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Freddie Mac and Fannie Mae:
Where the Domain of the Housing Bubble and the Domain of the Derivatives Bubble Intersect

June 9, 2003 (EIRNS)—Freddie and Fannie function to buy housing mortgages from mortgage lending institutions. By doing so, a mortgage lending institution, which has just issued a mortgage, can sell that mortgage to Freddie or Fannie for cash; it can then use the cash to make a new mortgage, and sell that mortgage to Freddie and Fannie, and so on, in the same manner several times over. During normal times, this activity would be merely liquefying the housing market; but since 1995, it has been used to allow mortgage lending institutions to make mortgages to finance the sale of houses priced up to the current limit of $310,000; the mortgage lending institutions sell the mortgage to Freddie or Fannie, and then make another mortgage loan for up to $310,000, etc.

This mechanism is crucial for the perpetuation of the housing bubble, providing lending institutions the vast scale of liquidity needed to provide households the financing to purchase vastly over-priced homes.

As a result of this process, Freddie and Fannie have become gigantic. In terms of asset size, the four largest financial institutuions in America are: 1) Citigroup, $1.1 trillion in assets; 2) Fannie Mae, $822 billion in assets; 3) JP Morgan Chase, $720 billion in assets; and 4) Freddie Mac, $708 billion in assets. Thus Fannie and Freddie are two of the top 4 financial institutions in America.

As indicated in yesterday's briefing, Freddie and Fannie can carry out this operation by issuing three types of highly risky obligations: 1. corporate bonds that Freddie and Fannie issue; 2. Mortgage Backed Securities (MBS), in which Freddie and Fannie pool a group of mortgages together, put a guaranty on it (for which they earn a fee), and then they package these MBS to insurance companies, pension funds, international investors; etc; and 3. outright derivatives, which Fannie and Freddie have.

The table shows the domain where the highly leveraged housing bubble and the highly leveraged bubble of derivatives intersect. Freddie and Fannie have turned to the use of derivatives to manage the housing bubble, to prevent it from exploding. Between 2000 and 2001, Freddie Mac doubled its derivatives holding to above $1 trillion, as it aggressively turned to derivatives. Freddie Mac has delayed the release of its 2002 annual report, but it is believed that its derivatives portfolio exceeds $1.3 trillion.

Federal Reserve Board chairman Alan Greenspan is the other key ingredient to the housing bubble: he has used his power at the Fed to lower interest rates so that the rate on a 30-year mortgage hit 5.32 percent, the lowest rate in four decades. However, the success of this whole scheme depends, among other things, upon continuing to keep interest rates low. Were interest rates to spike up, this would convulse the Mortgage-Backed Securities market, and the derivatives market of Freddie and Fannie. In 1994, a half percent increase in interest rates blew out the MBS market, which was then far smaller. Further, the derivatives market in general, is alreay producing instabilities. An interest rate increase would serve as a trigger to de-leverage the hypothecated $11.2 trillion U.S. housing bubble.