Our Founding Fathers showed their genius when they created a dynamic that encourages extending the hand of compromise across divides for the common good.
We have just seen a fine example of this in the compromise reached between Fannie Mae and Freddie Mac on the one hand and Rep. Richard Baker on the other. The agreement between the Louisiana Republican and the government-sponsored enterprises is a victory for all of us who are concerned about the safety and soundness of the financial system, and both sides should take a bow for this historic step.
As a result of the compromise, Fannie and Freddie have agreed to enhance their safety and soundness efforts in six important ways:
- The GSEs have agreed to issue publicly traded, externally rated subordinated debt for each company that will equal or exceed 4% of on-balance-sheet assets after a three-year phase-in.
- This accomplishes two worthy goals. First, it strengthens the GSEs' capital position. The debt will be in addition to, and not a substitute for, current components of their capital structure. Second, it gives the markets yet another tool with which to discipline Fannie and Freddie. The debt will be issued semiannually, and its pricing will be an important signal of the markets' view of these enterprises' financial health.
The GSEs have agreed to maintain more than three months' of liquidity, assuming no access to the debt markets. Such a step is extremely important. Liquidity weakness - not insolvency - typically lays financial institutions low. Strengthening liquidity, as this agreement does, ensures that Fannie and Freddie have a substantial cushion, which would give them and other players time to act if financial difficulties arise.It is no wonder that this liquidity management technique is consistent with the principles established by the Basel Committee on Banking Supervision.
- Until permanent risk-based capital regulations are adopted by the Office of Federal Housing Enterprise Oversight, the GSEs have agreed to use an interim risk-based capital stress test based on parameters established in the Federal Housing Financial Safety and Soundness Act of 1992. Both the parameters and the outcome of the tests will be publicly disclosed quarterly. Here again, this approach to safety and soundness - stress testing of an institution's capital position - is strongly endorsed by the Basel committee.
- In a further effort to give the public a transparent view of their operations, Fannie and Freddie have also agreed to monthly public disclosure of the results of interest rate sensitivity analysis. This may well set a world standard on frequency of disclosure.
- Importantly too, this interest rate disclosure standard is supplemented by quarterly public disclosures of the GSEs' credit-risk sensitivity. This standard will demonstrate the expected financial effects of an immediate 5% decline in house prices. Again, this kind of public disclosure may well be a worldwide first.
- Last but not least, the GSEs have agreed to give the public and Congress a financial-condition rating from a nationally recognized statistical rating organization.
More specifically, these ratings will assess the risk to the government posed by each enterprise.Taken individually, each of these steps is important for strengthening safety and soundness.
Indeed, many of these steps are major advances in safety and soundness and are likely to be templates for action by other financial institutions.
Perhaps even more importantly, taken as a whole these measures form a package that supplies a much stronger safety net under Fannie and Freddie. This is just the kind of stuff that should win applause from the general public and even from a crotchety old former regulator like me.
Mr. Ludwig, comptroller of the currency from 1993 to 1998, is managing partner of Promontory Financial Group LLC in Washington.
