The two housing GSEs (government-sponsored enterprises) Fannie Mae and Freddie Mac, dominate the mortgage finance sector. They operate on tremendous amounts of leverage and they exposed to swings in their asset and liabilitiy values if interest rates move. They claim to have hedged their interest rate risk through derivatives, but even if that were true, then some other financial institutions are now exposed to enormous risk. Forbes magazine provides this take on the current accounting scandal at Freddie Mac and its implications.
Their exposure here is to hedge contracts valued at over $1 trillion, hence $6.5 billion is a small reserve should interest rates begin rising. The concern is that if rates rise, Freddie (nyse: FRE - news - people ) could implode much like the Long Term Capital Management hedge fund or the Orange County investment fund. Only this time, the fallout could cause a system-wide financial panic. Freddie is like a huge ship plowing through icebergs. The market thinks the Treasury standby credit facility will keep them safe, but it is actually the Federal Reserve Bank that is acting like an icebreaker for them. Their recent pronouncements on keeping interest rates low, even in the face of strong economic growth, is probably designed to forestall a devastating loss at Freddie. (Don’t believe the Fed’s cover story about being concerned over deflation; their real concern is too scary for public consumption). A recent article in the Wall Street Journal pointed out that Freddie’s derivative position is so massive, it is impossible to unwind except over an extended period of time. Meanwhile, the accounting recognition of the $6.5 billion in reserves is equivalent to the ship throwing its bilge pumps overboard while Congress and the regulators are busy rearranging the deck chairs.
