FRE) should be taken as no less than a warning shot into the forehead. I've said several times over the last few years that Freddie and Fannie Mae ( FNM) are the next great financial accidents waiting to happen. Whenever you allow anyone to trade with an implied put option courtesy of Uncle Sam, bad things happen, as witnessed in the savings and loan bailout of the late 1980s and early 1990s. A second lesson all of us should have learned is that just because someone is big and rich doesn't mean he (or she) is smart; there is nothing more dangerous than traders who are too smart for their own good playing in the derivative sandbox. Once upon a time, the Japanese were considered the role model for a new and wondrous brand of state-sponsored business-as-war capitalism. Who makes that analogy anymore? And after the assorted crash landings of Enron ( ENRNQ), Bankers Trust, Long-Term Capital Management, etc., is anyone still impressed with financial razzle-dazzle? The risks, for now, are concentrated in mortgage-related securities. The spreads on corporate debt, until now one of the driving forces behind the recent rally in equities, could be affected as well.
explained here last year, both firms are short a call option on bond prices and both need a positively sloped yield curve. The plunge in yields last week raises the likelihood of additional prepayments in the two firms' mortgage portfolios, which will lead them to buy more bonds and contribute to another bullish flattening of the yield curve in a vicious cycle. The road to hell is paved with short options: The best traders control the decision points on where and when to close a position, and anyone short an option has ceded that critical right.