Freddie and Fannie in Fx

The term too big to fail is atrocious, it is an oxymoron that grates at every fiber of my free market body. Investor’s reaped the benefits of Fannie Mae’s and Freddie Mac’s stock price appreciation over the past decade and now the federal government is going to pick up the bill. Fannie and Freddie combined have 5.2 trillion of housing debt outstanding. This amounts to half of the housing debt in the country; they facilitate loans by buying them from banks and insuring the payment of principal and interest. Freddie and Fannie make money charging a guarantee fee of interest and principal to banks. It buys loans from banks and bundles them into Mortgage Backed Securities. Through these securities Fannie and Freddie receive monthly payments from the loan. They use short term government loans to finance these mortgage backed securities. The system is solvent and profitable until a large amount of individuals default on their loans. This decreases not only the value of the MBS but the monthly revenue that Freddie and Fannie receive. Both stock prices have lost 90% of their August 2007 value, and there is fear that both companies may not be able to meet credit obligations. Both companies have adequate liquidity and the dip in the stock prices can be attributed to fear not rationality.

Investors however flocked to Fannie and Freddie bonds, because they receive investment capital in bankruptcy prior to stock holders. Secretary Paulson signaled the companies would not be nationalized. However the question remains whether the Fed will open up the discount window to Fannie and Freddie. This is the most likely scenario, which has huge ramifications with in the Fx market. First it underlines the notion that some entities are too big to fail. On top of that the liquidity needed to prop these institutions up is around 100 billion, which will not directly affect the dollar but the dovish notion will. The Fed’s credibility is razor thin at best and this action will send the dollar into a freefall.

It hurts me to say but I support this decision because these two entities are too big to fail. Combined they insured 81 percent of all mortgage securities generated in the first quarter, more than double the percent guaranteed in Q1 of 2007. In short the credit crunch has forced all banks to only provide rock solid mortgages. These credit crunch situations need entities like Freddie and Fannie to provide needed liquidity to the housing sector. The moral hazard presented by insuring Freddie and Fannie outweighs the danger of liquidity freezing up in the financial sector. If the housing market is to recover Freddie and Fannie will play a large role, and expect the Fed to announce the option of using the discount window to both companies. In order to trade this buy the EUR against the USD you won’t be disappointed.