The regulatory agency responsible for oversight of Fannie Mae and Freddie Mac warned banks and thrifts to be aware of risks associated with certain derivative-associated debt being issued by the government-sponsored enterprises.

Concerned the government agency status held by government- sponsored enterprisesincluding the Federal Home Loan Bank System, Sallie Mae and the Farm Credit systemmay seduce some unwitting, unsophisticated investors into purchasing what they may believe are high quality, low risk, Aida Alvarez, director of the Office of Federal Housing Enterprise Oversight said as part of the agencys required on-site examination, its examination and regulatory oversight group is now attempting to identify the overall risks inherent in Fannie and Freddie business activities.

Alvarez, speaking before the California League of Savings Institutions Western Secondary Mortgage Market Conference in San Francisco July 13, said its analysis would include an examination of the effectiveness of their internal controls in managing large pools of derivatives. David Jeffers, a Fannie Mae spokesman, acknowledged OFHEO had been in contact with Fannie regarding its derivative activityand added Fannie was cooperating with the regulatorbut would not comment on specifics of the examination. Freddie Mac had no comment.

Fannie Mae and Freddie Mac have issued nonmortgage derivatives tied to various formulas and indices to lower their borrowing costs, Alvarez said. Those derivatives, such as interest rate swaps and foreign currency swaps, serve to protect them against adverse turns in the indices or formulas that determine the payments on these structured notes.

A recent study by the Federal Reserve estimated total structured debt for 1993 issued by all issuers, both corporate and GSE, was $93 billion. The five mentioned government-sponsored enterprises accounted for $59 billion of this total. The bulk of these securities do not involve unusual market risk, Alvarez said, but some do.

Experts have raised the possibility that this debt, while posing little risk to a GSE, could lead to significant losses for unsophisticated buyersa small savings and loan, for example, she said. And, she added, federally insured institutions are permitted to buy unlimited quantities of these notes, a fact that has the potential to create a significant safety and soundness concern.

Alvarez said the buyer of these high risk notes takes on the market risk for what appears to be an attractive yield. But the buyer may end up with zero return over time if rates move significantly, primarily because of the imbedded option or complex interest-rate formula, whose value may be difficult to quantify. Those buyers, she added, fail to understand that while they are not buying credit-sensitive paper, this new form of agency debt may still carry substantial market risk.

While Alvarez admits Fannies and Freddies derivatives use is a nonissue with regard to their safety and soundness, she contends the issue is nonetheless a regulatory issue. Some analysts, however, charge OFHEO may be out of its jurisdiction in warning banks and thrifts over the dangers of GSE derivatives.The Office of Thrift Supervision, the Comptroller of the Currency and the Federal Reserve have jurisdiction over banks and thrifts.

But when asked whether it was suitable for OFHEO to exam this issue, Alvarez said, I think its an issue for the regulatory agenciesand were talking about agency paper, I need to be in contact with the issue.

OFHEOs comments on the GSEs derivative activity may have been ill-timed, however. Alvarezs July 13 comments coincided with the pricing date for Freddie Macs first-ever global debt offering.

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