They walk like financial institutions, they talk like financial institutions and they certainly transact business like financial institutions. But in the eyes of the Federal Reserve Board, Fannie and Freddie may not make the cut.
The two secondary market companies have joined the World Bank. several prominent foreign lenders and the Federal Farm Credit Banks Funding Corp. in critiquing a Fed proposal to extend legal protections for the derivatives market.
They all fear they do not meet the definition of "financial institution" contained in the draft regulation. As a result, they may have trouble operating in the derivatives market, which they have been using to improve yields and offset certain risks.
The Fed's draft rules were issued in May to implement section 402 of the Federal Deposit Insurance Corp. Improvement Act and are intended to reduce systemic risk in the financial system by clarifying the legal status of netting contracts in the event of a bankruptcy.
Specifically, the proposed regulations say that netting contracts, widely used in the derivatives market, will receive a primary position in a bankruptcy proceeding so long as they have been entered into by qualified "financial institutions."
The Fed proposed a two-prong test to determine whether a firm qualifies as a financial institution for purposes of netting protection.
To meet the definition, the Fed said, an entity would have to participate "actively in a financial market for its own account" and be willing to act as either a buyer or seller for other counterparties. In addition, it would have to handle certain volumes of derivatives in specified time frames.
The Fed's proposal "may leave substantial market participants unprotected by the netting provisions, thereby decreasing financial market efficiency and liquidity and increasing systemic risk within the banking system and financial markets," said Mitchell Delk, Freddie's vice president for government relations, in an Aug. 20 comment letter.
"We believe that the definition of ~financial institution' should be expanded to include government-sponsored enterprises," added Timothy Howard, Fannie, executive vice president and chief financial officer. In an Aug. 20 comment, he said Fannie currently has derivatives contracts outstanding with a notional value of $1 billion and a mark-to-market value of more than $100 million.
The Fed has indicated that it does not want to extend its protections to the user side, although it could carve out a special exception for the GSEs. The Fed's position has been attacked by several major derivatives dealers as contrary to the efforts to reduce systemic risk since in some circumstances dealers and end-users are essentially equivalent.