The Right Coast

Editor: Thomas A. Smith
University of San Diego
School of Law

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Monday, July 14, 2008

Fannie and Freddie: an economic horror movie
Tom Smith

The WSJ over the years has covered it.

The bailout was inevitable.  But there ain't no such thing as a free spending orgy.

HERE is a good post from an economist at UCSD abut the Fred and Fan mess.  A commentator noted that I spoke as if subprime loans were underwritten by them, which is of course not true.  In the heat of the moment, I was lumping the mortgage mess together.  The worst subprime loans were issued by private banks and not bought by GSEs such as Fred and Fan.  But clearly there has been a big moral hazard at work in the government sponsored mortgage market, but what form did the excessive risk taking take?  Too much leverage in the GSE portfolios? Underwriting too risky loans?  Why too risky?  Nothing like a complete disaster to arouse one's curiosity.

THIS is also good.

Perhaps I should say more about this, but the role the Fed is taking on in the financial industry now is starting to get worrying.  Peter W. seems to get this.  A must read.  There is a real danger of a Fed dominated national investment policy coming out of this.  If the Fed regulates investment banks, it will be hard for them to resist really managing their investment policy.  Which would be very bad.

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Tom Smith


You helped me out, in "comments" below, with 'Rather, the rotten foundation of this mess is many billions of dollars worth of much more exotic assets, starting with variable interest and no-money down loans to poorly qualified borrowers'. But I've read elsewhere that Fannie and Fredddie don't (or aren't meant to) deal in such loans. Does that mean that their particular problems are a sort of infection from other institutions?

Posted by: dearieme | Jul 14, 2008 12:46:31 PM

I'm not sure what the exact underwriting standards (they are probably called something else) that Fred and Fan have had. It may be as you say that interest-only loans for example can't be securitized by them. Also, these rules have changed over the years. But, it is certainly true that they have moved through their system a lot of loans that are a lot riskier than they should have moved. Banks like IndyMac which just failed, did a lot of the very risky stuff directly.

I'm also not sure if there are differences between what they can hold in their portfolios and what they can securitize and sell off. You also have to keep in mind that it is not so much the characteristics of the individual loans that matter, as what portfolios of these things behave like. So for instance, you referred to repayment risk the other day. It used to be anyway that repayment risk would get dropped into a separate tank, called "toxic waste", and some crazy institution would buy that, sort of like I imagine an event risk policy at Lloyds.

I have read and I believe that Fred and Fan started to buy riskier and riskier assets over the last 5 years, because they needed the returns and as restrictions on them were relaxed. We will no doubt hear more about this as new regulations get imposed on what they can do by the Fed and the US Treasury. I heard this morning something about income reporting requirements in the new law, which are going to make it harder for people who can't "document" their incomes to get loans, for example.

So in short I'm not really sure what species of higher risk loans Fred and Fan were playing with. Poorly qualified borrowers at least, apparently. I'm not sure about money down. Traditionally it was a minimum of 20 percent down, but there are ways to get around that any broker can explain to you. Maybe not balloon payments, but I think they could buy adjustable rate loans, but I'm not sure. Those certainly are getting a lot of people into trouble now. And as inflation is going to get worse as markets figure out this bailout, even more trouble in the future probably.

ACTUALLY take a look at this:

This makes me think the real problem is not so much the riskiness of the assets themselves as the extreme leverage used to buy them. I guess that's like blaming the fuse instead of the match or something, but you could also say that if they were going to have such risky assets in their portfolio, they shouldn't have borrowed so much to buy them.

Posted by: Tom Smith | Jul 14, 2008 4:13:40 PM