Fannie Mae and Greece’s Problems Enabled by Basel

On the surface the failures of Fannie Mae and Freddie Mac would appear to have little connection to the fiscal crisis in Greece, outside of both occurring in or around the time of a global financial crisis.  Of course in the case of Fannie and Freddie, primary blame lies with their management and with Congress.  Primary blame for Greece’s problems clearly lies with the Greek government. 

Neither Greece or Fannie would have been able to get into as much trouble, however, if financial institutions around the world had not loaded up on their debt.  One reason, if not the primary reason, for bailing out both Greece and the US’s government sponsored enterprises is the adverse impact their failures would have on the banking system.

Yet bankers around the world did not blindly load up on both Greek and GSE debt, they were encouraged to by the bank regulators via the Basel capital standards.  Under Basel, the amount of capital a bank is required to hold against an asset is a function of its risk category.  For the highest risk assets, like corporate bonds, banks are required to hold 8%.  Yet for those seen as the lowest risk, short term government bonds, banks aren’t required to hold any capital.  So while you’d have to hold 8% capital against say, Ford bonds, you don’t have to hold any capital against Greek debt.  Depending on the difference between the weights and the debt yields, such a system provides very strong incentives to load up on the highest yielding bonds of the least risky class.  Fannie and Freddie debt required holding only 1.6% capital.  Very small losses in either Greek or GSE debt would cause massive losses to the banks, due to their large holdings of both.

The potential damage to the banking system from the failures of Greece and the GSEs is not the result of a free market run wild.  It was the very clear and predictable result of misguided and mismanaged government policies meant to create a steady market for government borrowing.