Fannie Mae, Freddie Mac and the Peso Problem

by on July 15, 2008 at 7:41 am in Economics | Permalink

A government bailout of the GSEs should not be a surprise.   After all, for a long time the markets have been predicting that sooner or later there will be a very expensive bailout.  What do I mean?  According to Freddie Mac (quoting the OMB)  "mortgage rates are 25 – 50 basis points lower because Fannie Mae and Freddie Mac exist in the form and size they do."  Now, that is almost certainly an exaggeration but to the extent that interest rates are lower due to the GSEs some significant part of that is due to the market valuing the government’s implicit guarantee.  In other words, interest rates are lower because the market is valuing the implied insurance.  Now, the whole point of insurance is that sometimes the insurer must pay.  Thus the market has been telling us all along that sooner or later the taxpayer was going to pay.

Maybe the taxpayers will have to pay today or maybe in some future tomorrow but the benefits of the GSEs are intimately tied to the costs – there is no such thing as a free lunch.  The lunch may look free for a long time – as in the classic peso problem – but what that means is that when the bill comes due it will be big. 

1 Bernard HP Gilroy July 15, 2008 at 9:22 am

Thus market has been telling us all along that sooner or later the taxpayer was going to pay.

No… “the market” has been telling us all along that the market believed that sooner or later the taxpayer was going to pay. Please please please don’t feed into the adolescent wish-fantasy that “the market” is somehow omniscient and omnipotent. The market tells us about beliefs and preferences, not about facts. That’s why there can be shocks and panics.

2 Anonymous July 15, 2008 at 10:47 am

Last Friday, credit default swaps (CDS) on the United States of America (!) widened from 9bps to 20bps.

So what is the market telling us, that will be obvious to everyone only in hindsight?

3 Alex Tabarrok July 15, 2008 at 11:57 am

This post is about insurance not market “prediction” in the usual sense. The GSEs could lower interest rates because lenders were willing to pay for the implied insurance. In a sense, that is a prediction but no more than when you buy auto insurance you are “predicting” an auto accident.

at’s comment is very good and frightening.

4 David J. Balan July 15, 2008 at 3:56 pm

I know almost nothing about the mortgage crisis, but I don’t think it’s true in general that lower prices brought about by a government guarantee means that one should expect the government to eventually have to pay on the guarantee. For example, if deposit insurance prevents bank failures, and cause interest rates to be lower as a result, the government will never have to pay on that guarantee provided that the guarantee actually serves to prevent bank failures. Free lunches for all!

5 sort_of_knowledgable July 15, 2008 at 7:29 pm

Even though Fannie is not a line-item on the budget, its implicit backing allows it to borrow at lower rates than any other entity other than the federal government. This is the primary reason for the 25 – 30bp difference between jumbo and conforming.

I have also heard that the rate is higher because Jumbo’s refinance more often at a lower rate because the absolute amount makes it worthwhile to refinance.

6 Frank July 16, 2008 at 10:19 am

The market is predictable and is almost an exact science , I have been predicting all the current troubles for years but have to confess i didnt get the dates right.

But I was right to within a decade.

The housing bubbles burst maybe a year early because the players knew it was going to happen.

Think about it how many houses are really worth what is being paid for them.

Hell most are not worth the 1990 price . So how do you bail out trillions of dollars in over stated assets. Answer is probably that you dont and its time to accept the pain. But I expect your tax payers will pay in the end.

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