As a lender to us you might be worried how much

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As a lender to us, you might be worried how much capital we’ll hold as a buffer against all future defaults: for every $100 that we guarantee, we’ll hold only 45 cents. And because we want as big a market share as possible, we’re going to backstop some dicey mortgages. For this type of risky investment, we know that you are expecting a big return. However, we are only going to pay you the yield on government bonds plus a little extra. You would think our investment pitch was crazy and reject the deal outright. But if we came along and whispered to you that we have a wealthy uncle – his name is Sam – that will make you whole on the money that you lent us no matter what happens, do you care about the risk? If you believe that Sam will be there, you’ll give us your money freely. This, of course, is a description of the business model of Fannie Mae and Freddie Mac. Put simply, they were Guaranteed To Fail. And it was a recipe for disaster for taxpayers. And
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6 unlike the banks or AIG, these risks were out in the open. Analysts have been pounding their fists on the table for years about them. Not only did each presidential administration not pull the plug, it instead chose to extend the guarantees even further, passing on their risk to the next administration. In the process, each achieved its short-run goals of boosting consumption and spending by having households tap into their housing equity through first and second mortgages and home equity lines of credit. Being nowhere to be found on the government’s books, the guarantees appeared to be a free lunch -- until they weren’t. As this Ponzi scheme of government guarantees has now ended, the misfortune of mopping up the mess has fallen on the current administration. How should it fix Fannie, Freddie, and the Debacle of Mortgage Finance ? Consider the scale and complexity of the problem. The government cannot simply default on the GSE debt with the intention of passing losses onto creditors. About 50% of this debt is held by financial institutions and about 20% by foreign investors, who also own the majority of government debt. Due to their size and interconnectedness, the GSEs cannot simply be unwound in the ways that have been successful for smaller financial firms. We are dealing with $3.5 trillion mortgage guarantees, a $1.7 trillion mortgage portfolio, and a $2.2 trillion position in derivatives. Not only does the unwinding from the GSEs have to be handled well, the Federal Reserve also has to plan its own exit from the $1.5 trillion position of GSE debt and GSE-backed securities that it accumulated as part of the rescue package for the economy. It is clear thus that any resolution to the problem of the GSEs will likely involve several years, if not decades, of careful crafting and execution. There is no reason why this work cannot start now in at least some measure.
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