I am not usually a fan of his style, but in this case, his outburst was justified and eerily prescient!

By Steven E

Worst financial crisis since the Great Depression? Yes—but don’t be cowed by talk of calamity. Disasters call for prudence and circumspection, not frenzied action. Congress, in particular, must carefully consider the downsides of any bailout plan before granting the Treasury department the unprecedented, unfettered, and certainly un-American power to nationalize private assets of dubious value with $700 billion of public money—a monumental sum that eclipses even the cost of the Iraq war. For congress, waiting a few weeks to legislate a solution does mean protracting the current crisis. But there is no reason to believe that the world economy would collapse in that time. On the other hand, it is reasonable to believe that implementing the proposed bailout plan may have long-term adverse effects on capitalism. The solution congress is about to legislate will foster corruption, increase market volatility, address the effects of a problem rather than its cause, and it sets a dangerous precedent. None of these shortcomings are being discussed by the press.

1. It will lead to corruption.
   Laws that govern securities trading are designed to prevent malfeasance and self-dealing. These regulations don’t apply to the Treasury department because the department was never intended to transact with the private sector. Having the Treasury department bid on private securities would be a mistake. The department has no checks and balances. We’ll see cronyism in the distribution of these funds. At the same time, there will be no provisions for judicial review, public contests, or appeals. The process will be secretive, undemocratic, and anticapitalist.
2. It will not resolve market volatility, and may increase it.
   The lack of transparency that is bound to accompany the infusion of $700 billion into the economy—more specifically, into firms that took down our economy—will rally some investors sometimes and disappoint others. The point is there will be more surprises, not fewer.
3. It addresses the effects of problems rather than their cause.
   This bailout addresses the effects of serious problems (declining house prices; defaulting mortgages; a drying credit market) but ignores the cause of those problems (regulatory missteps).

   An approach that offers the veneer of financial security without addressing the roots of instability amounts to a formula for disaster. A sudden flurry of liquidity in the credit markets can lead to a bout of foolish borrowing by distressed corporations. Financial institutions may repeat some of their earlier mistakes.

4. It sets a precedent. This begins with $700 billion, but who knows where it ends?

The entire country is faced with an economic catastrophe. Two men—Henry Paulson and Ben Bernanke—say the solution is to have every American lend $2000 to a secretive governmental agency. This is not our only option. We can think of others. Ask yourself this: Even if all the Bush administration’s hyperbole about financial mushroom clouds is true, even if that rhetoric weren’t suffused by the administration’s ignoble history, even if Henry Paulson and Ben Bernanke were the two most capable, trustworthy men on the planet (and yes, they are capable and trustworthy, but in a few months a new administration will take office and there may be a new treasury secretary), even if a solution were absolutely necessary to avert a full-scale depression—even if all that were the case, wouldn’t it still be preferable for congress to take time to evaluate other options? This solution may prove more dangerous than the problem.

Fannie Mae and Freddie Mac are privately owned and run government sponsored enterprises (GSEs). Fannie Mae was founded as a government agency in 1938 to develop the secondary mortgage market. In 1968, in part to remove its activity from the federal budget, it was converted into a private corporation. In 1970, Freddie Mac was created by Congress, also as a private corporation, to expand the secondary mortgage market.

The GSEs purchase mortgage loans from banks. Those banks are happy to sell their mortgages to free up capital to originate more mortgages and to avoid interest rate risk – they mostly issue long term fixed rate mortgages but pay their depositors a variable rate of interest leaving them vulnerable to increases in interest rates. The GSEs then combine similar loans into mortgage pools. These pools are formed into pass-through securities where the principal and interest on the mortgages in the pool are passed through to the investors in the securities. The GSEs can either sell the mortgage-backed securities to other investors or retain the securities for themselves. Either way, the GSE bears the default risk of the mortgages, which is the source of the recent crisis.

Congress thought that by assuming default risk on mortgage-backed securities, Fannie and Freddie would increase demand for those securities thus increasing the supply of capital available to mortgages, lowering mortgage interest rates and spurring home ownership.

The government never gave an explicit backing to the GSEs, but it was widely believed that Fannie and Freddie would not be allowed to fail. A private entity with government backing is a terrible idea because it creates significant moral hazard. Because such a structure “privatizes the profits, but socializes the losses”, its managers have an incentive to take a lot of risk to maximize the potential gains.

Fannie Mae and Freddie Mac have a dual comparative advantage:

• The implicit government backing gives them lower bowering costs
• Lower capital requirements allows them to take on more leverage

The value of these privileges is estimated to be worth between $122 and $182 billion according to a 2005 study by the Federal Reserve – mostly accruing to its shareholders and managers. Between 1998 and 2003, Fannie’s top fixed executives received $199 million! With so much at stake Fannie and Freddie built formidable lobbying machines and engaged in aggressive lobbying traditional banks are barred from undertaking.

These advantages allowed them to crowd out private mortgage lenders and concentrated all the risk in two institutions. This essentially guaranteed that they had become too big to be allowed to fail as they own or guarantee about half of the $12 trillion US mortgage market.

As house prices declined and home owners started to default on their mortgages, losses at Fannie and Freddie started to mount. Given how little capital they had, they started facing a liquidity crisis. Congress’ first reaction was to preserve the status quo and allow Fannie and Freddie to grow out of its problems. Last December the limit on the size of mortgages purchased by the GSEs was raised from $417,000 to $729,750. This July, legislation was passed allowing the US Treasury to extend credit to the GSEs or purchase equity in the company.

Allowing the GSEs to guarantee more mortgages only crowds out private banks and in turn encourages those to take more risk. Similar legislation which allowed insolvent S&Ls to survive during the 1980s forced healthier to take more risks and made the S&L crisis much worse than it would have been.

The July rescue attempt failed. The firms’ stock prices collapsed as investors feared they would be wiped out in a government rescue. This curtailed the firms’ ability to issue capital which in turn forced the government to rescue them. It probably would have been best for the agencies to be fully nationalized, but that that would have required an act of Congress. Instead Fannie and Freddie will be taken in “conservatorship”, a watered-down form of receivership, by their revamped regulator, the Federal Housing Finance Agency, until they are once again “sound and solvent”. They will have access to a loan facility secured by their assets. To avoid moral hazard, the Treasury will buy preferred shares as needed which will be repaid ahead of existing preferred and common stock.

The deal is not as bad for taxpayers as it could have been. In exchange for keeping the firms above water, the government will receive a $1 billion fee in preferred stock at no cost along with warrants giving it the right to 80% of the firms’ common stock at a nominal price. The two CEOs are being replaced and the organizations will no longer be allowed to lobby lawmakers.

It worries me that the eventual outcome for Freddie and Fannie has been left for Congress and the next administration to sort out. Winding them down might not be an option yet given how important they currently are to the mortgage market, but their business should eventually be privatized and split between a dozen or more banks with no government backing. In down markets a few of those may fail, but it would not undermine the stability of the mortgage market as a whole as the concentration in Fannie and Freddie has, especially given how little reserve capital they were allowed to hold. It’s a good sign that the Treasury plan calls for them to shrink by 10% a year starting in 2010 until they reach an undefined “less risky size”. This will allow banks and other financial institutions to expand their role in the mortgage market, ultimately resulting in a stronger mortgage finance system.