Making Fannie and Freddie Pay for Their Free Lunch

Joseph Stiglitz says just say no to free lunches:

Fannie’s and Freddie’s free lunch, by Joseph Stiglitz, Commentary, Financial Times: ...The US government is about to embark on ... a partnership, in which the private sector takes the profits and the public sector bears the risk. The proposed bail-out of Fannie Mae and Freddie Mac entails the socialisation of risk – with all the long-term adverse implications for moral hazard – from an administration supposedly committed to free-market principles.

Defenders of the bail-out argue that these institutions are too big to be allowed to fail. If that is the case, the government had a responsibility to regulate them so that they would not fail. No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to “self-regulation”. But that is what we have done with the financial system.

Even if they are too big to fail, they are not too big to be reorganised ...[to] meet the basic tenets of what should constitute such a publicly sponsored scheme.

First, it should be fully transparent, with taxpayers knowing the risks they have assumed...

Second, there should be full accountability. Those who are responsible for the mistakes – management, shareholders and bondholders – should all bear the consequences. Taxpayers should not be asked to pony up a penny while shareholders are being protected.

Finally, taxpayers should be compensated for the risks they face. ...

All of these principles were violated in the Bear Stearns bail-out. ... The same administration that failed to regulate, then seemed enthusiastic about the Bear Stearns bail-out, is now asking the American people to write a blank cheque. They say: “Trust us.” Yes, we can trust the administration – to give the taxpayers another raw deal.

Something has to be done; on that everyone is agreed. We should begin with the core of the problem, the fact that millions of Americans were made loans beyond their ability to pay. We need to help them stay in their homes.... This will bring clarity to the capital markets – reducing uncertainty about the size of the hole in Fannie Mae’s and Freddie Mac’s balance sheets. ...

We should not be worried about shareholders losing their investments. In earlier years, they were amply rewarded. The management remuneration packages that they approved were designed to encourage excessive risk-taking. They got what they asked for. Nor should we be worried about creditors losing their money. Their lack of supervision fuelled the housing bubble and we are now all paying the price. We should worry about whether there is a supply of liquidity to the housing market, so that those who wish to buy a home can get a loan. This proposal provides the necessary liquidity.

A basic law of economics holds that there is no such thing as a free lunch. Those in the financial market have had a sumptuous feast and the administration is now asking the taxpayer to pick up a part of the tab. We should simply say No. [...much more here...]

Comments

[John V]

Some thoughts,

The bailout is a bi-partisan effort from Congress. The support from the general public is anything but clear cut. I've seen many negative reaction action articles from Cato on this bailout and incredibly scathing critiques from Mises (two sites I read frequently or on occasion)...neither of which are kindred spirits of Stiglitz. Same goes for those hated GMU "shills". Basically, I see people of all stripes supporting and opposing this....resident blog boss Dr. Thoma being one these tepid supporters. I do not, personally, support this. I just Stiglitz isn't trying to paint this as an ideological or partisan issue. I haven't seen that at all.

Moral hazard, Dr. Stiglitz? That's an understatement.

"No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to “self-regulation”."

That IS self-regulation. (shakes head)

"First, it should be fully transparent, with taxpayers knowing the risks they have assumed...

Second, there should be full accountability. Those who are responsible for the mistakes"

Isn't that part of the problem with the Fannie and Freddie in the first place?

I don't see how one talks about moral hazard, carelessness and questionable and predictable bailouts with even bringing the nature of these very government-propped institutions into question.

A basic law of economics holds that there is no such thing as a free lunch.

No Kidding. Let's backtrack to the seeds of these problems then, shall we?

Finally, I find it a bit funny that someone as intelligent and astute in economics as Dr. Stiglitz is being so myopic in making this all about "the administration" when it seems quite clear that there is a seemingly limitless abundance of blame to go around to every corner of several generations of DC politicians....from the Fed to the WH to Congress.

He wants to blame this administration? Fine, but for heaven's sake, don't stop there. The list goes on and on.

[John V]

If I may take a page from Anne...(Pardon the pun, Anne would never read this) :)

http://www.cato.org/pub_display.php?pub_id=9559

Treasury Secretary Henry Paulson's bailout plan for mortgage giants Fannie Mae and Freddie Mac should be titled "The Bondholder Relief Act of 2008": The taxpayers will be providing the relief to holders of Fannie/Freddie debt, many of whom are foreigners.

Paulson has asked Congress for a blank check from the taxpayer to pay off investors for losses already incurred and likely to be incurred in the next few years. He told Congress that, if it promises unlimited funds to backstop the lenders, Fannie and Freddie are unlikely to draw on the credit line. But the nonpartisan Congressional Budget Office estimates the most likely outcome to be a cost of $25 billion over the next two years - and more if housing deteriorates further.

He also wants authorization for Treasury to buy senior preferred shares in Fannie and Freddie. That prompted Sen. Jim Bunning (R-Ky.) to remark that he thought he'd woken up in France. Yes, socialism is alive and well in America - thanks to a Republican Treasury secretary.

Absent from Paulson's plan is any protection for taxpayers. They'll fund the downside if losses mount at the two mortgage giants. But if Fannie and Freddie recover, stockholders and management gain. Call it "casino capitalism" - taxpayers bankrolling management high rollers.

The plan doesn't ask stockholders or management to suffer for their financial indiscretions. The players who put their companies in jeopardy get to stay in charge - Paulson says he isn't looking for "scapegoats." Someone should remind him that capitalism without failure is like religion without sin.

There are now three possible outcomes:

* Congress passes the Treasury plan in its current form. That gives us the status quo on steroids - Fannie and Freddie continue to make risky bets and rack up more losses, with the taxpayer guarantee fueling the financial fiasco. This would be the worst outcome, but it's where we're headed.
* We could truly privatize the two companies: Remove the federal guarantee and force them to retrench and reform. Fannie and Freddie would have to raise private capital and downsize their bloated portfolios. They'd become just two ordinary-sized financial firms, whose balance sheets would be measured in billions, not trillions, of dollars. A long shot now, this would be the best outcome.
* Nationalize both companies and end all pretense that they're private. (Fannie was a government agency until 1968; Freddie was only chartered in 1970.) They could return to being federal guarantors and packagers of mortgages, and would hold no sizeable assets themselves. This last approach is called "honest socialism."

Republicans, especially in the House, have found their political spine and are pushing back against Paulson's largesse for Wall Street. House GOP Leader John Boehner demands more time to review the proposal - and opposes attaching it to the Housing bill.

That bill has rightly drawn a veto threat from the White House (renewed yesterday). It actually weakens the financial condition of Fannie and Freddie by levying a special tax on them to fund other spending programs. It would certainly be paradoxical to attach a bill to strengthen the two to a bill that weakens them.

The Treasury's provision of the government's full faith and credit guarantee to Fannie and Freddie has stabilized the situation. Rather than rush through a bad reform, Congress should get it right. Trillion-dollar businesses should never again be wards of the taxpayer.

Legislate in haste, repent at leisure.

[John V]

http://www.cato.org/pub_display.php?pub_id=9557

Should Fannie Mae and Freddie Mac enjoy special tax and regulatory privileges unavailable to other publicly traded corporations? Why should U.S. taxpayers be required to lend them money, or pick up the tab if they can't pay their bills?

The answer of course is that Fannie and Freddie should get no such privileges and taxpayers should not have to protect them.

Fannie and Freddie are specially privileged "government-sponsored enterprises." They're exempt from state and local taxes. And their required "core capital" (mainly stock) is merely 2.5 percent of assets, compared with a 6 to 8 percent norm for banks. As a result, their $5.3 trillion of debt is piled precariously atop a thin cushion of only $81 billion in core capital. It's risky business. But who bears the risk?

Fannie and Freddie pay an artificially low interest rate on their bonds because everyone assumes that, if it came to it, the U.S. Treasury would bail them out. The artificially fat spread between interest rates earned on mortgages and interest rates paid on bonds amounts to a big subsidy. That thwarts competition. It also undermines market discipline, because creditors have little incentive to monitor the firms' borrowing and investments.

Another unique privilege has been a $2.5 billion line of credit with the U.S. Treasury. Not enough? Treasury Secretary Henry Paulson recently proposed offering Fannie and Freddie unlimited access to the U.S. Treasury for 18 months. He invoked the old "confidence" game, claiming a blank check on the U.S. Treasury "is the best means of increasing market confidence" in Fannie and Freddie. The idea also proved to be an excellent means of decreasing confidence in U.S. Treasury bonds and the dollar, both of which lost value on the news.

Contrary to a common misimpression, Fannie and Freddie provide no mortgages. They just buy bundles of mortgages from lenders and swap them for mortgage-backed securities. They also invest in private mortgage-backed securities, paying for them by getting deeper in debt.

What they own or guarantee amounts to 42 percent of all mortgages, but we know from recent experience that, if Freddie and Fannie bought less, other institutions and investors (including pension funds) would simply get a bigger share. Fannie and Freddie were involved in scandalous accounting fraud in 2003, manipulating earnings to boost their executives' pay. The Office of Federal Housing Enterprise Oversight reacted by raising their capital requirement, greatly limiting their capacity to grow. Yet that certainly didn't make mortgages scarce from 2004 to 2006.

The greater the failure of government regulation, the greater the political urge to give regulators more power and money. But regulators have no magical power to anticipate unforeseen problems, and no incentive to put sound economics ahead of short-term politics.

Secretary Paulson dreams of "a new world-class regulator" for the troubled enterprises. Their current regulator, the Office of Federal Housing Enterprise Oversight is apparently too old at age 16 and not "world class." But regulation of Fannie and Freddie has always been heavily politicized, and there is no reason to expect that to change under a new entity. While Congress controls the oversight office's annual budget, Fannie and Freddie are famously generous with campaign contributions, giving them critical sway over their regulator's regulators.

Alan Reynolds is a senior fellow with the Cato Institute and the author of Income and Wealth.
More by Alan Reynolds

In a properly critical survey of the economic evidence about Fannie and Freddie, W. Scott Frame of the Atlanta Fed and Lawrence J. White of New York University concluded the best solution would be to end both the special privileges of Fannie and Freddie and the accompanying legal restrictions on the diversity of their investments. Among second-best solutions, they suggested the opposite of Treasury Secretary Paulson's proposal—namely that top officials should explicitly state the government will not guarantee Fannie's and Freddie's debts. They also suggested the opposite of congressional legislation—that the maximum sizes of mortgages the enterprises buy should be frozen rather than increased in order to focus support on less affluent homebuyers.

They are correct, but such good economic advice is too often trumped by politics. A new regulator is unlikely to be any better than the old regulator because the whole notion of a government-sponsored business is thoroughly politicized and inherently corrupt.

Potentially massive loans from the Treasury and Fed are no solution to their already excessive debt—the last thing they need is more. These two politically privileged companies pose a "systemic risk" to the economy precisely because they became much too big in the past two decades. Any serious solution must begin by requiring Fannie and Freddie to do what other troubled firms are routinely required to do—sell assets, raise capital, and reduce debt.

Fannie Mae and Freddie Mac need to be downsized and de-leveraged, relieved of special privileges and loan guarantees, and broken into small pieces agile enough to sink or swim on their own, without taxpayer support.

[John V]

End the Mortgage Duopoly

"The focus must now be on the way forward. This should entail putting both institutions on a sound financial footing, and never again allowing them to become a drain on the taxpayer and a threat to financial stability.

By last week, both corporations were operating at odds with their own charters. Consider Freddie Mac, chartered by Congress in 1970. Its first stated purpose was "to provide stability" in the secondary mortgage market. Its second purpose (of four) was "to respond appropriately to the private capital market." But Freddie and Fannie had both become a source of financial market instability, helping to drag down share prices of other firms exposed to their obligations, and forcing private capital markets to respond to their possible collapse.

...the result must be true privatization. That means no more government lifeline: no Treasury line of credit, no Fed line of credit.

...Freddie and Fannie must cease to be "special," and become quite ordinary.

They must also be downsized, because institutions so dominant in housing cannot be truly private. Additionally, as banking expert Bert Ely has pointed out, Freddie and Fannie have bulked up their balance sheets by taking on excessive interest-rate risk. Like savings and loans in the 1980s, Fannie and Freddie have maturity mismatch — borrowing short and lending long. That risk is a function of their large holdings of mortgage-backed securities. No matter their efforts at hedging that risk (which has previously landed them in trouble), there are no perfect hedges.

Fannie and Freddie must also be reformed because of their role in the culture of corruption in Washington. They have become political ATM machines for campaign contributions. That has to stop.

We must also realize that, whatever the deficiencies of the mortgage market in Depression-era America, that era is over. There is no "market failure" in housing finance today, except the one created by government-backed institutions dominating housing finance."

[Bruce Wilder]

Action and reaction.

This "moral hazard" argument is getting very tired. I'm not saying it is wrong. (I am all for a moral capitalism, though I seriously doubt that the prospect of diffuse loss is an adequate substitute for close governance.) I'm saying it is a distraction.

It is very easy to fulminate about "moral hazard", in the language of a morality play, without actually knowing anything about the institutional details of banking and mortgage finance -- with scarcely any acknowledgement that the detailed rules and norms matter a lot, or that system has been driven off the rails by fairly recent changes in policy.

I haven't even seen anyone establish to my satisfaction that the F & F shareholders are getting much of anything here. The holders of bonds and other securities and guarantees are, very possibly, getting a great deal indeed. But, that Great Gift, which may run into several hundreds of billions, is scarcely even alluded to, and it is that Great Gift holders of F & F bonds and guarantees, which is functionally necessary, to some degree, to keep the banks and the financial system from collapse.

I don't see the mechanism of corporate control, which would give the F & F shareholders much real power or responsibility. (At least with Bear Stearns, there were major shareholders with real power in the running of the company.) Maybe, Stiglitz knows something I don't, and I welcome correction on this point.

Frankly, I think Stiglitz and the rest should shutup and let Tanta take the floor.

[evagrius]

I wonder what other financial boondoggle will come up affecting taxpayers and the public at large?

[Eric Dewey]

An important element of this is the point John V raises above - that bondholders of Fan and Fred are being protected.

When a staunchly Republican, free-market Administration is asking a Democratic Congress to take actions that can fairly be called socialist, and gets what they want in less than 10 days time, this is clearly a matter where the political element will trump the economic ideology.

And who are these foreign bondholders? Brad Setser has some very good information about that.

The US is now realizing what it means to be a debtor nation - and the shape of our political and economic future will be based in large part on 1) the degree to which the voting public understands what is happening, and 2) where they choose to place the political blame.

[run75441]

Dr. Thoma

Again much of this goes back to the dismantling of the Glass-Steagall Act, starting in 1987 with Greenspan leading the charge on lossening restrictions on banking investments or a one stop shop, so to say.

Short of reinstituting the same restrictions, what would you do to bring this again into line. It is obvious the market place does not have the werewithal to self govern itself as co-chairman of citbank Theobald suggested.

I have my own thoughts on this; but, I am curious as to where you would go on this issue. We are going to pay the price on Fannie Mae and Freddie Mac. Not to do so anf allow JP Morgan and Bear Stearns a free pass would be short-sighted.

Your input is appreciated.

[dd]

Indirectly the bondholders are being protected; but directly the entire financial structure is being subsidized but ultimately it's a net lose for taxpayers, pensioners, SS, and anyone with a "retirement" account.
Per the CBO the current legislation will:
"Provide temporary authority to the Secretary of the Treasury to purchase any obligations and other securities in any amounts issued by the government-sponsored enterprises (GSEs) involved in the mortgage market. Those GSEs include the FederalNational Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Home Loan Banks (FHLBs)."
http://64.233.167.104/search?q=cache:E9uLUosCrgUJ:www.cbo.gov/doc.cfm%3Findex%3D9592+HR+3221+treasury+securities&hl=en&ct=clnk&cd=1&gl=us
Notice it is Freddie, Fannie and FHLB and in the broadest terms covers "any obligation" and that would include OTC derivatives.
I have searched but cannot find the exact wording in HR3221 and perhaps someone can point to exactly the authority granted to Treasury; but the CBO's expression extends the authority into the trillions.
It's not about "mortgages" as this nation has been done the S&L bailout route; just as Bear Stearns was not about bondholders; it's about hiding the disastrous but incredibly profitable (for management) unregulated OTC derivatives debacle.
To do that they must gut the SEC and traditional investor protections. No problemo watch the headline:
"Stronger financial market on horizon, Geithner says
New York Fed chief and SEC's Cox testify on regulatory reform"
read the fine print:
"Since it might fall to the SEC to give up some of its regulatory responsibilities..."
http://www.marketwatch.com/news/story/stronger-financial-system-likely-end/story.aspx?guid=%7BC2E2E386-0460-42AF-A7AA-3399770E6041%7D&dist=msr_1
The rest of the bill is manageable and reads a lot like the RTCI; but the grant of power to the Treasury is a disaster and IMHO unconstitutional as it extends the Constitutional boundaries beyond all recognition; but as everyone knows it's a "quaint and outdated" document.

[RW]

Moral hazard does seem to be one of those things everybody talks about but, like the weather, no one seems to do anything about it. But I have to admit I am far more weary of references to "socialism," that tired, old sad sack of an American hobgoblin. Americans love freebies, particularly at someone else's expense, and don't much like it when they suspect that that someone else may have turned the tables but ...

What is happening now and indeed what has been happening for some time is far more accurately characterized as crony capitalism or, if one prefers, an oligarchic republic typified by extensive economic rent seeking; whatever it is does not bear much resemblance to socialism as normally understood (cf. http://en.wikipedia.org/wiki/Socialism).

Dean Baker describes the conservative welfare state at http://www.conservativenannystate.org/ and, since this seems to be a day for excerpts, here's a short quote from the introduction:

"Political debates in the United States are routinely framed as a battle between conservatives who favor market outcomes, whatever they may be, against liberals who prefer government intervention to ensure that families have decent standards-of-living. This description of the two poles is inaccurate; both conservatives and liberals want government intervention. The difference between them is the goal of government intervention, and the fact that conservatives are smart enough to conceal their dependence on the government.

Conservatives want to use the government to distribute income upward to higher paid workers, business owners, and investors. They support the establishment of rules and structures that have this effect. First and foremost, conservatives support nanny state policies that have the effect of increasing the supply of less-skilled workers (thereby lowering their wages), while at the same time restricting the supply of more highly educated professional employees (thereby raising their wages)."

Where I would differ from Baker is that I think the Plutocrats have been rigging the deck to exclusively favor capital and the top .01% of the economic pyramid over everyone else (including the remainder of the putative top 10%) and the "higher paid workers" Dean Baker refers to are beginning to realize there's blue urine in their shiny rice bowls; see Lee Arnold's excellent graphic discourse on the substantive nature and consequences of the Bush tax cuts at http://youtube.com/watch?v=SA1f2MefsMM to improve digestion.

[save_the_rustbelt]

Suppose a GSE is allowed to "fail" I'm a little fuzzy what happens.

I assume there would be a Chapter 11 filing.

I assume the mortgages would be repackaged, some sold, some kept.

I assume the shareholders would get $0 and the bond holders would take a severe haircut.

But I really do not know.

Anyone know?

[ndd]

Bruce Wilder:

Frankly, I am getting sick and tired of the people who are getting sick and tired of the moral hazard argument. The argument that has yet to interfere with a single bailout in the last 30 years.

[dd]

The issue is priority between bondholders (entity issued debt) and OTC derivative counterparties. No one wants to go there; imagine understanding that OTC derivative counterparties have priority over Freddie, Fannie and FHLB bondholders (not GSE backed MBS; but bondholders) in their ability to "net" outstanding positions. Imagine bondholders understanding their "priority" is meaningless as the derivative "asset" positions are a hollow joke. It is why Bear was bailed.

[Fred]

I'm getting pretty sick of this notion that a total collapse of the financial system is something we want to avoid. Keynes's ideas are no longer revolutionary. It is understood that deficit spending is not a major problem if the economy is facing a depression and big-time deficit spending can ALWAYS stop a deflationary depression. Why should we incur a trillion dollar deficit to bail out the financial system, as opposed to a 2 trillion dollar deficit for several years in succession, created via tax cuts on the middle class, to compensate for the deflationary effects of a financial system collapse? A financial system collapse followed by middle class tax cuts will mean a huge transfer of wealth from the rich to the middle class--why are so-called progressives opposed to this?

[Fred]

Correction: a huge transfer of wealth from the rentiers (including middle-class boob retirees who invest in index funds and couldn't read a financial statement to save their lives) to the middle-class producers.

[Compensation]

"Finally, taxpayers should be compensated for the risks they face..."

Except that it is not taxpayers who are bearing this risk. Taxpayers don't even pay enough taxes to fund current expenditures, let alone another multi billion bailout. The money for the bailout will be borrowed from overseas, and the printing press will effectively be used as collateral. Pensioners, and other inflation vulnerable entities are bearing this risk, and they are never compensated for the additional risk they bear. Their role is not even acknowledged.

[Refuse]

STR..."Suppose a GSE is allowed to "fail" I'm a little fuzzy what happens."

Foreign savers refuse to loan any more money to citizens to buy a home, at least at low interest rates. Foreign savers start demanding enough interest to compensate them for the risk of default. In short, mortgage rates rise.

[Fred]

Actually, let's trace the whole financial collapse scenario out. The government makes it clear that there will be no bailouts. Individuals and businesses with more than $100K in a single account move their money somewhere safer. Banks find themselves despearate for cash and are forced to pay high rates on CDs. Eventually, most of the banks, the GSE and a variety of other financial system business fail. Massive deficit at FDIC requires bailout. Stock-holders in financial firms lose everything, bond-holders take a haircut. Foreign bond-holders complain loudly. Government responds that they need to learn to read English fine print. Foreigners respond by a variety of punishments on American corporations that have made direct investments. Full-scale trade war. Manufacturing returns to the United States. Warren Buffett and other cash-rich investors recapitalize the banking industry. SP500 falls by 50%. Boomers go on massive savings spree to make up for losses in housing and stock market values. At this point the way becomes unclear. Possibly the investment required to bring back manufacturing, combined with a reduced trade deficit (due to trade war) for everything except oil, causes enough business investment to make up for the household savings spree. If not, then government must run big deficits, preferably through middle-class tax cuts. Final result: financial system plays a much smaller role in the economy, manufacturing plays a bigger role, reduction in wealth and income disparities, partly due to collapse of asset values, partly due to rise in after-tax wages (due to manufacturing boom together with middle-class tax cuts). I see nothing wrong with any of this. Just don't let the trade war escalate into a shooting war.

[Apocalypse Not Now]

A bit apocalyptic. Interest rates would rise, and people who don't pay back money won't get any more loans. That's about it. We go back to the days of positive real after tax interest rates, and dead beats don't get credit. Home prices stabilize at marginal utility, instead of bubble level.

The only thing necessary to prevent depression is to keep credit flowing to nascent small businesses, and the GSEs have nothing to do with that. Just keep the small business loans flowing to prevent high unemployment.

Minimax strategies that depend upon alarmist apocalyptic scenarios have been overdone.

[hjmler]

How about a 95% net-worth tax on all the officers and board members of these firms getting bailouts - and it should include a 10-year reach-back to recover any assets given way to friends, or family or disposed of by any method - just like states do to nursing home patients who require public funds to cover their care expenses. And just as with indigent nursing home residents we can allow these malefactors of great wealth a $50 a month "crazy money" stipend for denture adhesive.

[Bruce Wilder]

ndd: "Frankly, I am getting sick and tired of the people who are getting sick and tired of the moral hazard argument. The argument that has yet to interfere with a single bailout in the last 30 years."

One might, at least, notice that the need for the bailout implies that the prospect of loss did not serve to restrain anyone from foolishness. If the reality of loss requires relief, it is not clear that failing to provide the relief should be accounted a remedy, which will prevent future failure.

[Fred]

A bit apocalyptic

Only because the apocalypse won't be allowed to happen. We WILL be getting a bailout of the GSE's, that is. But without a bailout of the GSE's, there is little question that most of the banks in this country would soon fail. (Incidentally, apocalypse is a Greek words which literally means "revealing of what is hidden" or simply "revelation". A collapse of the financial system would be just that--a revelation to a lot of people.)

[Andrew Hartman]

It seems to me that Fannie and Freddie were always pretty much a Democratic show. And wasn't it the Bush administration and Republicans in Congress who forced them to restate
their earnings a few years back? Why does Stiglitz get this
wrong? Anyway, both organizations are ridiculous. Nationalize
them and move on. Just asking: I wonder how many shares of
each are owned by members of Congress?

[baileyman]

William Greider has it right, it's because these lenders are in the USURY business.