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The Fannie and Freddie Debacle

The Government (& the Media) Got It Wrong
Posted by Leo M. Tilman, October 29th, 2008, 9:14am

There is little doubt that the nationalization of government sponsored enterprises, Fannie Mae and Freddie Mac, in September was a major contributor to the escalation of the credit crisis to its most violent stage yet.

The Fed’s and Treasury

’s rationale was straightforward: foreign central banks and other major holders of Fannie Mae’s and Freddie’s debt needed to be appeased so that both firms could have uninterrupted access to funding and could continue fulfilling their important roles in the housing and mortgage markets.

The media’s love affair with the notion that these firms posed systemic risk to the financial system seemingly justified the action.

Needless to say, holders of Fannie Mae’s and Freddie Mac’s preferred and common stocks did not fare particularly well in the process, losing practically their entire investments.

It is surprising that the worsening credit crisis that followed did not attract a greater public debate about the Fed’s and Treasury’s decision.

The damage resulting from the government nationalization could be seen on multiple fronts. First, the preferred stock market became virtually paralyzed, preventing other financial institutions from accessing desperately needed capital. Second, many financial institutions were faced with additional writedowns on their holdings of Fannie Mae and Freddie Mac’s securities, which further reduced their lending capacity and left them with no choice other than the forced selling of securities in their portfolios. This, in turn, sent adverse ripple effects across financial markets, housing, and the real economy.

The mainstream media’s focus was misdirected throughout. Instead of discussing the wide-ranging implications of the Fannie and Freddie debacle for the ongoing crisis and beyond, attention was instead focused on the specific events leading to the government takeover and the characters involved. The following account was particularly representative. Treasury Secretary Henry Paulson called Morgan Stanley CEO John Mack. Mack summoned two of his top investment bankers into a meeting. From that point, the lives of everyone involved were never the same. These bankers barely saw their families and severed communications with colleagues. Some 200 people worked on analyzing Fannie Mae and Freddie Mac’s balance sheets and capital around the clock for weeks if not months as they meticulously examined every possible option and solution.

The outcome? An action that betrayed a troubling lack of understanding of how modern capital markets work. It is likely to go down in history as a major public policy mistake.

Fannie Mae and Freddie Mac were important case studies throughout the writing of Financial Darwinism. They were a classic illustration of the so called mortgage/agency carry trade – a more sophisticated analog of the old adage “Borrow at two percent, lend at six percent, and be on the golf course at 3:00 pm.” Their business models lacked dynamism. Their risk-taking was obscured by large funding advantages (or “balance sheet arbitrage”). Their guarantee businesses were widely described by equity analysts as fee-based businesses as opposed to businesses that took systematic risks, suggesting that there was confusion about the nature of their business models among outside observers. Lastly, their overall risks and capital adequacy lacked transparency, just like those of such financial institutions as AIG, Lehman Brothers, Bear Stearns, and Washington Mutual.

While acknowledging these limitations, many experts agree that there was no imminent danger that either Fannie or Freddie would collapse. Foreign debt holders would have been reassured if the government had simply put in place enhanced implicit or explicit guarantees. In due time, as the housing market stabilized, these extremely sophisticated firms would have been well-positioned to develop a new kind of strategic vision and adopt enhanced management and risk practices. The necessary risk-based transparency and proper regulation could have been achieved. Out of all the possible options, full nationalization was the worst solution – bar none.

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Financial Darwinism explores the origins, drivers, and implications of the ongoing tectonic financial shift. It then equips executives and investors with actionable approaches to creating lasting economic value amidst complexity and uncertainty.



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