Risk Analysis: Fannie Mae and Freddie Mac - Case Study Example

Fannie Mae and Freddie Mac Introduction Risk management refers to the systematic process inwhich risks are identified, assessed and managed. The process of risk management involves making decisions and implementing them appropriately to minimize adverse effects of these risks in an organization. A risk in business could be defined as a situation that involves exposure to possible losses. Risk management is essential in that it helps to understand the potential risks in a business whereby measures are established to identify, minimize or mitigate them (Finance Maps of World, 2013). Fannie Mae and Freddie Mac are government sponsored enterprises that tend to provide stability and liquidity to the mortgage market. This paper seeks to identify the kind of risks involved in the downfall of Fannie Mae and Freddie Mac; two mortgage companies based in the US and provides detailed suggestions on how similar risks could be avoided in future. Case study summary The case study analyzes Fannie Mae and Freddie Mac, two enterprises that are government sponsored and based in the United States. The companies play an integral role in the US mortgage investments and therefore their down fall would have great impact on the US home ownership and in the world at large. The usual business risks that involve both external and internal factors led to deterioration of the companies and huge losses were incurred. Considering the role played by the companies in the US housing finance system, the government came to its rescue by attempting to calm the market. The government established ways of boosting confidence in the companies by granting them access to a discount window and allowing the Treasury department to purchase stock from the two corporations. The two companies have had foreign central banks and governments as most of their debt owners leading to the US government making a decision to placate them. The two companies have been taken over by the federal government being termed as an expensive decision that may lead to dollar vulnerability and increased inflation rates. This rescue, despite saving the interest of mortgage owners in the future will also increase the public debt. In these two companies, profits have seemingly been privatized while risks have been socialized. Cost of borrowing for the two companies should decline owing to the government’s intervention where it stands behind their debts. Loan buying and selling will as well continue now that the government is backing the companies. Fannie and Freddie company’s downfall that led to the government’s intervention has been attributed to several deferred decisions, and miscalculations by government officials and the companies’ executives. These include; rapid purchasing of risky subprime and loans, often borrowing with inadequate capital to prevent unexpected losses, not taking heed to the dangers that inflated housing market poses and failure to raise adequate new capital to face the expansion of the housing slump. Other reasons leading to the downfall of Fannie Mae and Freddie Mac included politics, partisan infighting that led to the postponement of strengthening regulatory oversight, computer power and accuracy over estimation. They also under measured and under managed market and liquidity risks. Lack of transparency in the overall risks as well as capital efficiency also contributed to their downfall. The case has a brief outline of the risks that caused this downfall. Deferred decisions of the companies’ executives, government policies and law makers’ regulatory oversight had their share in the companies’ downfall. Risks that were involved with Fannie Mae and Freddie Mac case study A risk is a situation that involves endangered exposure of a business or company to possible losses. Every business has its varying risks. Fannie and Freddie have had their share as per the case study. The types of risks involved in Fannie and Freddie were both internal and external. Internal risks are those resulting from their executives’ miscalculations as well as deferred decisions while the external risks involved in the government and lawmakers as well. These risks include financial risk, political risk, technological risk, legal risk, inflation risk, liquidity risk and others. Financial risk Financial risk involves the loss of key and critical resources like funding. Financial risk is the risk of potential loss. The company in this case lacks adequate cash flow as required and is therefore unable to meet its financial obligations. A company’s financial risk tends to take into account its leverage. When a company’s amount of leverage is high, the financial risk also gets high on its stakeholders. Such a company fails to cover its debts and risks entering bankruptcy. Fannie and Freddie financial risk included capital inadequacy. The perception by the market that Fannie and Freddie had a government guarantee gave the companies the ability to issue debts at rates lower than it would without this guarantee (Finance Maps of World, 2013). The companies’ safe loans in the subprime market failed to meet the standard, thus pushing away the lending market. In 2007, the subprime mortgage crisis saw in it a high number of borrowers being unable to pay their mortgages anymore. As a result, house prices fell. More strict lending standards also made it hard to secure mortgages for potential borrowers. The fall in house prices led to huge losses for the companies. The high lending to low income families as a government supported policy posed as a great risk because no capital was set to protect unexpected risks. The losses would be incurred as a result of the low income families not being in a position to meet their obligations. Being one of the United States largest mortgage lenders, the US government decided to take control and back up the companies. The government stood behind the companies’ debts. The bailout of the companies has however been criticized and termed as the biggest expense to be impacted on the US taxpayers. In its defense the government claimed that watching the companies fail would affect the US and the world at large. Organizational and operational risks This involves parts of an organization’s administrative and operational procedures. The risk may arise from systems, people or processes through which an organization operates. Faulty machines may result to inaccurate records that may eventually lead to huge losses. Fannie Mae and Freddie Mac over-estimated the power and accuracy of their computer systems. The companies’ computers were not in a position to fully analyze the many risky loans that investors, lawmakers and customers wanted them to buy. Their computer programs and mathematical models could not identify unsafe bets of the new complex products. As a result, they continued to buy the risky loans and eventually there was default in payment by mostly low income borrowers. Political risk Government and government policies also affect businesses. Clinton administration pressured Fannie Mae to expand mortgage loans the low and the medium income loan borrowers. This would be done by increased ratios of loan portfolios in the poverty stricken areas. Due to the increased ratios, there was a demand from the primary mortgage for the company to ease its Credit requirements on mortgages. This political pressure mounted on the companies to expand to lower income customers led to the issuance of riskier mortgages. The real risk was the possibility of large numbers of borrowers failing to fulfill their obligations. The company utilized the implicit backing by the government for customers to borrow at will but did not set aside adequate capital that would protect them from losses in case of default in payments. Market risk Changes in the market value factors may lead to a decrease in investment portfolio or in the value of trading portfolios. The standard market factors are stock prices, interest rates, commodity prices and foreign exchange rates. As a result of Fannie and Freddie developing strong political influence that saw them avoid scrutiny and protect their special status, some concerns were confirmed. These were the longstanding concerns on whether the companies had enough capital to curb the risk they were undertaking. The concerns were eventually confirmed when MBS and the housing market collapsed. This collapse of MBS and housing market led to an effective reaction by alarmed investors and creditors. Creditors limited their credit supply while alarmed investors sold their shares. Asian central banks foreign investors started to sell. The market capitalization of Fannie and Freddie dropped drastically. Fannie market capitalization fell from 38.9 billion dollars as at the end of 2007 to 7.6 billion dollars as at the end of August 2008. A failure of Fannie and Freddie would cause a great turmoil in the US financial markets, thus the government had to attack the potential failure by placing the companies under conservatorship. To regain confidence in the credit market, the US government bought the MBS and controlled the two companies. Interest rates for mortgages were reduced and the two CEOs of Fannie and Freddie got dismissed. Liquidity risk The executives of Fannie Mae and Freddie Mac under measured and under managed the liquidity risk in line with the market risk. As a result no necessary measures were taken to avoid or reduce the impact of losses that were eventually incurred. The losses almost led to bankruptcy of Fannie and Freddie were it not for the US government’s intervention. Unable to recover their losses, the government bailed them out amid criticism and led to high taxation. Many investors sold their shares and creditors limited their supplies. Credit Risk and Investment Risk Credit risk occurs when borrowers become default and are unable to make payments as promised. It is also known as default risk. Investment risk on the other hand is associated with credit risk when the investor risks, the potential loss of his principal as well as interest. Due to the high risk loans bought by Fannie and Freddie as demanded by borrowers, there was a high risk of default in payment. After the collapse of the housing market and MBS, the investors, including foreign investors sensed an investment risk making them sell their share by a large percent. Thus, were it not for the federal government would have eventually led to complete failure by the two companies. Technological Risk For an effective business development, it is equally important to keep up with crucial technological developments. A business should monitor the technology advances in the environment. This can be done through communication with other business owners or tuning in to the current trends by tuning online. Fannie and Freddie over-estimated the power and accuracy of their computers. While they were dealing with new complex products, their computers were not up to the standard. Fannie Mae’s computer systems were unable to fully analyze the many risky loans that lawmakers, investors and customers required of them. The products were so new for their programs and mathematical models to identify the unsafe bets. They admitted to not really knowing what they were buying. Suggestions on how to avoid similar risks in future Going by Fannie Mae and Freddie Mac downfall, several miscalculations and deferred decisions are said to have contributed to the misfortune. Lack of a risk management plan may have caused the negative effects on the two organizations leading to financial backup by the government to sustain them (Finance Maps of World, 2013). We hereby outline the necessary steps that should have been taken to avoid the risks impact and what should be done to avoid a repeat of the situation in future. A risk business management plan should consider both internal and external factors. An organization may not be able to control external risk factors, but an effective risk management plan provides ways and measures to deal with the effects and minimize the potential losses that may occur. In order for a business to avoid these kinds of effects caused by business risks, an appropriate risk management plan should be established. A risk management plan is essential and plays an integral role in helping to understand the potential risks to a business. Ones the risks are understood, ways to minimize, mitigate or recover from their effects are suitably identified. The process of risk management starts with identifying the risk, assessing and managing or mitigating it (Finance Maps of World, 2013). For the risks that cannot be fully managed, suitable ways are put in place to recover from their impact. To avoid the recurrence of a similar situation in future, Fannie and Freddie should set up a business plan. This will help them identify any potential risk, analyze and evaluate its impact and then treat it. A risk management plan should be reviewed and updated after which a business impact analysis should be conducted. Risk identification Identification refers to the process of pointing out issues that pose as risks. A risk management plan should start with risk identification. Identification of potential risks to a business is the first step in preparing an effective risk management plan. Once the scope of business risks is clearly understood, cost-effective and realistic strategies are developed to deal with the risks. In risk identification, important factors like resources, key services and staff should be considered. Time, reason, place and the way the risks may happen should also be considered. The risks should then be categorized as internal or external. Effective identification of risks should involve all staff members in an organization (Finance Maps of World, 2013). Events that may hinder achieving objectives either completely or partly are also identified as risks. Methods used in identification are scenario based and objective based identification. Risk assessment After a risk has been identified it has to be assessed to determine the magnitude of the loss it poses. Assessment helps in making the right decisions to be able to prioritize the implementation of the plan. Assessment of a risk may face difficulties in determining the occurrence rate due to lack of accurate statistical past information. Evaluating the impact of a risk also has challenges. Risk assessment has a role to provide an organization with information that makes it easier to understand the primary risks. This helps an organization to prioritize its risk management decisions. Once risks have been successfully identified and assessed the techniques to manage them are evaluated. Every risk is dealt with based on its impact and magnitude. A risk could be avoided or eliminated, reduced or mitigated. This process is referred to as risk treatment. Risk avoidance involves doing away with the activities that carry the particular risk. Avoiding risks, however, may block gains too. Avoidance of risks may prevent one from venturing into a particular business, therefore no profits will be earned (Chandra, 2011). Risk reduction on the other hand, involves reducing the effect or impact of the loss to occur. For instance, if Fannie and Freddie had insured their business, losses incurred as a result of borrowers inability to pay their loans. A risk could also be shared among different parties thus reducing its effect on one party. Risk retention involves accepting the losses as a result of the risk identified. Risks are retained by default if not transferred or avoided. After methods to avoid, transfer, mitigate and retain the risks. Implementation occurs. This involves avoiding the avoidable risks, transferring where possible or even sharing. This leads to reduced impacts of the risk to an organization. The risk management plan should often be reviewed and evaluated to make the plan positively effective. Below we identify measures that Fannie and Freddie would take to prevent, mitigate or reduce the negative impacts the risks may cause their business. Financial risk management Once a business has identified and assessed a financial risk, a way of preventing or managing the risk should be put in place. Managers with the financial responsibility should have a working experience of the practices and principals of financial risk management. Financial reports help in financial decision making. The financial risk management will aim at analyzing, controlling and where necessary, reducing the risks to a more acceptable level (Chandra, 2011). If Fannie and Freddie had an effective risk management plan, a proper way of improved capital adequacy would have been laid out. They would have adequate capital for all risks taken therefore the collapse of the housing market and MBS market would not have led to the great magnitude losses that the two companies. Insuring a business is another suitable way to help a business recover from financial losses. Technological risk management Technology innovations help to expand institutions. An institution needs to deepen its capabilities in technology risk management. This helps to upgrade the systems as well as handling security incidents and system failures. With an up to date technology system, Fannie Mae’s computer systems would have been efficient in analyzing the risky loans that they were needed to buy from their customers, lawmakers and investors (Chandra, 2011). Accuracy would therefore have been achieved and only the suitable loans would have been processed. New products that require advanced systems of operation should be catered for. Responsible technicians should be available to upgrade the company’s computer programs. Operational or organizational risk management A business should ensure that there are breakdowns in corporate governance and internal controls. This kind of risk leads to financial losses through fraud, errors or system failure. Fannie and Freddie lacked organizational management that would keep a close eye on their system and update them whenever necessary (Chandra, 2011). Deferred decisions in the companies’ operations contributed to the losses that were later incurred. Modern machines and experienced operators should be put to task. Political risk management Political risk can have substantial risks on an organization. Political risk is a risk of possible money loss owing to government regulations. An organization may not be able to prevent political risks, but it can establish measures to cover from its impacts. Pressure mounted on Fannie by government administration to make loans accessible by low income borrowers eventually led to non-payment or default in payment. In such a case, the companies should have insured their business to cater for such possible incidents (Chandra, 2011). Taking the risk seriously would make companies adopt proactive steps that would enable them to assess and mitigate the risks as identified. Companies investing in political resources like Fannie and Freddie, however sustain competitive advantages. Market risk management An assessment of a market risk nature and complexity should be based on trading and foreign operations. Companies should be able to identify, measure, monitor as well as control the exposure to the market risk considering its size, risk profile and complexity. In the case of Fannie and Freddie, they should always be sensitive to possible changes in equity prices and foreign exchange rates. Credit risk management Credit risks are brought about by potential possibilities of borrowers failing to meet their obligations. Mitigating this risk should start with getting to understand the adequacy of the loan loss. An effective process of credit risk management would have established measures for Fannie and Freddie thus the losses incurred as a result of default would be minimized. Insurance may reduce the impact of this kind of risk. The credit risks emerged as a government regulation to the companies to extend their services to poverty stricken areas where borrowers ended up being unable to meet their obligations. Conclusion Every business requires a risk management plan to help deal with the potential occurrence of losses. Fannie Mae and Freddie Mac companies’ downfall would have been prevented if a proper risk management plan had been established. Risks that included financial, credit, market, operational and technology risks led to the conservatorship of these companies. The government as well as the companies’ executives led to the organizations’ inefficiency. All these factors are said to be as a result of the lack of a risk management plan. Risk management plan is essential and plays an integral role in the growth and development of every business. An effective risk management plan involves, risk identification, assessment and management. The risks may not be fully avoided, but it’s possible to manage them. External risks are beyond a business control but a business can set up means to reduce their impact on an organization. Managing a risk may involve avoiding, mitigating, or retaining it. References Chandra, D. (2011, November 14). Risk Identification in Risk Management. HubPages. Retrieved April 28, 2015, from < http://dilipchandra12.hubpages.com/hub/Risk-Identification-in-Risk-Management> Finance Maps of World. (2013, July 8). Types of Risk Management. Finance.mapsoftworld. Retrieved April 28, 2015, < http://finance.mapsofworld.com/risk-management/types/> Finance Maps of World. (2013, July 8). Risk Management. Finance.mapsoftworld. Retrieved April 28, 2015, < http://finance.mapsofworld.com/risk-management/> Read More