Fannie, Freddie & America’s Triple-A Rating

How the housing crash knocked a hole in Uncle Sam’s credit rating…

IF YOU THINK THAT Australia’s entry into deficit land doesn’t eventually threaten its credit rating, let us take you back to the quiet conference room of a London hedge fund circa 2003, writes Dan Denning in his Daily Reckoning Australia.

I was in the small crowd, along his friend and author Addison Wiggin, listening to an informative speech by a US-based analyst on the “duration gap” between Fannie Mae’s short-term liabilitiesand its long-term assets.

No, it may not sound that exciting. But what transpired over the next thirty minutes was a real eye opener. Because the analyst pointed out how, if you borrow short-term and lend long-term, you expose yourself to changes in interest rates. You may have to refinance your debt at much higher interest rates, while the value of your long-term assets falls.

This was a problem for America’s government-sponsored enterprises (the GSEs), otherwise known as US mortgage giants Fannie Mae and Freddie Mac. The analyst insisted that while their assets – residential US mortgages or mortgage-backed securities issued by other lenders – only pay off over the long-term, their liabilities (meaning the bonds they issue to fund their purchases and loans) were short term.

Sure, the GSEs enjoyed lower borrowing costs than other corporate borrowers, thanks to their implied US government guarantee. But, the analyst said, they would face higher borrowing costs if interest rates spiked. If that were to happen, the GSEs would likely be unable to grow their balance sheets or earnings. And when your business is essentially borrowing money to buy mortgages, higher interest rates not only make borrowing more expensive, they also (as we’ve seen lately) affect the value of your assets. Higher interest rates meant death for the GSE growth model, he predicted.

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