of the firms, though Baker
did cite the regulatory oversight issue as a
continued discussion point between the
parties.16
Nonetheless, the mood has
shifted from the "confrontational to the
cooperative", according to Morgan
Stanley Dean Witter. "Baker got what he
wanted", notes Thomas O'Donnell, an
analyst at Salomon Smith Barney. "We
should hear relatively little from the gov-
ernment near term", says Gary Gordon
an analyst with Paine Webber. Indeed,
according to CNBC.com, in a Republi-
can controlled House, Baker would no
longer be head of the GSE subcommit-
tee, as all committee chairs rotate after six
years. While there is an outside chance
that he be could become head of the
House Banking Committee, another leg-
islator (Margaret Roukema R-N.J.) is
considered next in line.17
In response to
these events, shares of both firms have
risen almost 40% since late summer,
according to CNBC.com.
-Joseph Cilia
, The agencies hold capital of 3% of assets versus
banks' B%. They operate with about $32 ofdebt for
each dollar of capital compared with an average of
$11.50 for large banks.
' Gillen, David, "Fannie Mac Takes On Its Foes,"
Blcomberg Magazine,June 2000, p.42
' Ibid., p.44
' !bib., p. 44
5
Remarks by Chairman Greenspan to Representa-
tive RichardBaker (R-La.), AEI Conference on the
GSEs, Washington, D.C., May 23, 2000
6
Op cit., pp. 44
7
See "Going! Going! Gone!" by Donna Zagorski in
theJune 2000 issue ofCMN
' According to Bloomberg, Fannie has generated
record upon record operating profit for the last 49
consecutive quarters, with 1999 profit totaling $3.91
billion.
' Barta, Patrick, "LoanStars: Why CallsAre Rising to
Clip Fannie Mae's and Freddie Mac's W~", l¾II
Street]ourna~July 14, 2000
10 "Fannie Mae Takes On"...p.44
11
Op. cit., pp. A6
" Ibid., pp. A6
""Fannie Mae Takes On"...pp.42
" OFHEO News Release, March 22, 2000
15 Remarks by Chairman Greenspan to Representative
Richard Baker (R-La.), AEI Conference on the
GSEs, Washington, D.C., May 23, 2000
" Securitized Perspectives, Morgan Stanley Dean Witter,
October 20, 2000, pp. 5
17 Dunaief, Daniel, "Smooth Sailing for Fannie and
Freddie", CNBC.com, October 26, 2000
7

8. )
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Senior Capital Markets Analyst
Craig West (312) 322-2312
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