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Sunday, July 13, 2008

"The Canary in the Coal Mine" for GSEs

John Jansen at Across the Curve [followed by a series of comments on this issue gathered from various blogs, and my own comments at the end]:

More on the GSEs, by John Jansen: The financial press is replete with stories about meetings in Washington regarding the status of FNMA and Freddie Mac. The gist of the reporting is that the various parties to the conversations are busy discussing various funding options for the GSEs if such aid is warranted. One of the items mentioned in most of the stories is a previously scheduled Freddie Mac sale of $3billion of securities. Bloomberg suggests that the notes are short term and a quick check of the Freddie Mac home page informs the reader that the agency is issuing $2 billion 3 month bills and $1 billion 6 month bills.

The various articles suggest that there is some concern or angst regarding investor support for that sale. The reports suggest that these sales will be an important test of investor sentiment regarding the GSEs. I think that the success of this sale will demonstrate very little. That amount of issuance is paltry and could be funded by Secretary Paulson himself and a dozen of his former colleagues at Goldman Sachs.

In my opinion, the canary in the coal mine for the agencies is the repo market. If large institutional suppliers of funds (money funds and sec lenders) shun agency debt as collateral for their lending, that will mark the beginning of a far more serious phase of the problem and would signal hard times ahead. So I will busy myself in the early trading tomorrow observing the movements in the rate at which agency collateral trades relative to government collateral.

I also think that this entire conversation will be (for the short term) academic if the Treasury announces a substantial capital infusion sometime later this evening. If that occurs, the spread narrowing trade which began on Friday should continue with a vengeance.

The statement that Paulson delivered on Friday was meaningless and senseless. I believe that they will announce serious measures this evening to support the eviscerated and hobbled mortgage giants. ...

Update: Here's the statement from Treasury Secretary Henry Paulson. It offers "a temporary increase in the line of credit the GSEs have with Treasury," and "temporary authority for Treasury to purchase equity in either of the two GSEs if needed":

Paulson Statement on Freddie Mac, Fannie Mae, Bloomberg: Following is the text of a statement issued today by Treasury Secretary Henry Paulson:

Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction.    

GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure. In recent days, I have consulted with the Federal Reserve, OFHEO, the SEC, Congressional leaders of both parties and with the two companies to develop a three-part plan for immediate action. The President has asked me to work with Congress to act on this plan immediately.    

First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury.  Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.    

Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.    

Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer. Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator's process for setting capital requirements and other prudential standards.    

I look forward to working closely with the Congressional leaders to enact this legislation as soon as possible, as one complete package.

Update: From the Fed:

Press Release Release Date: July 13, 2008

For immediate release

The Board of Governors of the Federal Reserve System announced Sunday that it has granted the Federal Reserve Bank of New York the authority to lend to Fannie Mae and Freddie Mac should such lending prove necessary. Any lending would be at the primary credit rate and collateralized by U.S. government and federal agency securities. This authorization is intended to supplement the Treasury's existing lending authority and to help ensure the ability of Fannie Mae and Freddie Mac to promote the availability of home mortgage credit during a period of stress in financial markets.

Update: Robert Waldmann with gametheoryspeak:

Bailouts and Moral Hazard , by Robert Waldmann: Here we are again, just into a Bear (sterns) market and we have to face the fact that Fannie Mae and Freddie Mac are waaaaay to big to fail. A strong case can be made that a bailout will cost relatively little and failure to come to their assistance will cost a lot...

OK so we have to bail out the FM's. However, it is irritating that the people who made this mess obtained tens of millions in compensation doing so. I can translate my populist rage into gametheoryspeak noting that bailouts create moral hazard problems. The US government can't let Fannie or Freddie or even the medium size bad Bear fail. It shouldn't make executives decide to run risks only because they know that if they roll snake eyes, the treasury or the fed will bail them out. So What is to Be Done ?

It seems simple to me (and many many others). The institutions are too big to fail, their officers are vulnerable to bad incentives. The correct policy is to keep the institution from failing in a way which will serve as a lesson to the officers of other institutions.

I think the optimal policy is simple. The chairman of the Fed tells the CEO of To Big to Fail Bank (tbtf bank) that the FED will pick up dodgy assets with face value X if mr CEO picks up dodgy assets with face value equal to 90% of his wealth as reported in the Forbes 500 or 5 years of his (or her hah?) total compensation. Then Bernanke can mention that he is not a shareholder of tbtf bank, but, if the CEO were to say no and the bank were to go bust and he were a shareholder he sure would sue (and presumably win).

Now the CEO can appeal to the 13th amendment and resign on the spot, but he loses if he says yes and loses more if he says no. If he says he is resigning, BB (Ben Bernanke not Big Brother) says his successor will be offered the same deal with the added proviso that CEO I not be paid anything by tbtf bank beyond what CEO I can claim is due to him in court. And so on. BB will get down to someone so poor that he is willing to put 4 years of compensation at risk in order to be CEO.

Unlike the highly compensated officers, that person might even be competent to manage a bank (stranger things have happened).

Update: More from John Jansen - a bit of analysis - as much as possible anyway. As he notes, the proposals are vague, and that makes analysis difficult:

Sunday Night Stream of Consciousness on the BailoutThe Treasury announced a bailout package for the GSEs this evening. The proposal contains three pieces. The Treasury will seek to increase the nominal line of credit to the agencies (I believe a little over $2 billion currently) and will need Congressional approval for that action. They will also seek approval from the Congress to make equity investments in the GSEs.

Finally, the Federal Reserve has once again been drafted to open the discount window and make it available to both FNMA and Freddie Mac.

This would seem to make explicit the guarantee of agency debt which has always been implied. ...

Details are lacking here. ... To really formulate an opinion on this rescue I think that we need to wait and see the particulars. Until the details are available my instinct is that this is not a great idea. The taxpayers are assuming a massive set of liabilities and assets with no clear path to the ultimate outcome. I think that when we think this through the outcome will be that the laissez faire approach which has been in vogue the last three decades will be in serious jeopardy. It has been that approach which the regulators supported and allowed for the creation of organizations which are too big to fail and has now threatened the system twice in a four month period. Regulators and government have violated the most basis principals of risk management by permitting such massive accumulation of capital in the hands of a few.

I think the pendulum of history is about to sweep back in the opposite direction and it will reintroduce a level of government involvement which has not been seen in quite some time.

What type of equity will the Treasury purchase? What is the trigger for such an event? At what price will the taxpayer be long in the housing market? I suspect that the Bear Stearns model will apply here and if the treasury does get involved as an owner it will mean a very sad ending for current stockholders. ...

This has been stream of consciousness and I apologize.

One final thought which might apply to bond trading in the short run. If the agencies do need to tap the discount window, it will require the Federal Reserve to sterilize those actions with sales of treasury coupon securities. The Federal Reserve has already lent out a significant portion of its balance sheet in an earlier iteration of this crisis. To the extent that they need to supply significant liquidity to FNMA and Freddie that might engender another set of problems.

This is like something out of Alice and Wonderland as things get curiouser and curiouser.

Update: Felix Salmon chimes in with Parsing Paulson: The Fannie and Freddie Bailout:

Hank Paulson is a tough guy. He's no pushover: just look at that phone call to Jamie Dimon, telling him that anything over $2 a share was altogether far too much money to pay for Bear Stearns. So what are we to make of his statement regarding Fannie Mae and Freddie Mac? With apologies to Jack, here's the parse:

Paulson: Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction.

Translation: We can't afford for Fannie and Freddie to go bust, and we're Republicans, so there's no way we're going to nationalize them. And no one could conceivably afford to buy them. Which leaves only one option: somehow maintaining the status quo. Which is not going to be easy, seeing as how their trillions of dollars in assets are imploding daily in the biggest US housing crunch since the Great Depression.

Paulson: GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure.

Translation: China and other major foreign investors hold a huge amount of Agency debt, on the understanding that it's risk-free. I'm here to tell them that, yes, it's risk free. Nothing to worry about here. And to prove that there's nothing to worry about, I'll put out a press release on a Sunday night which is designed to reassure you all. There, you're reassured, right?

...

Paulson: Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer.

Translation: Don't call this a bailout.

Paulson: Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator's process for setting capital requirements and other prudential standards.

Translation: When was the last time you saw a "two-point plan"? I needed a third point, and I thought that maybe a few phone calls between the Fed and OFHEO might count. Sound good to you?

Paulson: I look forward to working closely with the Congressional leaders to enact this legislation as soon as possible, as one complete package.

Translation: Congress thought it was just going to be messing around with OFHEO, but now they're going to be asked to authorize the purchase of billions of dollars of the most underperforming shares on the NYSE. But if they don't roll over and do just that, they'll know that I'll be pointing the finger at them if Fannie and Freddie run into any further difficulties. And who wants the blame for nobody being able to get a mortgage any more? They'll do the right thing, the craven little pols. Frankly, they're the least of my worries.

Update: Yves Smith: Thin Gruel in Paulson Statement re Fannie, Freddie; Fed Opens Discount Window and The Real Test of the Not-Yet-A-Plan Fannie & Freddie Operation, Arnold Kling: Bailed it Shall be, Tyler Cowen: Parsing Paulson.

Update: Richard Green:

Brad Delong said it first:

The chance that American taxpayers will actually lose any money if Ben Bernanke and Henry Paulson decide that Fannie and Freddie need government support is very low:

  • The interest payments they have coming in are greater than the interest payments they have going out.
  • Their government guarantee is itself a very valuable asset that they have made a lot of money off of in the past and will make more off of in the future.
  • They are not even in liquidity trouble--unless they begin to have problems rolling over their discount notes...
  • As long as it is generally understood that they are too big to fail, they should not even have liquidity problems--absent a depression that bankrupts many currently-solvent homeowners, that is.

I would like to mention three other things based on the 15 months or so that I worked at Freddie.

(1) One reason Freddie got in trouble about how it reported its earnings is that Senior Management did not believe that GAAP treatments of earnings reflected the economics of the company, and so it needed to fudge (the company's self-investigation, called the Baker-Botts report, made this quite clear). This does not excuse its behavior--publicly traded companies must comply with GAAP. The correct thing would have been for management to explain the problems with GAAP in the MD&A Statement.

But Senior Management was correct that GAAP earnings did not (and does not) give meaningful metrics of GSE corporate performance.

(2) Just my two cents, but I don't think the company's mortgage underwriting could be characterized as reflecting moral hazard. The company was quite conservative about loans that qualified for purchase, and perhaps would have been more conservative were it not for the Affordable Housing Goals (and BTW, there is no evidence that the Affordable Housing Goals in any way helped channel mortgage credit to underserved communities or families). In any event, the people running Freddie were not the Savings and Loan cowboys who would lend to anyone for anything.

(3) It is very hard to measure corporate cash flow at Fannie-Freddie, because funding and amortization are both happening constantly.

One other disclosure, I own something like 300 shares of Freddie stock that I received as compensation when I worked there. Feel free to discount anything I say about these matters as a result of this.

Update: Jim Hamilton:

The Fannie and Freddie assistance plan, econbrowser: I see much to like about this....

The first thing I like about this plan is the fact that the ultimate determination of the level of risks to be absorbed by the federal government is being left to Congress. How much risk there is to the taxpayers in the various new lending facilities introduced by the Fed is subject to some debate, but that there is some risk, and that new loans from the Fed to the GSEs would increase this risk, is indisputable. One of the clearest lessons from history is that the fiscal and monetary functions of the government must remain separate. ...

The second thing I like about the plan is that such action by Congress would take the form of a dollar limit-- here's how much we're willing to stake, and no more-- with residual losses presumably laid on the GSE creditors. I've argued that's exactly the way the debate needs to be framed. ...

Granted, action by Congress can be a cumbersome process, often painful to watch. This I presume is why the plan includes a promise by the Fed to provide immediate lending, if needed, which I'm seeing as a kind of bridge loan. I would assume that may be quite a necessary and appropriate element of the plan. ...

For my part, I urge Congress to say yes.

Update: In response to Paul Krugman's column (see above), Brad Delong says:

The way Laura Tyson puts it, a mortgage packager and guarantor is almost surely a good thing--but the GSEs should never have been privatized in the first place. Organizations with great government privilege are government responsibility--and there is no way in which they should ever have been let loose from oversight and made responsible to their private shareholders alone. ...

[Fannie and Freddie] cannot be allowed to collapse because we want to keep the economy near full employment, which means that construction-sector employment can't be allowed to fall faster than tradeable manufacturing-sector employment can rise. But they could be put into "conservatorship." And there is no reason that their stockholders need to emerge from this with any money at all.

Update: Where do I stand on all of this?

On the size of the problem, I'm with Richard Green, Brad DeLong, and Paul Krugman. A rescue may be needed, but it doesn't look like we are facing an insurmountable problem that endangers the broader economy. As for what to do going forward, increased capitalization is one step, and I think Robert Waldmann's idea of making sure owners have a substantial stake in the companies fortunes is a good one even though this is a case where risks have been regulated fairly well. On monetary authorities putting public money at risk, I'm less worried than Jim Hamilton about the strict separation of authority in these bailouts. As I've argued before (without convincing many people), even if the Fed doesn't take on any risky assets at all, it already has the power to impact the federal budget and cost taxpayers money through its decisions (e.g. if there is no action at all by policymakers in terms of a bailout, so no public money is put at risk in the sense above, or the wrong action and the economy tanks, then the resulting crash in GDP would cause social insurance payments to go up and tax payments to fall increasing the budget deficit and hence the future tax bill). In addition, congressional involvement can impede or block the quick reaction we need to deal with a financial crisis. Thus, I quite agree that this is, ultimately, a congressional matter to be decided by elected officials. But perhaps congress can extend some type of automatic authority that allows monetary authorities to step in up to a limit, and then require approval for anything beyond the preset limit. That would give monetary authorities the flexibility they need to deal rapidly and flexibly with most situations without putting more than the preset amount of public funds at stake.

Finally, like almost everyone else, I don't think we can allow these firms to fail.

    Posted by on Sunday, July 13, 2008 at 03:24 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (45)

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