By creating for‐profit joint stock companies, with an implicit guarantee that Washington would step in if they were in distress, the two enterprises were able to raise funds more cheaply than their rivals and securitise vast pools of home mortgages.
While home prices were rocketing and investment bankers and rating agencies were making top fees creating collateralised debt obligation bonds, which included subprime mortgages, few people were paying much attention to the potential for disaster.
A combination of loose monetary policy, lax risk assessment, and the ability to easily shift risk off the balance sheets of conventional mortgage lenders by securitisation led to a perfect storm last year, as the housing bubble burst.
Because of Fannie and Freddie’s government‐sponsored enterprise status, they are not subject to the same capital adequacy standards as other financial institutions. Consequently, the ratio of assets (loans and investments) to net worth is extremely high, which means that the ratio of their liabilities (debt and guarantees) to net worth is also high. Such leverage means high profits when housing prices are rising, but insolvency when prices crash.
Although Fannie and Freddie’s shareholders have taken a beating, the US Treasury has promised to support share prices “if necessary” and make the implicit guarantee to protect bondholders explicit by providing credit, along with the Federal Reserve. The lesson is that, when government pollutes capital markets by implicitly guaranteeing debt, market participants recognise that they will be protected if the enterprises run into difficulty. That is why foreign investors, including the People’s Bank of China, hold more than US$1.3 trillion of Fannie and Freddie bonds.
In a global financial system, moral hazard means that by socialising risk in a particular sector, overall financial risk increases. Instead of concentrating risk on owners and investors, a government safety net socialises capital markets, allowing errors of judgment to accumulate while profits are being made. When the asset price bubble bursts, the safety net falls onto taxpayers.