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By Adam Gorlick

Since the government announced its takeover plan of Fannie Mae and Freddie Mac, stock markets in the United States and around the world have rallied and mortgage rates have dropped. But the latest turn in the credit crisis is far from over.

Darrell Duffie, the Dean Witter Distinguished Professor of Finance, spoke with Stanford Report about having the country’s two largest mortgage finance companies placed into conservatorship and what it means for taxpayers and the economy.

What were the key factors leading to the government bailout of Fannie Mae and Freddie Mac?

You need to put this in context of the credit crisis we’ve seen over the past year-and-a-half. The housing markets in the United States were under incredible pressure, prices were going down and people were not paying their mortgages. So securities that were backed by mortgage payments were starting to go down in value. These two agencies—Fannie Mae and Freddie Mac—didn’t have enough capital to stay afloat on their own, and they had to get some support from the government.

Is there a worst-case scenario for how much this could cost taxpayers?

A few weeks ago, the government estimated $25 billion. But we’re talking about these two institutions having debt obligations to the order of $5 trillion, which means that $25 billion is almost nothing. It’s just a small percent of their debt obligations. If a few percent more were lost, it could mean much more than $25 billion.

How will the takeover affect mortgage rates and the availability of home loans?

It is generally believed that this will provide a lot of support to financial markets, directly through the provision of capital to these agencies and indirectly because the government has separately decided that it will buy mortgage-backed securities in the open market. So, through both of those channels, there will be higher prices on mortgage-backed securities. That will mean that those making loans to homeowners like you and me will be able to offer them at lower rates because there will be somebody who will be willing to buy those loans at a reasonable price.

The government already intervened earlier this year to prevent the collapse of investment bank Bear Stearns. Now it’s stepping in to take over the country’s largest mortgage finance companies. Does this send a message that if big businesses get in too much trouble, the government will bail them out?

It does tend to send that message. Not so much to big business in general, but if there’s a financial institution whose failure would cause general market instability, the government has more or less indicated that it would have to step in and make sure those large institutions don’t fail. The term that’s used is “too big to fail.” But it’s not only those that are too big; it’s also institutions that are critical to the provision of liquidity to general markets.

We used to think those institutions were large commercial banks. People talked about the Federal Reserve having the responsibility to step in whenever a regulated financial institution was close to failure. But now it’s believed that the umbrella of security for “too big to fail” institutions extends well beyond commercial banks to investment banks such as Bear Stearns, and now Fannie Mae and Freddie Mac and possibly others in the future.

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Also on Stanford Knowledgebase:

  1. Effects of the Government Takeover of Freddie Mac and Fannie Mae
  2. Prof. Darrell Duffie Defends Financial Speculation
  3. Government Testing Ways to Avoid Foreclosures, Says HUD Secretary Preston

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