Fannie/Freddie and their Chilean Parallel

My response to a comment made by Mr. Ballard under the “Fannie and Freddie” post: well, they should begin to stabilize or they "should" begin to cost taxpayers some serious cash.

I had the opportunity to do a course on Latin American banking systems while on exchange in Buenos Aires. There are many interesting parallels between the Chilean banking situation in the late 1970s early 1980s and what is happening right now in the US. In the 70s as a response to a major banking crisis, the Chilean government gave what amounted to a full guarantee to a major Chilean mortgage bank. This created an unlimited liability for the Chilean taxpayer. Chilean banks, incentivized to take on significant risk given that they were guaranteed in the case of default, exploited this opportunity and developed mortgage portfolios that were exceedingly risky. Eventually, due to an outside shock, the system collapsed and the Chilean economy was sent into a two-year depression, accompanied by all the social costs that this entailed.

Anyone who analyses the situation recognises the central failure here: regulation. If a government is to accept an unlimited liability of this kind, prudential regulation must accompany it to keep banks’ portfolio risk in check. The US government needs to follow up this move with a proper policy for prudential regulation on the mortgage front, or risk a fate similar to that of the Chilean banking system in the 1980s.

I commend the US government’s initiative to scale back the size of Freddie and Fannie, opening up the door for competition in this market. When it comes to banks, larger institutions are less likely to fail –but the old adage “the bigger they are, the harder they fall” is quite poignant here.

How do we as traders profit off this? It certainly scares away the bears who thought there might be some kind of eminent disaster in the wings due to the failure of either Freddie or Fannie. The US government eliminated the uncertainty associated with the worst-case scenario in this action. Treasury bills are down, now that the government has an exposure to these risky mortgage assets. This all has bad implications for the value of the dollar. Of course, all this will already be priced in by the time we normal people get to the markets tomorrow.

I am going to bet holders of bank stocks are breathing a sigh of relief right now. All I can say is that I wish I had listened to Scott Taylor last week and made that bank play... What I am going to do: play volatilities at mid-day with a few put options on bank stocks, after the excitement has subsided. I'm still pessimistic about this whole situation.