Moral hazard taken to new height
Fannie and Freddie have been enabled to borrow almost as cheaply as the US Treasury because of the nudge-and-wink implicit promise that the US taxpayer stood behind the two. So now they own or guarantee five trillion dollars’ worth of US house mortgages, covering half the housing stock in the country. The multi-trillion figure is mind-bogglingly huge. The Republican right has campaigned against Fannie and Freddie for years, because that low borrowing cost represents an unfair advantage, which private lending institutions cannot match. The Democrats have protected that privileged-borrower status – and the open-ended taxpayer exposure on which the status is based. The Democrats do this partly because home ownership is a populist issue, subsidising it seen as a social good (which no doubt it is, if not taken to extremes). But partly it’s because Fannie and Freddie hired lots of Democratic party hacks over the years, on the payroll or on the lobbying team, and provided lavish campaign contributions.
Both political sides are in the wrong on this. It is outrageous to have the taxpayer on the hook for losses while Fannie and Freddie shareholders and executives make bundles of money taking risks. Sure, the main risk was having a huge exposure to house prices and minimal capital cushion in case of bad times. That is to say, at least Fannie and Freddie were not permitted to indulge in the garbage lending of the Republicans’ darlings: Countrywide and others now bankrupt and forgotten. But that under-capitalisation risk has been predicted for a long time to be an enormous liability waiting to bite the federal government. It is inexcusable that politicians failed to deal with it and to protect future taxpayers. All the happy talk from two Fed chairmen, and others who should have known better, that the US housing market never had seen a deep price drop – and thus would not see one in future – was irresponsible. Prices had never (or almost never) become so out of line with incomes as they did this decade. A steep drop became more and more likely as the unaffordability increased.
Now it is tough on Fannie and Freddie that the shady sub-prime and liar-loan lenders pumped up the housing bubble across the board, making Fan and Fred’s prime loan customers overpay for homes, too. That was not Fan or Fred’s doing. But if they had been less greedy, they would have listened to plentiful words of caution and raised enough capital to withstand a downturn, which is now bringing increased defaults on their prime loan book.
Is it the shareholders’ fault? Do they deserve the same fate as Bear Stearns stockholders, or worse? If we are going to let markets work then they must suffer that fate, with the stock becoming worthless. Of course shareholder democracy has not been working, but it never will do unless mutual fund and pension fund managers take enough of a beating that they resolve to exercise some discipline over the companies where they hold the vast majority of the stock. How many times do we have to learn that corporate executives will be self-dealers if no countervailing force reins them in? The company’s owners have to create independent boards that actually do what the theory of stock-owner capitalism says they should do. In this context, the Treasury’s rather incoherent proposal over the weekend to be allowed to buy stock in the two mortgage companies sounds like moral hazard taken to a new height. Bailing out Fannie and Freddie’s stockholders and executives would mean that they, and those like them, will have no incentive to manage their risks prudently.
With a lot of luck, a stockholder bailout is either not what Treasury Secretary Paulson actually intended, or Congress won’t let him do one, or both.
What is a bit more scary is that there seems to be Congressional foot-dragging about standing behind Fannie and Freddie’s bonds (as distinct from their equity). If Congressmen play politics to the point that sovereign investors and other big holders lose confidence that the Treasury will ultimately keep those bonds whole, it could get really ugly in a hurry, and not just by sending US long-term interest rates up as perceived risk rises. It is a trifle amazing that the stock market acted complacently the day after the bailout plan was trashed in Congress. Either investors are in denial – not for the first time in this year of crisis – or they see the politicians as merely posturing before caving in. The trouble is that a solution has to emerge despite the backdrop discussed above: that history of Republican and Democratic positions on Fannie, Freddie and on the private lenders’ shoddy practices. The two parties’ combined – but never to be acknowledged – culpability for this enormous mess could get in the way of cleaning it up.
Optimists see Congress’s balking at the Paulson bailout plan as a healthy demand that Fannie and Freddie’s regulatory situation be fixed while government has the whip hand. Agreeing to a blank cheque from taxpayers if Fannie and Freddie need it, without any quid pro quo, does seem like asking for more trouble down the road. But it will not be easy or quick to cajole a polarised, overly ideological Congress and Administration to agree whether to nationalise them or take them into some form of receivership, set up a Resolution Trust to manage their assets, or some other fix.
Meanwhile, these two outfits, or equivalent replacements that preferably would be entirely in the private or the public sector, are vital to keeping some level of mortgage lending activity going. If all home lending ground to a halt, the economy would be in far worse trouble than it is. There are still new families forming, with enough income that they can afford a mortgage. There are, too, always plenty of families moving, for jobs or retirement. We need all of them in the market, buying houses. As Paulson said, with understandable irritation, to a grandstanding congressman who promised to derail the Treasury proposal: “Then you need to offer a better plan.”
With every new financial market scramble, the pessimists’ warnings that this would not be an easy correction are shown as realistic. Billionaire speculator George Soros and maverick professor Nouriel Roubini are doing better as prognosticators than the more mainstream ‘suits.’ Of course, they can afford to give voice to their true opinions, while economic officials and Wall Street seers cannot afford to dent confidence any more than it is already dented.
It does look as if the US Government (taxpayer) is going to be much more indebted by the time this crisis touches bottom than it was before the troubles started. The Bear Stearns $29bn bond bailout and the $150bn in rebate cheques were quite likely just an appetiser.
Ballooning public debt usually brings inflation in its wake. Certainly inflation is a way for tax-shy countries to make paying down debt feel easier. Those Japanese, Singapore and Russian central bankers may want to think about the kind of currency in which they are going to be repaid. They may not have much say over it where existing debt is concerned. But for how much longer will they go on extending credit on easy terms to a borrower that is having as hard a time getting its act together as the United States? The global framework that led us all into excessive imbalances of trade and debt needs to be transformed, much as, domestically, the status of Fannie and Freddie needs sorting out. Any volunteers?