Quasi-fiscal scoundrels

Paulson’s subprime mortgage borrower bail out
The Bush administration appears to have converged on a plan to help financially challenged subprime mortgage borrowers sucked into their state of indebtedness through adjustable rate mortgages with very low, up-front borrowing rates, so – called teaser rates – which re-set after two or three years to a much higher level – up to three percent or more above the introductory teaser rates. Many of these subprime mortgage borrowers would no longer be able to afford their monthly mortgage payments following the interest rate resets, and would stand to lose their homes as a result.

The Bush administration proposal, put together in negotiations of Treasury Secretary Henry Paulson with the mortgage industry, freezes the introductory teaser rates for subprime borrowers that are still just about afloat (roughly current on their mortgages, i.e. at most a little bit pregnant), but have credit scores below 660. The proposal prevents the low introductory teaser rates for these subprime borrowers from resetting to higher rates for five years.. Subprime borrowers with a credit score of 660 or higher, who are more likely to be refinanceable with new loans on commercial terms, will be fast-tracked. Josh Rosner, a consultant at Gram Fisher was quoted in the Financial Times of 7 December as saying: “This modification of existing contracts without the full and willing agreement of all parties to those contracts, risks significant erosion to 200 years of contract law”. He is right. By offering a higher ex-post subsidy for those with a lower credit score, it also piles moral hazard on top of moral hazard.

This proposal is a classic example of a politically attractive, economically ugly quasi-fiscal window dressing exercise.

Quasi-fiscal policy measures
Quasi-fiscal measures are government actions that are economically equivalent to taxes or subsidies but are not formally classified as such. They are off-budget taxes and subsidies, often administered by entities other than the general government. I would include in the quasi-fiscal category also all forms of off-budget and off-balance sheet financing by the government, that is, all financial arrangements that increase the net indebtedness of the government but do not, for technical reasons, show up (at least not in the short run) in the conventional government financial accounts. 

Examples of quasi-fiscal measures are non-remunerated reserve requirements imposed by central banks. To the extent that minimal reserve requirements exceed the quantity of reserves that would have been held voluntarily in their absence, they represent a tax, equal in magnitude to the quantity of reserves held involuntarily multiplied by the financial opportunity cost of holding these involuntary reserves. Other examples include price controls on food, which amount to a subsidy on food, requirements to surrender foreign exchange earned from exporting to the central bank at an unfavourable exchange rate, which amounts to a tax on exports or export quotas which depress the domestic price of the exportable good below the world price, which amounts to a tax on the producer and a subsidy to the consumer. Government guarantees provided at less than their opportunity cost are another popular quasi-fiscal instrument.

In the US, quasi-fiscal measures have long distorted the housing market and the market for housing finance. The deductibility of mortgage interest from the Federal income tax is a quasi-fiscal subsidy. With inflation positive and likely to remain so, a further distortion is introduced by the fact that it is the nominal interest cost that is deductible.

Freddie Mac and Fannie Mae, the two Government Sponsored Entities – notionally private listed companies but de-facto Federally guaranteed, engage in securitisation of eligible mortgages and insuring mortgages. Their combined balance sheets at the end of 2006 was about $1.65 trillion, $843bn for Fannie Mae and $813bn for Freddie Mac. The total mortgage credit book of these companies is, however, much larger than their balance sheets. In the case of Fannie Mae, in addition to a mortgage portfolio of $729bn (the unpaid principal balance of mortgage loans and mortgage-related securities held in its portfolio) there also were Fannie Mae Mortgage-Backed Securities held by third parties worth $1,777bn and $20bn worth of other guarantees. The corresponding numbers for Freddie Mac were $704bn for its mortgage portfolio and $1,477bn for its Mortgage-Backed Securities outstanding. The total amount of mortgages and mortgage-backed securities outstanding of the two GSEs is therefore around $4.5 trillion. 

On December 7, 2007, the 10-year US Treasury yield was 4.01 percent and 10-year Freddie Mac and Fannie Mae bonds yielded 4.64 percent. A-rated corporate bonds yielded 5.83 percent and high-yield or junk yielded anything over 7.5 percent. Recently, City Group borrowed $7.5bn from the Abu Dhabi Investment Authority at 11 percent. Let’s be generous and assume that, without the de facto guarantee of the Federal government, the two GSEs would have to borrow from the markets at terms slightly better than Citigroup, say, 10 percent. The annual subsidy provided by the tax payer to the GSEs, and through them to American mortgage borrowers is therefore 5.36 percent of $4.5 trillion or $241 bn. Even if you halve that, it’s still a nice figure. 

To this massive subsidy benefiting households borrowing against eligible residential property, the Treasury now proposes to add a further subsidy, whose amount is as yet unknown, but which will be small compared to the massive subsidy provided through the two GSEs. For those fortunates whose teaser rate get extended for five years, the subsidy is the difference between the level that would have been effective following the reset and the teaser rate. There is a corresponding tax on the lending institution or on the current owners of securities backed by the mortgages whose rates have been frozen. The subsidy on borrowers whose refinancing will be fast-tracked (and the corresponding tax on the lender or the investor in mortgage-backed securities) cannot be determined until we know the actual terms of the fast-tracked re-mortgaging and find a way of computing the counterfactual mortgage cost without the government-imposed fast-tracking. 

I can see little justification for these interventions in housing finance. There may be positive externalities associated with home ownership and with owner-occupation of residential dwellings. That would provide an argument for subsidizing home ownership or owner-occupancy. It would not provide an argument for subsidizing borrowing secured against residential homes. 

If the information provided to the financially distressed subprime borrowers was incomplete, misleading or outright dishonest, there should be recourse to the criminal justice system. For those subprime borrowers who bet on being bailed out by ever-rising house prices, the adagium: “you break it, you own it” applies. They gambled and they lost. There is no argument based on fairness or efficiency for allowing them to stay in homes they cannot afford without a subsidy. Foreclosure and repossession were designed for just such occasions. The fact that we are approaching an election year should have no bearing on this. Unfortunately it does. This bailout of the imprudent and the short-sighted is unfair to the prudent and far-sighted. It also creates terrible incentives for future overborrowing. 

The bailout proposed for the subprime market is wrong for two reasons. First, because it is a bailout. Second, because it is a bailout implemented with quasi-fiscal instruments rather than with explicit fiscal instruments: a tax on investors in subprime mortgages (or securities backed by them) and a subsidy to subprime mortgage borrowers. Quasi-fiscal instruments are opaque and non-transparent. They serve and are intended to hide the true nature and the real cost of what the government is up to. They kill accountability for the use of public resources. It redistributes not through explicit taxes and transfers but by interfering with the price mechanism. That is why it is so popular with opportunistic politicians everywhere. 

Every politician wants to finance his or her pet projects and hobby horses in an off-budget and off-balance-sheet manner. The public sector knew and applied most of the tricks performed by corrupt and criminal private sector outfits like Enron long before Enron became a household word. Take, for instance, Gordon Brown’s International Finance Facility. This is an off-budget and off-balance sheet arrangement or special purpose vehicle (SPV) that securitises future development aid commitments of the UK government.

The off-balance-sheet vehicle borrows against these future aid commitments to finance development today. Whether it is a good idea to rob future poor Peter to pay today’s poor Paul is an important issue, but not the one I wish to focus on here. What the SPV permits the government to do, is to borrow today without having it show up as borrowing in the government’s financial accounts. The earmarking of future aid commitments will, of course, constrain future government budgetary elbow room, but for myopic and opportunistic politicians, there is no difference between 10 years from now and the next millennium.

The quasi-fiscal measures proposed for the subprime borrowers and lenders have the advantage of never showing up in the government budget. The implicit Federal government guarantees for the debt of Fannie Mae and Freddie Mac are a contingent liability. Even if they are not priced and accounted for in today’s government balance sheet, they could pop up in tomorrow’s Federal Budget and balance sheet should default threaten the GSEs. Of all the governments I know, only New Zealand attempts a comprehensive accounting for contingent assets and liabilities. That remarkable country indeed provides most of the information required for a construction of a comprehensive government intertemporal budget constraint.  Many of the financial shenanigans of governments would become much harder to perpetrate if they were forced to take the long view in the presentation of their accounts. Unfortunately, the kind of quasi-fiscal raid proposed by Mr Paulson for the US subprime market would not be captured even by a New Zealand-style comprehensive balance sheet of the government. Through direct government interference in price setting and through the government-imposed rewriting of long-term contracts, fiscal policy is conducted without leaving a trace in the government’s budget, today or tomorrow.

Argentina and other emerging markets dominated by populist governments are frequent users of government-created price distortions in the pursuit of electoral and other political advantage. In Argentina, the authorities rolled back and capped utility prices. In the US, the authorities prevent interest rate resets in the subprime mortgage markets. Is Argentina the new economic model for the Bush administration?

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website