Fannie, Freddie, and Schrodinger's Cat

Posted by: Michael Mandel on September 07

You know, when I think about the fate of Fannie and Freddie, I am reminded of the fate of Schrodinger’s cat. Erwin Schrodinger was an Austrian physicist in the 1930s who proposed a thought experiment to illustrate the pecularities of quantum mechanics. Imagine a cat in a sealed box with a flask of poison. You cannot observe whether the cat has drunk the poison. Is the cat alive or dead? (Don’t worry, no cats were harmed—a ‘thought experiment’ means that it was never actually done)

According to most interpretations of quantum mechanics, as long as the box is sealed, that’s not the right question. Until we open the box, the best we can say is that there’s a certain probability that the cat is dead and a certain probability that it’s alive. In some sense, the states of “cat alive” and “cat dead” exist at the same time.

But once the box is unsealed and we observe the cat, the two states collapse down to one. The cat is either alive and bouncing, or unfortunately passed on. And the process is not reversible. If you put the dead cat back into the box again, it will still be dead, no matter how many times you close and open the lid.

What does this have to do with Fannie and Freddie? For many years, Fannie and Freddie have occupied two states simultaneously. On the one hand, they have been operating as private profit-making enterprises, just like any other company. On the other hand, they have been operating with the implicit full faith and backing of the federal government, allowing them to raise money at a lower price than anyone else.

This superimposition of states worked, as long as no one looked in the box. Fannie and Freddie could make lots of money, investors could feel safe, and the government didn’t have to decide whether Fannie and Freddie were really protected or not.

But guess what? The box has been opened, and it turns out that Fannie and Freddie really have been government agencies all the time (you can decide for yourself whether this means the cat is alive or dead). What’s more, once we know they are government agencies, there is no putting them back into the box and pretending that we don’t know. In fact, no matter what Paulson and his friends do, Fannie and Freddie are now permanently wards of the state.

So where do we go from here? First, Fannie and Freddie are not profit-making entities. Their only reason for existence is to protect the housing market against crashes, not to take more risks and make them worse.

The right structure is probably something like the FDIC, which protects bank accounts up to a certain limited amount. The FDIC is funded by an insurance premium paid by banks, with the federal government as the ultimate backstop. In other words, deposit insurance is both limited and costs something.

In the case of mortgages, Fannie and Freddie should be merged into one government agency (Frannie?), which packages and sells mortgage-backed securities. The mortgages would be prime mortgages, up to a certain amount, just like now. The difference is that Fannie and Freddie would charge a fee for the service, which would be required to go into a reserve fund, to be held in case of future problems.

Over time, the reserve fund would grow. By law it would be invested only in low-risk treasury securities. Frannie would not make any profits, would not pay out any dividends, and would not make any other investments. It would just serve as a passive insurance fund. In theory, subprime and altA mortgages could be handled as well, with a higher insurance premium.

It’s going to take a lot of fussing and feuding to get to that common sense outcome. But Paulson is about to find out what physicists learned long ago: You can’t put Schrodinger’s cat back into the box again.


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Reader Comments

elcuervomejicano

September 7, 2008 06:17 PM

If unemployment gets to 7 or 8% in the next few months (80% chances) how much will be the losses in fannie or freddie.
500 bi or 1 tri.

Sam S.

September 7, 2008 09:12 PM

The government's FHA loan programs already operate in this manner - providing insurance to lenders and charging both and up-front and monthly premium and with recent changes to the program(s) the premiums are, at least for now, priced according to risk.

How would "Frannie" be any different?

Janne

September 7, 2008 09:56 PM

That was the single most completely garbled description of the Shrödinger's cat paradox I have ever encountered.

If you put a cat in a box with a bit of poison to eat, the cat will eat or not and be alive or dead, and whether you look in the box or not does not affect it, and there is no quantum mechanical uncertainty about it. Quantum mechanics or uncertainty has nothing at all to do with it.

The whole point of the thought experiment was to couple microscopic quantum effects to the macroscopic world to show how deeply unintuitive it is. In the real thought experiment you'd have a bit of a radioactive substance and a Geiger counter. The counter is wired to a mechanism that will release poison gas into the box. If the radioactive substance discharges a particle, the counter will decect it and kill the cat. If it doesn't, the cat lives.

And with _that_ setup you could interpret the cat as existing in a superposition of states - alive and dead at the same time - that only collapse into one reality when you open the box and not before. Of course, another common interpretation (and disregarding the fact that the cat is capable of observation all by itself) is that as soon as you get a macroscopic, mass effect (by having a macroscopic-size mechanism be activated by the particle) that is enough for the system to collapse into one definite reality. No human observation needed; it's enough that macroscopic reality observes it.

Eliminating the bit with the Geiger counter or particle detector renders the example completely and utterly pointless; for the sake of your career and for the sake of this publication I sincerely hope you are better at economics than science.

Joe Cushing

September 7, 2008 11:42 PM

I hate it,

If Fannie and Freddie are government entities, there is nothing that says we can't split them up into 20 pieces and sell them off to the highest bidders.

We could call it done at that point or.....

While we are at it, we can sell the post office, public schools, public utilities, and any other public business the government operates. Take the money and give it to old people who are collecting social security. Then end social security.

This is in part what they did in Chile and it worked great.

Herman D. HugeLoad IV

September 8, 2008 01:55 PM

[.....]"The difference is that Fannie and Freddie would charge a fee for the service, which would be required to go into a reserve fund, to be held in case of future problems."

Not to be a pessimist but, imagine for a moment that the suggested scenario becomes reality.

Now you have a rehabilitated Fannie/Freddie and a nicely growing reserve fund in case of a rainy day..

No, you don't. What you have is;

1. It's raining - cats, dogs, and another bubble that didn't burst (because the next one won't burst) it exploded.

2. Your reserve fund? Sorry, there's nothing here except a box full of congressional IOU's and no money.

Think it can't happen? OK, take a look at what Congress has done to the Social Security fund. And, dear friends, that's people's retirement...so if it can happen to Social Security you can bet your sweet bippy it's gonna happen to the "Frannie Reserve" except it won't happen over 20...30 years, it'll start immediately. Why? "Because the perfect storm can't happen again"

Yeah - right. If you believe that, I got a bridge in Brooklyn to sell 'ya.

Tom L

September 8, 2008 05:34 PM

Janne,

Observation is observation. It does not matter if the equipment is the human eye or the geiger counter. The point of the thought experiment was to highlight that which you cannot know for certain without direct observation, or that, more importantly, the act of observing the system is also the act of defining the state of the system.

For the purposes of this article and the consequences of the bailout of Freddie and Fannie, the analogy to Schroedinger's Cat is acceptable.

Ta,

Mike Mandel

September 8, 2008 06:27 PM

Thanks, Tom, I appreciate the support.

Brandon W

September 9, 2008 08:32 AM

Love the Schröedinger's Cat comparison!

Joe Cushing

September 9, 2008 04:55 PM

Just to be clear, it wasn't the use of the analogy I was critical of, just the idea that the government should grow.

Jim DiNovis Market Observer-Participant

September 27, 2008 11:34 AM

I would add an important distinction made by Nobel Laureate, in Solid State Physics, Phil Anderson. In the Macro-world, “more is different”. Thus, the emergence of complexity.

Using the maths of the quantum world on the macro world has explicit problem of scaling inaccuracy. When asked about using his profound knowledge of physics for economics Wolfgang Pauli quipped, the maths are to hard.

Put the math and model assumptions at the feet of these unstable financial beasts. Entice them with political catnip and abundant mortgage mice and stealthy feline play and eventually you find entrails on your door stoop.

Add to that what medical science tells us about giving poison (mice) to cats. Exceed the lethal dose and all cats die.

Thank you for your interest. This blog is no longer active.

 

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Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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