The implicit backing of Uncle Sam means two things (this is a non-expert expression of it and may vary from detailed reality a bit):

1. “The market” believes that if MBSs collapsed because the underlying loans went into default to a major degree, Uncle Sam would be forced by political realities to make MBS investors whole.

2. If Fan and/or Fred fail, Uncle Sam would have to intervene with cash infusions to Fred and Fan to make sure the mortgage market doesn’t totally collapse.

The first point has been an actual market expectation since the beginning of Fan and Fred. The second point has become an important issue because Fan and Fred have kept so many of the mortgages and/or MBSs for themselves and are exposing themselves to huge amounts of risk compared to what was commonly understood to be their original mission, which was to be a conduit between the mortgage lenders and the securities market. The OFHEO guy wants them to downsize their portfolios to at least minimize this second risk.

“Wow” is right, especially since, as you indicated and as I know for a fact from conversations with people in the lending industry, Fred and Fan are buying up ever-riskier mortgages (Interest-onlys, etc.), and (not discussed in this post) have lowered the minimum credit and other criteria borrowers have to meet to qualify as the type of loan they will buy.

It COULD be that the quality of some of these mortgages is so bad that they CAN’T turn them into MBSs, because the market would want too high of an interest rate to make up for the risk, which in turn MAY be forcing Fan and Fred to keep the marginal loans on their books. That requires a lot more investigative firepower than I could even hope to have. As Armando indicated, The Big Four auditors of both institutions have been pulling their hair out for nearly years now trying to get a handle on these two messes.

Given who was in charge of these institutions during the 1990s, I believe if and when this is ever fully investigated, the portfolio buildups that occurred during that time will be seen as a conscious effort by the institutions to dominate the housing market, in effect quasi-nationalizing it, that blew up in their faces during the 2000 mini-recession and the aftermath of 9/11.

- If you’re in it for the long-term (10+ years), be in one of the bigger index funds (S&P 500 or Total Stock Market) and simply ride things out.

Can you think of anyway to hedge against this possibility?