Freddie Mac and Fannie Mae in 5th grade terms

Economic Lessons from the 5th Grade-"

“The Government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.”
– Ronald Reagan

Jeff Foxworthy became famous and made a fortune with Red Neck jokes and comedy tours. He’s parlayed his notoriety and down-home humor into a popular TV game show called "Are You Smarter than a 5th Grader ?” You can test your 5th-grade knowledge with an online ten-question test. The show has proved to be hugely popular. I doubt that the questions on the show accurately reflect what is really being taught in the typical 5th grade classroom considering the general ignorance of the American public. If the material presented on the show is being taught, then most graduates of the 5th grade haven’t remembered much of it.

How many times have we been told that two years of algebra, a year of geometry, and one year of either trigonometry or calculus are crucial for the salvation of our Republic? I have no doubt that knowledge of these courses is essential in a number of highly specialized fields. I also have doubts that after high school the majority of Americans ever use anything beyond simple mathematics.

For most of us, there is very little call for higher mathematics. You certainly don’t have to be a math wizard to understand the math behind everyday economic transactions. There are many Americans who believe that the downturn in the economy is complicated and that capitalism is the culprit and has been discredited. The credit crisis was not the fault of capitalism but with anticapitalism brought on by government intervention. Congress created an economic fiction by subsidizing loans that no bank or mortgage company would have done if there had not been financial institutions behind them insuring the bad loans they were making. But how do you explain this so a fifth grader can understand it?

Let’s say that three fifth graders want to purchase the latest hot game for PlayStation and they heard that a fifth grade friend of theirs got $500 for Christmas. Each of them wants to borrow $50 for the new game. The first fifth grader says that he has a job mowing lawns and will be able to pay back the loan at the end of the summer. The second fifth grader gets a weekly allowance for doing his chores. No chores, no allowance. The same end-of-summer promise is made. The third fifth grader has a job walking dogs and babysitting, but she can guarantee that her parents will pay back the $75 at the end of the summer whether or not she can raise enough cash.

The first borrower has less risk than the second borrower, but what if there is a drought and people don’t need their lawns mowed? To account for this contingency, the borrower has some items he can sell on eBay that are worth more than $100. He has collateral. The second borrower has the greatest risk since he has no collateral to back up the loan if he defaults. There is almost no risk with the third borrower since the loan is guaranteed by a reliable third party. The only risk the third borrower brings is her parents might lose their jobs and move away. Even so, the small amount of the loan almost assures the $50 will be paid back. Even a fifth grader can understand that the third borrower is the least risky investment.

The mortgage debacle in America came to fruition because of promised government loan guarantees insured by assets from the VA, FHA, Freddie Mac (Federal Home Loan Mortgage Corporation), and Fannie Mae (Federal National Mortgage Association). It was the promise of the guarantee that made lending to high risk borrowers attractive to banks and other lenders. There was no perceived risk. The transactions seemingly only had an upside for the lender. As long as there is a guarantor, as in the case of a parent who will guarantee a $50 loan or government agencies with an unending source of capital, there was no incentive to scrutinize borrowers.

One of the best success models in teaching people basic consumer mathematics related to home ownership is Habitat for Humanity. Not only do the recipients of the new house have to invest a lot of sweat equity (200 hours for first adult with a maximum of 500 hours for the entire family), they must demonstrate an ability to pay the mortgage and learn about finance, budgeting, home repair, and maintenance.

Even a 5^th grader can understand these basic economic safeguards. It’s too bad that a majority of our elected officials are still stuck in the 3^rd grade."

From The Heritage Foundation...Do keep in mind as you read that Freddie and Fannie are not true free market enterprises. There are many articles out there on the web that make them appear this way and thus making this economic/mortgage crisis appear as though it was a free market failure. This is important to take note of or at the very least to check into.

“They Had a Blank-Check from the Federal Government”-"The left really has no idea what free markets are. Witness Washington Post columnist Harold Meyerson who wrote a column last week blaming the current credit crisis on ‘unregulated capitalism’ and ‘laissez faire’ policies. According to Merriam-Webster, ‘laissez faire’ means: “a doctrine opposing governmental interference in economic affairs beyond the minimum necessary for the maintenance of peace and property rights.” Keep that in mind as you read this transcript from CNBC between Becky Quick and Warren Buffett:

"QUICK: Let’s talk about Fannie Mae and Freddie Mac, specifically. These are two stocks that it seems like every time you turn around are touching new low levels. There’s a lot of concern out there on the market about these two stocks right now. What’s your general take on how they got here and what you think’s going to happen next?

Mr. BUFFETT: Well, how they got here was they had two businesses, basically.

QUICK: Mm-hmm.

Mr. BUFFETT: They insured mortgages on a huge scale, trillions, and then they ran sort of a hedge fund, a carry trade where they bought mortgages and borrowed extensively against them. And because they had really the backing of the United States government–and everybody assumed they had the backing. I assumed it. And the truth is they do have the backing of the United States government in terms of their debt, not in terms of their equity–they were able to borrow without any normal restraints in terms of capital or margin requirements or anything of the sort. They had a blank-check from the federal government.

QUICK: Mm-hmm.

Mr. BUFFETT: And they also had an added problem in that they had a dual mission. The government expected them to promote housing and the stockholders expected them to raise the earnings substantially every year. And as the years went by, they mphasized the latter more and more. They started talking about “steady Freddie,” and Fannie Mae said, `We’re going to increase the earnings at 15 percent a year.’ Any large financial institution that tells you that sort of thing is giving you a line of baloney. I mean, they may do it for a while, but when they can’t do it with operations, they do it with accounting and they cheat. And that’s what happened at both those places on a huge, huge scale."