Fannie Mae and Freddie Mac take credit risk and interest rate risk.

They take credit risk primarily by guaranteeing mortgages.

They take interest rate risk primarily by owning mortgages and financing them on their own balance sheet.  They also trade the interest rate risk of that book using derivatives.

The anti-GSE lobby always asserted (and I once erroneously believed) that Fannie and Freddie Mac would come to grief on their interest rate risk.  Taking interest rate risk is what the once-extensive anti-GSE lobby meant by charter creep.

Well the anti-GSE lobby were wrong.  So was I.  Fannie and Freddie did not blow up on interest rate risk – they blew up on credit risk.  Mainly they blew up on credit risk from non-charter mortgages but they still have had no noticeable interest rate problems during this cycle.

The Anti-GSE lobby always had an agenda

Wall Street always hated Fannie and Freddie taking interest rate risk – it encroached on the profitability of Wall Street trading desks.  Trading interest rate risk is the core business of Wall Street trading desks – and they hated having GSEs (with funding advantages) crowding them out of their own game.

But Wall Street loved Fannie and Freddie taking credit risk – that meant that Wall Street could splice and dice mortgages all they like – and know that eventually Uncle Sam will pick up any credit losses.

So they always pushed for limits on the interest rate risk that the GSEs could take.  I never heard FM-Watch or other anti-GSE lobbyists arguing for limits on GSE credit risk acceptance.

When the anti-GSE lobby now say “I told you so” they are lying.  They said the GSEs would blow up on interest rate risk and they were wrong – but they are falsely claiming intellectual credit anyway.  It helps their lobbying.

So how do the proposed reforms of Fannie and Freddie look?

All public proposals for GSE reform have the same feature.  They all allow Fannie and Freddie (or their replacement entities) to stay in the credit risk business by guaranteeing mortgages – but they insist that Fannie and Freddie shrink their balance sheet – and hence take less interest rate risk.

In other words they leave all the credit risk with the GSE – solving nothing from a taxpayer perspective and give all the interest rate carry (and most the revenue) to investment banks.  They do nothing to solve the problems that caused the GSEs to fail. 

That is also the structure of the conservatorship agreement by Hank Paulson forced the GSEs to sign – an agreement constructed by the staff of Morgan Stanley.  The agreement gave Wall Street precisely what it wanted – which is not surprising because it was drafted by Wall Street investment banks. 

The Mortgage Bankers’ Association proposal is even more egregious – but that is the subject for another post.  Even the Government Audit Office report leans heavily towards the wishes of investment bankers.  (You would think they would be better than that – but it seems they are only as good as the people lobbying them.) 

So here is a hope for the Obama administration.  Be very sceptical of the the vested self-interest behind anyone making GSE proposals.  [Whilst that includes me I am just shooting from the sidelines.  Investment bankers drew up the conservatorship agreement in the interest of investment bankers.  That sort of power should not go unchecked in America.]   

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