Fannie Mae, Freddie Mac and Harvard University are among public and private entities that could be shut out of the $605 trillion privately negotiated derivatives market they use to manage risks under legislation being debated in the U.S. Senate, according to an industry group.
The bill would impose a fiduciary duty on swaps dealers doing business with cities, states, government agencies, pension plans and endowments, applying standards that would require banks such as JPMorgan Chase & Co. and Goldman Sachs Group Inc. to put the interest of those entities ahead of their own.
“Dealers that would be subject to such a requirement would most likely stop doing business with those entities,” Timothy Ryan, chief executive officer of the Securities Industry and Financial Markets Association, wrote in an April 28 letter to Commodity Futures Trading Commission Chairman Gary Gensler. “The result is that these counterparties would lose access to an important array of risk management tools.”
Pension plans, cities, school districts and government- sponsored enterprises Fannie Mae and Freddie Mac, the biggest sources of U.S. home-loan funding, use privately negotiated swaps to protect themselves from losses tied to swings in interest rates, currency values or rising fuel costs.
Fannie Mae and Freddie Mac rely on derivatives to protect against potential losses from interest-rate changes on the $1.6 trillion of mortgage assets they own, according to regulatory filings. As of the end of 2009, the notional value of Freddie Mac’s derivatives book was more than $1.2 trillion, according to the company’s annual report. The total notional value of Fannie Mae’s derivative instruments was more than $967 billion at the end of 2009, according to the company’s annual report.
“If we lose access to our derivatives counterparties, it could adversely affect our ability to manage these risks, which could have a material adverse effect on our business, results of operations, financial condition, liquidity and net worth,” Fannie Mae said in an annual report filed in February.
Corinne Russell, a spokeswoman for the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, said they are “not federal agencies,” declining to comment further. Harvard spokesman John Longbrake declined to comment.
U.S. Treasury Spokeswoman Meg Reilly didn’t respond to a request for comment.
The fiduciary provision is part of a broader bill regulating the derivatives market for the first time and overhauling U.S. oversight of the financial system. The Senate today began debate on the bill and is considering amendments to the legislation.
Lawmakers have sought better protections for governments and public entities amid concerns that banks and advisers have sold contracts to them without fully explaining the costs or risks.
A $3 billion sewer bond refinancing that used interest-rate swaps arranged by JPMorgan in 2002 and 2003 sent Jefferson County, Alabama, to the brink of bankruptcy after the contracts backfired during the financial crisis in 2008.
The provisions being debated in the Senate now would impose a fiduciary duty on any swap dealer that enters into a contract with cities, states, federal agencies, pension and retirement plans and endowments.
While fiduciary duty isn’t defined in the bill, “most fiduciary standards include a duty of loyalty, which can be inconsistent with the activities of the swap provider,” said Jeffrey Koppele, a tax and derivatives partner at law firm Sonnenschein Nath & Rosenthal LLP in New York.
The bill would go beyond protecting governments by closing off their access to the market, said Michael Decker, managing director and co-head of municipal securities at SIFMA in New York.
“You can’t be a fiduciary and a counterparty at the same time,” Decker said today in an interview. “The provision would create such compliance risk and legal uncertainty that every firm I’ve talked to has said they wouldn’t be able to do business in the muni swap market under that legal framework.”