Friday, February 02, 2007

Covering your Fannie

Over at Mish's doom and gloom financial web site there's an interesting article on GSE's. When I say interesting, I mean it's interesting to me. I'm the sort of person who like to read books like my Christmas present this year, about how a bunch of very ambitious financial geeks nearly crashed the financial world in 1998. I also like other stories of financial madness.

The essential point of Mish's and William Poole's warnings is that when you are investing you have to balance risk against exptected return. If the investment is risky you expect to get a higher rate of return, and if it's safe you make do with a lower rate of return. Bonds from (ie. loans to) the government sponsored enterprises responsible for a large part of the mortgage market in the US have very low rates of interest. This indicates that investors think they are almost risk free. They think they are risk free because they imagine that the government is backing them and will bail them out in the event their huge bets derivatives positions go wrong for them. When I say huge, I mean (in the case of the two largest and most ridiculously named, Freddie Mac and Fannie Mae) around $4470000000000, which is about the same size as the US public debt held by the public. Of course Fannie and Freddie also have assets, so we are not talking about net debt, but the comparison is just in case anyone got lost in the zeros.

If Fannie's and Freddie's debt (bonds) are much more risky than the investors think they are, then that's bad news for the investors. They are not getting the return they should from their investments. Looking at it another way, they are more at risk of losing their investments than they think they are. So who are these silly investors? There's a good chance that your pension fund is one of them. They are, after all, some of the biggest investors in bonds.

(It isn't just a phenomenon restricted to US monoliths with silly names either. Risk spreads (the premium you get for taking a risk with your money) are at a very low level everywhere. In effect, the markets are saying things are safer than they have ever been.)

Perhaps your pension fund told you that they have a guaranteed minimum rate of return on the money you are planning to use for your retirement. So if they lose a lot of money because they underestimate risk then you still get to retire to the Florida Keys (assuming they are still there by that time. Or perhaps not.

At least here in Denmark, your pension probably only offers you a guaranteed average return, not a guaranteed return every year (Danish link). And at some point in the future they might decide to change that unilaterally (da). The first pension company has already done that (da) here.

So please put your seats in a vertical position, fold up your trays, and brace yourselves for a risk repricing event. Because if you "misprice risk, don't come looking to [the central banks] for liquidity assistance". I hope you found the central bankers' advice helpful. Personally, I found it a little unnerving.

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