Fannie Mae and Freddie Mac are where they are because they were run as the largest
hedge fund on the planet. A little calculation illustrates their business model.
Suppose that we offered you the following opportunity: We will invest $1, you lend us
$39. With this $40, we will buy bank-originated pools of mortgages that are not easy to sell and
face significant long-term risks. Although we’ll attempt to limit that risk by using sophisticated
financial hedging instruments, our models have large error and uncertainty. We’ll invest 15% of
the funds in low-quality mortgages that households will be unable to pay in a recession or a
severe housing downturn. And to make it even more interesting, we’ll become the largest
financial institution in terms of assets that are related to mortgages and together buy around
$1.7 trillion worth, making us truly too-big-to-fail.
But it doesn’t stop here. We’re going to offer insurance on a whole lot more mortgages
taken out in America, say $3.5 trillion (together), and guarantee them against default. We don’t
want much for offering this insurance -- maybe around 20 cents per $100 of mortgage -- but
that will provide us with $7 billion in profits per year (assuming absolutely zero foreclosures).
As a lender to us, you might be worried how much capital we’ll hold as a buffer against all future
defaults: for every $100 that we guarantee, we’ll hold only 45 cents. And because we want as big
a market share as possible, we’re going to backstop some dicey mortgages.
For this type of risky investment, we know that you are expecting a big return. However,
we are only going to pay you the yield on government bonds plus a little extra. You would think
our investment pitch was crazy and reject the deal outright. But if we came along and whispered
to you that we have a wealthy uncle – his name is Sam – that will make you whole on the money
that you lent us no matter what happens, do you care about the risk? If you believe that Sam will
be there, you’ll give us your money freely.
This, of course, is a description of the business model of Fannie Mae and Freddie Mac.