Monday, July 14, 2008

Fannie, Freddie & you

A joke in Washington these days goes like this: "What's the difference between Enron and Fannie Mae? Answer: The guys at Enron have been convicted."

(WSJ as part of a potted history)

The US will intervene to lend to Fannie May and Freddy Mac - by far the biggest home lenders in the US. They may even buy stock in the firms to support their equity price. Their equity prices have fallen by half in a week.

Paul Krugman sets out the background to the Fannie and Freddie problems. These institutions were not involved in the sub-prime crisis - they have just been caught with substantial lending to housebuyers who paid too much for their houses. Many borrowers have negative equity in their houses so that delinquency rates are high. This poses problems basically because these institutions are undercapitalised and the US government have effectively guaranteed their liabilities.

Krugman argues that it is no big deal that taxpayer money will need to rescue these firms - he argues theUS is in a major financial crisis and this ctype of intervention is inevitable. To Krugman Fannie and Freddie can’t be allowed to fail since with the collapse of subprime lending, they’re now more central than ever to the housing market, and the economy as a whole.

Its true that intervention is desirable from the viewpoint of the global financial system - it would be dealt a hefty blow were these firms to fail. These institutions have over $5.3 trillion in liabilities and the problems they face stem from the moral hazard implications of the US government guaranteeing these liabilities. Its ca repeat of the S&L saga. The difficulty here is that the current bailout provides the grounds for worse problems in the future. It is an apparently tough choice but not really a choice at all given that history cannot be rewritten.


Spiros said...

Harry, how are these companies different, if at all?

Francis Xavier Holden said...

It seems to me that the strength of finance tools like derivatives and hegdging is that like an insect on top of a pond using 20 legs they spread risk around so that it is thin in any one spot. These tools are now so unbiquitus that this spread/ interconnectedness has become a liability. As one leg breaks the miniscus it pulls the others down.

HC: Do you see it as true that the risk spreading tools work best at some optimum interconncectedness which is a long way less than 100%?

On teh other hand it always irritates me that its the people who take irrational risk like the Ponzi scheme participants, farmers with Swiss loans, high rate chasers in Pyramid, home buyers who have negative equity - who get bailed out by the government. Thus re-inforcing the unwanted behaviour.

hc said...

Spiros, I don't think they are very different. Big government-endorsed mortgage lenders with low equity.

FXH, Its true what you say. Its a lousy bargain but a difficult one to deal with well. The sharpies get away with it & repeat performance is encouraged - but not dealing with it causes problems for lots of innocent people.

Central banks need to regulate more strigently & governments need to avoid implied moral guarantees.

Spiros said...

It is kind of funny how in the home of free-enterprise capitalism the entire housing market, and indeed the entire economy is seems, is hostage to the financial fate of just two "government-sponsored" organisations.

Next time the Defenders of the Faith start going on about how terrible the French are with their dirigism and how the tentacles of the French State spread through business like a cancer, yada yada yada, and how the Anglo model of hands off capitalism is sooooo much better, they might like think about Freddie and Ginny.