Many times things seem more complicated than they are. Many experts use strange terms that keep the layperson from really understanding what is going on.
I really love it when I find an easy to grasp explanation that takes the complex and puts it into terms that I can grasp.
This is a description of the $1.5 trillion hedge-fund business model of Fannie Mae and Freddie Mac I found in an article this morning.
Here's a deal: We'll put in $1, you lend us $25. We'll invest this $26 in bank-originated pools of mortgages that are not easy to sell and face significant long-term risks. We'll try to hedge that risk, but our models have such large error and uncertainty that our hedges might not work.
One more thing: We'll put 15 percent of the funds in subprime mortgages whose borrowers won't be able to pay if we hit a recession or a severe housing downturn. Plus, just to make it interesting, we'll become the largest financial institution in terms of assets related to mortgages, making us truly too-big-to-fail.
For this type of risk, we know you'll expect a big return. But we're only going to pay you the yield on government bonds plus a little extra.
You'd 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 relative -- our dear old Uncle Sam -- who'll make you good on what you lend us, no matter what happens, you might well stop caring about the risk. If you believe that Sam will be there, you'll give us your money freely.
So there you have it. The implicit guarantee by Uncle Sam caused investors to throw caution to the wind and throw more money at mortgage investments than they should have. This caused a false signal to be given to the housing market and it was a big part in creating the housing bubble.
There were some who saw it coming and spoke of the dangers of this implicit guarantee way back in 2003. But at the time, who really knew what Fannie Mae and Freddie Mac were really all about. The layperson just knew that they made it easier for Americans to get a mortgage. No one cared anything about what an implicit guarantee inadvertantly might cause to happen.
I'm hoping that more people will explain these financial things in simple terms as above so that everyone can understand the situation and be able to discuss what needs to be done to get out of this mess.
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