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  • astral_tsar astral_tsar May 5, 2005 9:29 AM Flag

    They are doing EXACTLY the right thing.

    Well, Freddie is one that really gets people going.

    They do three things: (a) borrow money and lend it out -- like a bank; (b) sell loans but keep the risk of default -- like a credit insurer; (c) use derivatives to guard against risks inherent in (a) and (b). The reason they need part (c) is simple: if we considered the balance sheet and the guarantees alone, Freddie would be badly overextended.

    Given the size of (a) and (b), the derivatives probably make Freddie safer. But, as Buffett discovered in bailout negotiations for failed hedge fund LTCM, super-high leverage is never entirely safe. No matter how brilliant one's risk management.

    So Buffett's reasons for selling Freddie, as I understand them, were really fears about parts (a) and (b) together being too large. He felt that the way to control risk was the traditional route: to avoid assuming obligations that could easily outrun assets. I don't think he ever claimed that Freddie's derivatives increased shareholder risk, just that they didnt' reduce it enough.

    The more modern point of view is that it is possible to operate safely at nearly unlimited leverage, given sufficient attention to risk management (and access to derivatives). That point of view is apparently held to a pretty large extent by the rocket scientists who do risk management for Freddie. It's held much more fiercely and uncompromisingly by their layman admirers in management and among shareholders.

    Who is right? We dunno. For my taste, finance is not rocket science and there's nothing really new under the sun. Others believe that we're in a new era and that the conventional wisdom is useless: leverage no longer has anything to do with lender equity risk; spreads no longer have anything to do with lender profits; etc. Time will tell.

    Now the Buffett and Greenspan comments about "systemic risk" from derivatives are another thing entirely. Here they're not talking so much to GSE shareholders as to everyone in the financial world.

    Buffett's complaints about "systemic risk" due to part (c) alone were another issue ... not really directed at Freddie's shareholders. In fact Greenspan, far from unequivocally (the one six-syllable word not in his vocabulary) celebrating derivatives, has said that they're useful but dangerous.

    Anyway, my bad for bringing Freddie up on this board. The Freddie board is psychotic, but all I'll accomplish by raising it here is to spread the disease. Sorry.

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