Wednesday, September 10, 2008

Exposing Fannie Mae and Freddie Mac - The Risks

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our video for this posting can be found at:

While not bailing out Fannie Mae and Freddie Mac posed major risks to the world financial system, the bailout itself had the potential to be extremely risky to the United States itself and extremely costly to the U.S. taxpayer. The blank check guaranteed by congress for Fannie and Freddie was likely to be utilized in any number of ways.

By the time the bailout bill was passed, an audit had already revealed that Fannie and Freddie had $20 billion of known losses that they had yet to declare (unrecognized losses were probably much larger). New accounting rules meant that both companies would have to raise an additional $75 billion in capital and it was unlikely this could be done on the open market. These costs were minor though compared to those that would be generated if mortgage insurers went under (a high probability event) and couldn't pay off defaulted mortgages. Fannie and Freddie had over a $1 trillion of exposure to insured mortgages, mortgages that were for over 80% of the purchase price and therefore the riskiest in a market with falling home prices. These were also the mortgages that cost Fannie and Freddie the most when they defaulted.

Recession and falling house prices weren't the only major risks to Fannie and Freddie's finances, so was inflation. Obviously, the worse the economy, the more foreclosures there are and the less money recovered in the sale of a repossessed house. Fannie had $4.7 billion in foreclosed properties on its books by the first quarter of 2008, double the amount from a year earlier and increasingly rapidly. The prices being obtained for these houses were no where near their previous purchase prices and the gap was widening further. An inflationary environment however wouldn't do away with Fannie and Freddie's financial risks. Since both receive income based on long term mortgages (those in the 2000s had very low interest rates), but have to borrow short term to fund there operations, high inflation is potentially disastrous for both of them. If short term rates went into the higher single digits or more, Fannie and Freddie would continually lose money and the losses would become greater and greater as interest rates rose.

In the longer term, perhaps the greatest risk of the the Fannie and Freddie bailout was that the U.S. government could lose its triple A credit rating and then all government borrowing would cost more. S&P made a statement in spring 2008 that a government takeover of Fannie and Freddie was likely to result in such an action. Moody's made a similar comment in June.
The bailout bill passed by congress in late July was of course not the same as a takeover of the two companies, although it set up the possibility. Only six weeks later that possibility became reality.

NEXT: Exposing Fannie Mae and Freddie Mac - the Takeover

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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