Fannie and Freddie’s moral hazards

Fannie Mae and Freddie Mac have been taken into ‘conservatorship’. I’m no expert, but the issuing of new, common stock to the federal government and the drop in value of existing stock means that, effectively, Fannie and Freddie have been nationalised, albeit on a temporary basis. The Congressional Budget Office has apparently said that the potential cost is on the order of US$25bn. The about guaranteed by Freddie Mac and Fannie Mae is US$5.3tn or, put another way, twice the size of the entire UK economy. I wonder if this is the largest nationalisation ever.

Bailouts like this always raise the spectre of moral hazard. The implication was always there as Fannie Mae and Freddie Mac were set up as Government-Sponsored Enterprises; indeed, Ginnie Mae, which was hived off from Fannie Mae in 1968, actually has federal guarantees. In short, if an organisation knows that it will not be allowed to fail, it will take greater risks than it might otherwise do.

US Treasury Secretary Henry Paulson said, according to Guardian Daily, that the two institutions are “so big and so interwoven in the financial system that a failure of either of them would affect the whole world economy”. The result is that there is moral hazard by the very existence of players that have such an overwhelming position in a given market; the implication is that, should everything go west, the state will have to intervene.

I do wonder if the same applies when everyone in a given market is heavily involved in a given part of that market, particularly when the market as a whole is important. If everyone in banking became heavily involved in, say, arbitrage. If a problem were to emerge with the arbitrage market, the state might be forced to intervene because of the effective monoculture. There is a moral hazard in the existence of that monoculture. You would hope that individual banks (or whatever) would avoid such a position or, at least, advertise to their investors that they are engaging in a risky affair. If everyone’s doing it, groupthink will dimish the perception of risk and, because the system cannot be allowed to catastrophically fail, take advantage of the moral hazard.

xD.

2 thoughts on “Fannie and Freddie’s moral hazards

  1. The US government has bailed out Fannie Mae and Freddie Mac. This makes the US tax payer liable for over £2,900 billion dollars. So the US has done the same as the British government with respect to NR.

    Very Dodgy stuff indeed!!
    The capitalists now only use free market policies when it suits them?

  2. Hi Mark,

    Certainly, I think there is a problem here. The idea is that reward comes for taking risk. I contend that risk is very heavily managed to the benefit of those who wagered. There is a disconnect between the free market and the accumulation of capital.

    While the US taxpayer is potentially liable to the tune of some trillions of dollars, much of the value of what the US Government has effectively just bought will remain. As I said above, the cost is estimated by the CBO to be on the order of US$25bn.

    xD.

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