What Happens if Freddie Mac Becomes Insolvent?

While most of us were filling our bellies on Thanksgiving, James Hamilton took a dive into the balance sheets of Fannie and Freddie. And he's found some pretty scary figures:

• The total "book of business" held by Fannie and Freddie between them is now $4.7 trillion, mostly in the form of mortgage-backed securities as opposed to outright mortgages. That means their $65 billion in capital is just 1.4% of their book of business. That's worrying.
• Fannie and Freddie have been reasonably good at avoiding subprime: their $170 billion of subprime MBS is just 3.6% of their total book of business. But it's still $170 billion, which is 2.6 times their total capital.

In the comments, Anarchus has an even more sobering datapoint:

The majority of [Freddie's] book of biz is sound - 86% fixed rate, 91% owner-occupied and overall the garbage ratio is relatively small: 8% Alt-A, 9% IO and 1% option arm (note: due to the overlap of categories percentages are not additive). The problem FRE has is that the 38% of its book concentrated in '06 and '07 vintages has very different characteristics from the overall book: 39% Alt-A, 44% IO and 14% option arm. (WHAT were they thinking, these past 21 months, enquiring minds want to know?)

It's a very good question: Freddie Mac was not founded with the idea that it would buy a pool of mortgages 44% of which were interest-only.

Hamilton concludes that Freddie (and Fannie, too) should cut its dividend in order to increase and preserve capital: that's a no-brainer. But he remains agnostic on the question of whether OFHEO, Freddie's regulator, should relax Freddie's capital-adequacy restrictions and give it a bit more room for maneuver. Should the government use Freddie's balance sheet to try to restore liquidity to the mortgage market? Or should it first ensure that Freddie remains solvent? Anarchus is clear that "when we're probably no further along than the 2nd inning of a 9 inning game," the most important thing is to ensure Freddie's survival.

I have a lot of sympathy for this view, especially in light of what's happening to Countrywide right now. It doesn't seem to matter how big you are: if you're a mortgage company, you're at risk of failure.

So the next step, I think, is to take a very serious and realistic look at the downside of Freddie becoming insolvent. I really haven't looked into this, but I suspect that the implicit government guarantee would kick in, that Fannie and Freddie would continue to buy conforming mortgages, that their creditors would suffer no losses, and that taxpayers would be stuck with a bill for probably some 11-figure sum (over $10 billion, but below $100 billion). Not optimal, to be sure, but I don't see nasty systemic repercussions beyond the moral-hazard problems which have been a known issue for many years in any case. On the other hand, if OFHEO forces Fannie and Freddie to continue to dump performing mortgages into a downwardly-spiralling market along with everybody else, the damage to the multi-trillion-dollar housing market could be much worse.

So I'm still in favor of charging Fannie and Freddie with doing their job, and, in the process, of running the risk of insolvency if the mortgage market continues to deteriorate further. But I do appreciate that reasonable people can differ on this one.