Credit Crunch Characters (8) - Freddie and Fannie

The normal way to reduce risk in America is to get the federal govenment to ban the cause of the risk. That was beyond their powers in this case, but they gave the world Freddie and Fannie.

Banks and mortgage brokers attempt to reduce the risk on mortgage debt by selling it to Freddie Mac and Fannie May, the lending agencies sponsored by the federal government. The assumption has been that be this eliminates risk, because the federal government is guaranteeing the debt. Not really.

William Poole, the President of the Federal Reserve Bank of St. Louis, gave this warning about Fred and Fan.

An understanding of the risks facing Fannie Mae and Freddie Mac – which I will sometimes refer to as "F-F" to simplify the exposition – is important from two perspectives. First, investors should be aware of these risks. Although many investors assume that F-F obligations are effectively guaranteed by the U.S. Government, the fact is that the guarantee is implicit only. I will not attempt to forecast what would happen should either firm face a solvency crisis, because I just do not know. What I do know is that the issue is a political one, and political winds change in unpredictable ways.

These federal agencies create a false sense of security, but the implied guarantee could have an enormous cost. If it were to be honoured during a collapse, the American tax payer would pay the bill.

The value of Fred and Fan shares has been declining rapidly. No one knows how this will end, but one think is certain. The risk that was supposed to be eliminated will be born by someone and that someone is likely to be the same taxpayers who are struggling to pay their mortgages.

Politicians think they can legislate risk away.