More on Freddie Mac and Fannie Mae

What is behind the failure of Fanny Mae and Freddie Mac. Nothing very complicated really. Just old fashioned greed and stupidity, with a bit of government hubris thrown in.

Because they are government sponsored, lending to the FMs was considered to be risk free, enabling them to borrow at lower rates of interest than others in their business. This advantage allowed them to squeeze out their opposition, so they now control half the housing mortgages in the US.

Partly because the government forced them and partly due to bad management, the FMs made loans to many people who could not afford them. While house prices were going this seems like a great business to be in. Borrow cheap and lend on assets rising in price. The shareholders did well and the management creamed it.

Falling house prices changed the game. Many borrowers are now defaulting on their loans, but the FMs still have to continue making repayments to those they have borrowed from. Any losses are a hit on their capital. With the losses of the past year, both FMs had used up all their capital. One reason for this is that Congress had allowed them to reduce their capital during the good times. Once their capital is gone, further losses would throw the FMs into default, which would be a hit on those they have borrowed from.

Unfortunately, some of the largest lenders to the FMs are Asian governments, particularly the Chinese government. A superpower defaulting on its debt is not a good look, so the American taxpayer has stepped in and agreed to cover all futures losses of the FMs. They have no idea how big these losses will be, but this is better than losing face to the Chinese.

The government also hopes that keeping the FMs going will bring back the cheap mortgage finance, which will cheer up the housing market, but that is probably wishful thinking.

The shareholders in the FMs got the profits, provided they sold out in time, and the taxpayers will carry the losses. Not a bad business while it lasted.

This sorry incident also proves that human governments always overestimate their ability to eliminate risk.