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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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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- Fall '12
- Stefina
- Economics, Frankenstein, The American, Mortgage loan
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