Arnold Kling

Housing Bubble II?

Arnold Kling, Great Questions of Economics
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The lead editorial in today's Wall Street Journal (subscription required for access) compares secondary mortgage market agencies Fannie Mae and Freddie Mac with the corporate bogeyman du jour.

Shaking in your boots yet? Well, there are even more parallels with Enron.

Later on, the editors say

We aren't trying to scare readers here...

And what exactly would they say if they were trying to scare us?

This might be a good time to disclose that I used to work for Freddie Mac, and as a result of that association my largest single holding of stock is in that company.

The specifics in the editorial are flimsy--it is largely a rhetorical shot in the dark. Nonetheless, there is an element of validity to the concern.

The editorial argues that taxpayers are on the hook for all of the debt issued by Freddie Mac and Fannie Mae. Technically, this is not true. However, so many investors believe that it is true that it might be politically impossible for Congress to permit a large-scale default.

The editorial argues that the ratio of debt to equity at Freddie Mac and Fannie Mae is extraordinarily high, and that they are deeply involved in the use of financial derivatives. These are characteristics that they have in common with Enron and Long Term Capital Management, the latter being a famous hedge fund that failed.

I think that the high amount of leverage and the heavy use of derivatives raises important issues. As they try to squeeze higher returns out of the base of outstanding mortgages, the agencies could be evolving into gigantic hedge funds that happen to do housing finance, as opposed to housing finance agencies that happen to do some hedging.

I believe that the risk-based capital regulations on the agencies are appropriately effective for controlling the risks that are intrinsic to housing finance: interest rate risk and mortgage credit risk. However, those regulations may not be as effective for the types of risks faced by hedge funds, which include subtle movements in relative risk premiums.

Discussion Question. It has been argued that when the government insures financial institutions, such as banks, when the regulators control one type of risk, the institution will take another type of risk as it attempts to maximize returns. Is it possible to regulate the aggregate risk of an insured financial institution?

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