Right now, the US financial crisis is at a critical point. Fannie and Freddie are basically insolvent. They guarantee $5 trillion in mortgage debt. A cascading default scenario would bankrupt the US. We’re now at the point of “What Should Happen” versus “What WILL Happen”.
What should happen, as pointed out by Nouriel Roubini, is that if Fannie and Freddie have been profiting like a private company, then they should be restructured like one.
Leaving aside now the “positive” issue of how the government will deal with the insolvency of Fannie and Freddie, let us consider the “normative” question of not what it is most likely to be done (an issue that involves more politics than sound economics) but rather what should be done in an ideal world? The simple answer is that we need to limit as much as possible the moral hazard of a bailout of Fannie and Freddie. Such a bailout of the creditors/bondholders of the two GSEs would result in the “mother of all moral hazard-laden bailouts” in terms of its size and consequences. And such a bailout is neither necessary, appropriate nor desirable.
Of course most of Wall Street, domestic and foreign investors and Congress are already screaming and begging “Bail us out, bail us out!” as their $5 trillion holdings of agency debt will take a significant hit if the insolvency hole of the GSEs – after the shareholders are wiped out – is filled not with public bailout money but rather with an haircut on the bonds held by Fannie and Freddie creditors. On top of bondholders not wanting to take a hit almost every politician – including McCain that in a former life was one of the shamed and corrupt members of the Keating Five club when he facilitated the S&L scam – is now clamoring for a bailout of Fannie and Freddie under the argument that not rescuing them would lead to a collapse of the mortgage and housing markets. But these screams of “the sky will fall” if we don’t rescue Fannie and Freddie are vastly exaggerated and incorrect for a number of reasons.
First, notice that the hit that bondholders will take will be limited in the absence of their bailout. With a debt/liabilities of about $5 trillion and expected insolvency – as of now and in the worst scenario of $200 to $300 billion – the necessary haircut is relatively modest: either a reduction in the face value of the claims of the order of 5% (if the mid-point hole is $250 billion) or – for unchanged face value – a very modest reduction in the interest rate on their debt after it has been forcibly restructured.
Second, a 5% haircut is much smaller than the 75% haircut that the holders of Argentine sovereign bonds suffered in 2001-2005, much smaller than the haircuts that holders or Russian and Ecuadorean debt suffered after those sovereign defaults, and much smaller than the 30% haircut that holders of corporate bonds suffer on average when a corporation goes into Chapter 11 and its debt is restructured. So why should Uncle Sam – i.e. eventually the U.S. taxpayer – pay that $250 billion bill when investors in the U.S. and around the world can afford it? The same investors are getting a fat subsidy of $50 billion a year (whose NPV is much bigger than $250 billion) for holding claims that now provide a 100bps spread above Treasuries and are under the implicit guarantee of a full bailout.
Third, of the two options we need to pick one: either we formally guarantee those claims and start paying the Treasury yield on that debt saving the tax payer that $50 billion subsidy; or if we maintain the subsidy a credit event in the form of a small haircut because of insolvency would be the fair cost that such investors pay for earning the extra spread over Treasuries.
Fourth, while the haircut would reduce the market value of such agency debt and inflict mark to market losses to investors such losses are already priced by the fact that the widening of the agency debt spread relative to Treasuries – from 10bps to about 100bps – has reduced the mark to market value of such agency debt. So, in the current legal limbo of insolvent GSEs whose debt is however not formally guaranteed the persistence of the spread would lead to those $250 billion mark-to-market losses regardless of a formal default, restructuring and haircut on that debt. We may as well resolve that insolvency and restore the positive net worth of the GSEs by doing the haircut.
Fifth, a haircut on the debt of the GSEs does not need to destroy their business, the mortgage market or the housing market. The best debtor is a solvent debtor that has restructured and reduced its unsustainable debt burden: that is why firms coming out of a Chapter 11 process that reduces their debt burdens are viable businesses ready again to produce goods and services in a viable and profitable way. The worst thing that can happen to the GSEs is to remain as zombie comatose insolvent institutions whose debt burden is not restructured and who are barely propped by an implicit government lifeline. Do we really believe that GSEs with unrestructured debt kept alive in a zombie government “conservatorship” (the solution now most likely preferred by the U.S. administration) could function properly and continue their service of supporting the mortgage and housing market? Lets instead clean them up first and make them financially viable – after an out-of-court Chapter 11 style debt reduction – so as to ensure that they keep on providing the public goods that they are alleged to give.
Sixth, the existence of GSEs and the implicit subsidy that they provide to the housing sector and mortgage market is a major part of the overall U.S. subsidization of housing capital that will eventually lead to the bankruptcy of the U.S. economy. For the last 70 years investment in housing – the most unproductive form of accumulation of capital – has been heavily subsidized in 100 different ways in the U.S.: tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures.
The reality is that the U.S. has invested too much – especially in the last eight years – in building its stock of wasteful housing capital (whose effect on the productivity of labor is zero) and has not invested enough in the accumulation of productive physical capital (equipment, machinery, etc.) that leads to an increase in the productivity of labor and increases long run economic growth. This financial crisis is a crisis of accumulation of too much debt – by the household sector, the government and the country – to finance the accumulation of the most useless and unproductive form of capital, housing, that provides only housing services to consumers and has zippo effect on the productivity of labor. So enough of subsidizing the accumulation of even bigger MacMansions through the tax system and the GSEs.
In other words, let the investors take the hit, not the US taxpayer. Investors reaped the profit, let them cover the losses. Chapter 11 both of the companies, restructure them, and let them go fully private in a new, smaller form.
But that’s what SHOULD happen. What WILL happen? As Roubini alluded to, “the mother of all bailouts” is on the way.
Alarmed by the sharply eroding confidence in the nation’s two largest mortgage finance companies, the Bush administration on Sunday asked Congress to approve a sweeping rescue package that would give officials the power to inject billions of federal dollars into the beleaguered companies through investments and loans.
In a separate announcement, the Federal Reserve said it would make one of its short-term lending programs available to the two companies, Fannie Mae and Freddie Mac. The Fed said that it had made its decision “to promote the availability of home mortgage credit during a period of stress in financial markets.”
An official said that the Fed’s decision to permit the companies to borrow from its so-called discount window was approved at the request of the Treasury but that it was temporary and would probably end once Congress approved Treasury’s plan. Some officials briefed on the plan said Congress could be asked to extend the total line of credit to the institutions to $300 billion.
The actions, which taken together could provide an overwhelming surge of capital to the companies, were the second time in four months that the housing crisis had prompted the government to scramble over a weekend to rescue a major financial institution. Last March, the Treasury Department engineered the sale of Bear Stearns to prevent it from going into bankruptcy and cause a shock to the financial system.
Give away $300 billion to keep that $5 trillion from coming due at once. All that does is drop the financial crisis squarely in the lap of the next US President.
“The president has asked me to work with Congress to act on this plan immediately,” the Treasury secretary, Henry M. Paulson Jr., said Sunday on the steps of the Treasury building. “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.”
While senior Democratic and Republican officials in successive administrations have for many years repeatedly denied that the trillions of dollars of debt Fannie and Freddie issued is guaranteed, the package, if adopted, would bring the Treasury closer than ever to exposing taxpayers to potentially huge new liabilities. The two companies could face significant new losses this year as the wave of housing foreclosures continues. Officials seemed to suggest, however, that they had little choice but to intervene.
The Bush Administration has made it painfully clear that Fannie and Fredie will continue to operate under the moral hazard clause: Privatization of profit, socialization of debt. Another $300 billion straight out of the US Treasury for these giants of capitalism, please!
But here’s the problem…investors are no longer buying the moral hazard clause. There’s no profit to be had…only loss for the US taxpayer to absorb. The result? Investors are scrambling to leave Fannie and Freddie.
Fannie Mae and Freddie Mac fell as stockholders lost confidence in the Treasury’s plan to support the biggest U.S. mortgage-finance companies.
Fannie Mae dropped 7.5 percent in New York and Freddie Mac declined 0.7 percent, extending losses yesterday following U.S. Treasury Secretary Henry Paulson’s plan to avert the collapse of the mortgage firms. Washington-based Fannie Mae has slid 76 percent this year, and Freddie Mac, based in McLean, Virginia, has lost 79 percent in 2008.
Shareholders are at risk from Paulson’s plan because the government-sponsored companies may require new equity after already raising $20 billion in the past year to cover losses.
Paulson sought to shore up investor confidence July 13 when he said from the steps of the U.S. Treasury that he will seek authority to buy equity stakes in Fannie Mae and Freddie Mac and increase the government’s credit lines to the companies. Last week, their shares fell 50 percent and credit-default swaps on Fannie and Freddie bonds approached record highs.
Fannie Mae fell 73 cents to $9 at 7:12 a.m. in pre-market trading in New York. Freddie Mac declined 5 cents to $7.06.
Almost 216 million Fannie Mae shares were traded yesterday in New York, 22 percent of the stock outstanding. Almost 263 million Freddie Mac shares changed hands, or 41 percent of the total.
Nobody likes a sure loser. Like the bank run that sank IndyMac, investors are getting their money out and getting it out now. The Bush administration may not want to privatize these companies, but they may not have a choice.
There’s $5 trillion at stake here, enough to wipe out the US economy if the cascading default scenario kicks in.
Do you trust the Bush Administration to do the right thing in the waning days of a crumbling empire?
Be prepared.
