The Phaserl


U.S. Government Is Now a Major Counterparty to Wall Street Derivatives

by Pam Martens and Russ Martens, Wall St On Parade:

According to a study released by the Federal Reserve Bank of New York in March of last year, U.S. taxpayers have already injected $187.5 billion into Fannie Mae and Freddie Mac, two companies that prior to the 2008 financial crash traded on the New York Stock Exchange, had shareholders and their own Board of Directors while also receiving an implicit taxpayer guarantee on their debt. The U.S. government put the pair into conservatorship on September 6, 2008. The public has been led to believe that the $187.5 billion bailout of the pair was the full extent of the taxpayers’ tab. But in an astonishing acknowledgement on February 25 of this year, the Government Accountability Office, the nonpartisan investigative arm of Congress, issued an audit report of the U.S. government’s finances, revealing that the government’s “remaining contractual commitment to the GSEs, if needed, is $258.1 billion.”

This suggests that somehow, without the American public’s awareness, the U.S. government is on the hook to two failed companies for $445.6 billion dollars. And that may be just the tip of the iceberg of this story.

The official narrative around the bailout of Fannie and Freddie is that they were loaded up with toxic subprime debt piled high by the Wall Street banks that sold them dodgy mortgages. While that is factually true, the other potentially more important part of this story is the counterparty exposure the Wall Street banks had to Fannie and Freddie’s derivatives if the firms had been allowed to fail.

The New York Fed’s staff report of March 2015 concedes the following:

“Fannie Mae and Freddie Mac held large positions in interest rate derivatives for hedging. A disorderly failure of these firms would have caused serious disruptions for their derivative counterparties.”

Exactly how big was this derivatives exposure and which Wall Street banks were being protected by the government takeover of these public-private partnerships that had spiraled out of control into gambling casinos?

According to Fannie and Freddie’s regulator of 2003, OFHEO, “The notional amount of the combined financial derivatives outstanding of Fannie Mae and Freddie Mac increased from $72 billion at the end of 1993, the first year for which comparable data were reported, to $1.6 trillion at year-end 2001.” A 2010 report from the Federal Reserve Bank of St. Louis updates that information as follows:

“Fannie and Freddie presented considerable counterparty risk to the system through its large OTC derivatives book, similar in spirit to Long Term Capital Management (LTCM) in the summer of 1998 and to the investment banks during this current crisis. While often criticized for not adequately hedging the interest rate exposure of their portfolios, Fannie and Freddie were nevertheless major participants in the interest rate swaps market. In 2007, Fannie and Freddie had a notional amount of swaps and OTC derivatives outstanding of $1.38 trillion and $523 billion, respectively.

“The failure of Fannie and Freddie would have led to a winding down of large quantities of swaps with the usual systemic consequences. The mere quantity of transactions would have led to fire sales and invariably to liquidity funding problems for some of Fannie and Freddie’s OTC counterparties. Moreover, counterparties of Fannie and Freddie in a derivative contract might need to re-intermediate the contract right away, as it might be serving as a hedge of some underlying commercial risks. Therefore, due to counterparties’ liquidating the existing derivatives all at once and replacing their derivative positions at the same time, the markets would almost surely be destabilized due to the pure number of trades, required payment and settlement activity, and induced uncertainty, and the fact that this was taking place during a crisis.”

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