Sunday, Jul 13, 2008
Fannie and Freddie Explained
One Magazine: When Mortgages Buy the Farm
An article, written back at the start of the credit bust, with an accessible explantion of what Fannie Mae and Freddie Mac do, and why they matter.
Posted by fofp @ 07:59 PM (465 views) Add Comment
5 Comments
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1. plato said...
Great article. Very informative for the non technical.
Like this extract
"The top, most sought-after rating is AAA, which is equivalent to bonds from the sort of governments who aren’t likely to run off to Argentina the next morning. British and US government bonds are AAA, for example "
Wouldn't be too sure about that, This lot might have to do a runner by the end of all this.
2. Tartaglia said...
Excellent article inspite of the self promotion
3. icarus said...
Very good but a couple of things are worth adding. A pedantic point : Fannie & Freddie (F&F) own or guarantee $5+ trillion of mortgages, not $1.4 trillion quoted in the article. It's also worth putting CDOs into some kind of perspective. The total of US securitised products is in excess of $10 trillion. This is made up of mortgage-backed securities ($7.75 trillion) and asset-backed securities (ABS) ($2.5 trillion). CDOs are a kind of ABS and may or may not include mortgages.. Their value has been estimated at (or has varied) between $a few hundred bn and $2 trillion. GSEs like F&F deal in asset collateral securities (they buy loans, issue debt and use the loans as collateral for the debt) and not in CDOs. It's the CDOs (and CLOs) that are guaranteed by monoline insurers and are consequently rated by ratings agencies as AAA etc.
The article identifies two of the elements at the base of the financial crisis - lending standards in mortgages and leverage in the funding of securitised products. (It's worth noting that under Basel II the 8% capital requirement (capital reserve) is multiplied by 7% for AAA-rated investments on their balance sheets, making a total of just 0.56% !!!.) But without the third element the crisis would not have blown up anything like as quickly as it did. This is the dependence of investors in securitised products on short-dated funding. These products were often sold to conduits and SIVs that funded themselves mainly with short-dated instruments that were bought in turn by money-market funds. The cash for this was generated to a large extent by another form of financial alchemy that transformed long-term assets like municipal bonds into short-term debt that could be used for cash investments (the total generated in this way has been estimated at several $ trillion).
The article points out that balance sheet leverage can magnify the losses on the junior (equity) tranches of CDOs. This is a source of instability could be managed if the senior tranch holders were locked in for some time. The latters' dependence on short-dated instruments causes them to get out quickly and force fire-sales of assets and that, it seems, is the third essential element of the financial crisis.
The title of this article is intriguing. 'Buying the farm' is an American military term for dying, usually in action. At one time the expression was 'he bought it' = paid for 'it' with his life. 'He bought the farm' came into use later on. There are various explanations for this, one of which is that the insurance payout for somebody killed in action was enough to pay off the mortgage (on the farm?). Any ideas?
4. fubar said...
Excellent article. Until last week I had never heard of Freddie and Fannie, yet so many people seemed to be experts in the jargon and history of these behemoths.
I am also tickled by a nice turn of phrase and this article has a few lovelies.
"Enter Fannie Mae and Freddie Mac. They sound like Elmer Fudd’s cousins, but in fact, they’re two giant financial companies formed by the US government"
"James also realizes that, if he doesn’t make a particular loan, the competition down the road will, and they’ll get the fee. James is ready to make a loan to anyone who can fog a mirror."
5. martin said...
I'm with fubar, I too had not heard of these until last week and find this article both fascinating and extremely disturbing. If the wider public were really aware of the implications of the currently downward spiraling situation, then I believe their reckless spending may slow dramatically and this mess may speed to its eventual conclusion.
Like taking off a plaster, short and sharp would be best, not long and drawn out.