July 14, 2008
The rescue of Fannie and Freddie by Hankie and Feddie
The bail-out of Fannie Mae and Freddie Mac by the combined forces of the US Treasury and the Federal Reserve Board is the ugliest exercise of its kind I have ever observed outside early transition economies and mature banana republics.
There are two open-ended (possibly permanent) measures by the US Treasury and one supposedly temporary measure by the Fed. The Treasury’s proposals require Congressional approval to become effective, something that should be forthcoming some time next week. The Fed measure does not require Congressional approval.
The open-ended Treasury commitments are the creation of a facility enabling the U.S. government to become a major shareholder in the two GSEs, possibly for as much as $15 billion equity in each of the two institutions. The existing Treasury lines of credit to the insitutions (currently limited to $2.25bn each) would, as far as I can tell, become open-ended and uncapped.
The Fed is to provide the two GSEs with access to the discount window on same terms as commercial banks. The announcement is not very informative: “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. ….”
It is clear that this extends the lender of last resort role of the Fed to the two GSEs. Fannie and Freddie, under the current proposals, will not be able to use the primary discount window on the same terms as deposit-taking commercial banks or even on the same terms as the primary dealers. Primary dealers can only borrow overnight (via the PDCF); deposit-taking commercial banks can receive discount window loans up to a 3-month maturity. As I understand it - I have not been able to find this in any official publication - Fannie and Freddie will only have access to overnight loans, on the same terms as the deposit-taking commercial banks and the primary dealers: 25 basis points over the Federal Funds target rate. The PDCF accepts all kinds of collateral, including asset-backed securities. Fannie and Freddie can only offer government federal agency securities as collateral. Of course, the Fed can change its definition of eligible collateral any time it wants to, without need for Congressional approval.
I won’t discuss the justifications for rescuing Fannie and Freddie. I will, however, argue that, even taking as given the objective to maintain the role of Fannie and Freddie in US residential mortgage financing, the Paulson-Bernanke initiative is a crummy way to go about it.
Fannie and Freddie ought to have been nationalised. They are not viable as private institutions without a government guarantee for their liabilities. They were created to subsidize residential mortgage financing. If they do indeed subsidize mortgage borrowing, then they cannot also raise funds on commercial terms and earn the required risk-adjusted rate of return on their equity. The reason they appeared to be able to do so in the past, was that the markets and the public at large assumed that, despite the absence of any formal federal government guarantee, there was nevertheless a de-facto free federal government guarantee on its borrowing. The rents created by this de-facto guarantee were in part passed on to mortgage borrowers, in part to the original private shareholders and in part to the management and employees of the GSEs.
As I have not been able to access the US Treasury’s website since Sunday evening, I am not sure whether the authorisation to purchase the equity of the two GSE refers only to the existing equity, to new issues or to both. Whichever it is, it is clearly supportive of the share prices of Fannie and Freddie. Supporting existing shareholders of these two GSEs is not a legimate government activity.
A sensible alternative, from the perspective of both fairness and efficiency, would be to put the two GSE into a special resolution regime (SRR) that ring-fences their existing assets and liabilities. The government would appoint an administrator; the existing top management would be fired; the existing shareholders would lose their governance rights and would be put at the back of the queue of claimants to the value that would be realised from the sale of the GSEs or their assets. For proper fiscal accountability, both the assets and the liabilities in the SRR would have to be on the balance sheet of the Treasury or some other government entity included in the consolidated accounts of the general government.
Outright nationalisation, with the existing shareholders getting nothing and without any guarantees for the existing creditors would be another fair and efficient option. So would the purchase by the government of all the mortgage and mortgage-related assets of the two GSEs. Existing creditors and shareholders would be paid in order of seniority without any guarantees.
Both the option to acquire equity in the two GSEs and the extension of their credit lines represent contingent liabilities for the US Treasury and thus for the US tax payer. Extending primary discount window access to Fannie and Freddie exposes the Fed to a contingent liability. As long as the collateral offered by Fannie and Freddie consists just of federal government and agency debt, the additional quasi-fiscal exposure is limited. If, as I expect, the range of eligible collateral that can be offered to the Fed by the two GSEs is expanded in the future to include private financial instruments, including illiquid RMBS subject to material default risk, the quasi-fiscal contingent burden put on the tax payer by the Fed could end up much larger.
The Treasury has taken another big step on the road to Utter Fiscal Obfuscation. It is doing everything it can to disguise the fact that it is entering in commitments that create potentially massive contingent liabilities for the US tax payer. Even if the purpose served by this increase in contingent liabilities is worth the cost, the manner in which it is done is designed to avoid fiscal accountability. This is as welcome to the Executive as it is to the Congress.
The continuing corruption of the Fed’s mission through its growing use as a quasi-fiscal agent of the US government is deeply worrying. Admittedly, this latest extension of list of eligible counterparties at the primary discount window is small beer when compared to the creation in March 2008 of the off-balance sheet vehicle/SPV in Delaware which houses $30 bn of Bear Stearns’ most toxic assets, all but the first $ 1billion of which represent a contingent exposure of the Fed. If, as I expect will happen, the range of eligible collateral Fannie and Freddie can offer at the discount window is widened in the future, and if the maturity of the loans available to them at the discount window is extended, this latest enhancement of the Fed’s role as a lender of resort will be a further step on the road to the Fed as quasi-fiscal recapitaliser of first resort.
Since 1997, the Fed has long been the least operationally independent central bank in the industrial world. This latest episode suggests its main current purpose is to be an unaccountable quasi-fiscal agent for the US Treasury. If that is correct, the Fed’s capacity to deliver price stability in the future may have been fatally impaired.
I don’t think the “Paulson Plan” is about solving economic problems as much as deferring/diluting political ones.
By passing the buck to Congress, the Republicans are creating a share the blame scenario — much like the Iraq war vote. By limiting the initial contributions to existing shortfalls, they are able to kick the can down the road past November and leave the larger problem for the Democrats to deal with.
Fortunately or not, the equity markets don’t seem to like it very much either. However, the currency and bond markets have given it a big thumbs up so far.
A shame and a crime…
Posted by: SS | July 14th, 2008 at 10:50 pm | Report this commentI don’t necessarily agree with bailing them out, but I do understand why. First, they haven’t bailed them out yet. The Treasury and the Fed are just laying the foundation to do so. Second, the Fed has opened the discount window to both mortgage giants. Finally, there was an implicit guarantee that the Federal Government backed both giants.
Posted by: Andrew W | July 14th, 2008 at 11:50 pm | Report this commentDear Professor, your scathing wit is a consistent joy! I wonder what Hankie thinks?
And we should not forget such all-time classics as: “Comment on tomorrow’s announcement by the Treasury and Bank of England”.
Posted by: RCS | July 14th, 2008 at 11:59 pm | Report this commentI love your blog, but you have no idea of American politics. It isn’t outcomes that matter but appearances. Then again, economists always seem to make that error.
Posted by: Ryan Lanham | July 15th, 2008 at 12:38 am | Report this commentThe Treasury could simply be a massive game of “chicken”. By threatening to buy Fannie/Freddie stock, Paulson &al. may be hoping to scare away the short sellers and drive the companies’ share prices up. Then they could recapitalize in the private markets and a bail-out would not be required.
If so, and if today’s action is any guide, the market is calling this bluff.
I find it hard to believe the Bush Administration honestly wants to support these enterprises in any way.
Posted by: Nemo | July 15th, 2008 at 12:48 am | Report this commentWhy not just break them up and give the parts to the 20 or so largest bondholders? That way, the Chineese, Russian, British, Dutch and Taiwanese central banks can take on the risk, and benefits of getting their money out of their investments. Let’s nationalize F&F to the foreign governments that really own the assets. Hell, if they can make money at it, maybe they’ll want to invest more capital in US mortgages by setting up their own mortgage companies in the US. I can just see PBOC_mac as being at least as large a player as IndyMac was.
Posted by: Darryl Wright | July 15th, 2008 at 2:03 am | Report this commentAround 594 BC a new leader was appointed in Athens, Greece named Solon. In order to ease tensions between the rich and the poor, Solon forgave all debts and freed all slaves connected to debt. He then set up a class system of government that allowed rich and poor a voice in making law. Thereafter, Greece proceeded to experience one of the greatest economic booms in its history. It lasted over a hundred years.
Posted by: Finding Nemo | July 15th, 2008 at 2:04 am | Report this commentHA- HA- HA- HA- HA- McCain & Obama brag about raising $22 Million during June 2008 EACH. In total, they’ve each raised hundreds of millions.
You can always count on Uncle Sam to bail out his rich banker buddies. This is nothing short of Solon in reverse. Well, let me officially welcome you to the New World Order- OH, I mean “Ownership Society.” Attention all ye slaves to debt- yours will never be wiped clean.
I think Paulson is pursuing a reactive strategy which focuses on continuing to juggle the problems and push them out as they come up. He doesn’t have the time or the political power to convince Congress and the President to take long term transformative measures of the system in an election year.
The upside of this approach is that it can always be reversed. Fannie and Freddie can be nationalized or ring fenced in the future if they need to be.
I don’t think there is a way out of this crisis for the US, and no politician or appointed official has the guts to say it. With highly levered consumers and government, low savings, a falling US dollar and increasing commodity prices, the US is caught in a process of reversion to global norms of consumption vs income.
Good luck
Posted by: PN | July 15th, 2008 at 2:52 am | Report this commentI realize this is seriously belated, but it sadly seems to get more appropriate by the day…
Ron Paul 2008
Posted by: Speaker73 | July 15th, 2008 at 3:54 am | Report this commentThere is another important aspect: The Chinese government is the largest holder of Freddie and Fannie bonds, with over $300 billion in holdings. Total foreign holdings of such bonds are well over $1 trillion. If Freddie and Fannie default, there is a good chance that the U.S. would see a massive asset liquidation by foreigners, resulting in a plummeting dollar.
I don’t think Paulson would be able to jawbone his way out of that one.
Posted by: Justin Rietz | July 15th, 2008 at 6:19 am | Report this commentThe United States is not a mature banana republic, Professor Buiter?
Immature, then?
Lately it’s been ruled by a dynasty’s brat fronting for a gang of craven thugs.
Until last year’s Pentagon coup. (Pfaff actually had the courage to write about coup but of course he lives in France.)
Now the voters get to choose between the deposed gang’s best friends and a lamb with perfect pitch.
The one wouldn’t touch the gamblers and swindlers and the other can’t.
Every proper banana republic slides into wild inflation and, behold, the USA is sliding right now. (And toward stagnant wages, a consolation for the right crowd).
A brat king, paranoids running the palace, a coup, swindlers and gamblers handlng the money, stagflation amuck. It all looks rather bananaish to me.
Posted by: Jan Smith | July 15th, 2008 at 6:46 am | Report this commentInteresting, as always. Americans cannot the word “nationalization” as, in Kansas, it means “communist”. But they like the term “loan guarantees” (see, Chrysler in 1980s, Amtrak, etc.) or “conservatorship” deals (S&L mess in 1980s and the Resolution Trust Corporation). But the $15 bil. injection is nothing when one considers the 5 trillion of mortgages and a very realistic 1% mark down within a quarter, on mark-to-market rules, will be a $50 bil. whack….so at best the $15 bil. is just holdover money for the next 2-3 weeks.
Also, the FED’s balance sheet is thin. It has only $22 bil. of float after the Bear Sterns deal, and Wall Street and a couple of regional banks (WaMu is one) are borrowing heavily at the discount window.
In all, it reminds me of the Turkish mess 1999 and its massive $21 bil. (=4-5% of GDP) rescue of its messy banks. Likewise, the size of the loss from the mortgage mess will be at 5-6% of U.S. GDP. But his one is sung in English! And unlike Turkey’s White Knight rescue from the IMF, the American numbers are very large which can only flood the debt markets and devalue the USD. 2 bucks for a euro, anyone?
Posted by: Ali Ettefagh | July 15th, 2008 at 10:00 am | Report this commentAs US government liabilities, contingent liabilities and proclivity for bailouts increase, the US sovereign triple-A credit rating looks increasingly inconsistent with Japan’s yen debt rating of A1 by Moody’s and AA by S&P. Is this another area where the credit rating agencies’ objectivity and responsiveness can be questioned?
Posted by: Tim Young | July 15th, 2008 at 11:03 am | Report this commentWell at least the Markets are behaving in a somewhat rational manner in selling out of this sector unlike the Politicians who are buying in using taxpayers assets and credit.
We may well be able to look back on this in 3-5 years time and be able to say that we saw the final phase of the beginning of US decline economically and politically to say nothing of militarily. The Austrians (Economists) were right, it all starts and finishes with credit/money supply creation excess and currency debasement.
The words “Cash is King” seems to ring true in times such as these and going forward.
It is setting though setting up a once in a lifetime wealth creation opportunity by buying into banks that hopefully survive at overshot prices on the downside, mostly outside of the US. Timing as always and selection the challenges and the reward.
Posted by: D. Smith | July 15th, 2008 at 11:21 am | Report this commentI think that Justin Rietz nails it on the head (except China likely owns more than $500 billion of Agencies). Paulson will do everything he can to avoid a dollar crisis on his watch. Of course the GSEs are important to support the US housing market, but there are other ways to address that need. The key driver of US policy is the need to make the Chinese, Russians, etc. whole. That’s basically what the “strong dollar” policy amounts to these days.
Oh, and since McCain’s tax policy proposals would pile over $4 trillion on the US national debt ovet the next 10 years, I also think that Willem Buiter should explain how those proposals make any sense.
Posted by: Carlomagno | July 15th, 2008 at 12:38 pm | Report this commentThanks for telling it like it is professor. Paulson and Bernanke are putting an outrageous spin on the current situation.
What we are getting is another taxpayer bailout of the investment class.
Posted by: joe | July 15th, 2008 at 2:24 pm | Report this commentThree things that can change to achieve stability for US average citizen:
1) Decline standard of living
2) Increase wages
3) Increase savings (immediate)
2 and/or 3 are required for 1 not to occur. 2 and 3 can not occur, and the Treasury/Fed is realizing you can not borrow it either ultimately.
So 1 will unfold and it does.
Posted by: TR | July 15th, 2008 at 4:07 pm | Report this commentIf one of them, Fannie for example, had failed…the other, Freddie, would have survived with all the remaining business of Fannie. And no need to keep the public subventions.
Posted by: Enrique | July 15th, 2008 at 4:37 pm | Report this commentThere’s one solution left to debt-stricken America: Sell Iraq to China.
Posted by: Shevvers | July 15th, 2008 at 4:50 pm | Report this commentWell,I see banana republics everywhere. Who is the chimpanze?
Posted by: mario ribeiro | July 15th, 2008 at 9:02 pm | Report this commentGovernment buying securities from open market isn’t new. Hong Kong government did buy substantial amount of blue chip equities during the Asian Currency Crisis as one measure to fend off currency speculators. The outcome was fantastic. Currency speculators lost. Hong Kong government made tens of billions.
Mark to market debt instruments and the resulting writeoffs were non cash charges. When crisis is over, GSE may recoup sizeable amount of assets.
Posted by: jon | July 15th, 2008 at 9:37 pm | Report this comment[…] Willem Buiter fulminates on the real meaning of the GSE bailout: The Treasury has taken another big step on the road to Utter Fiscal Obfuscation. It is doing […]
Posted by: PrefBlog » Blog Archive » July 15, 2008 | July 16th, 2008 at 2:51 am | Report this commentThe dollar will continue to drop in value as the U.S. government/FED looks and acts with socialist-like strategy (i.e. acquiring Fannie and Freddie). Its unbelieveable that their egos are so big that they believe they are actually bigger than than the marketplace (the people) itself. The technology age is the Fed’s worst enemy as it seems to give them the absolute (short-term) power of printing their own paper at inconceiveable speeds and levels. The U.S. government is the largest employer in the U.S. Its Social Security system is one of the largest owner’s of America’s debt (talk about drinking your own blood). At this rate, the dollar will eventually become an unacceptable paper currency in the global marketplace as the government officially becomes bankrupt (more liablilities than assets). The real question is, who bails them out? Not me.
Posted by: Doug Wolkon - Author of The New Game | July 16th, 2008 at 3:57 am | Report this commentThis is the end result of a long string of illegal, unconstitutional government schemes. Freddy and Fannie should never have been created. Nationalization is similarly unconstitutional. The government needs to get out of the way and let the free market work so that some of these deadweight institutions can fail.
Posted by: Pliny | July 16th, 2008 at 2:32 pm | Report this comment[…] best blogging buddy (thanks to his views on biofuels) Professor Willem Buiter of the FT, when he writes that: “Outright nationalisation, with the existing shareholders getting nothing… would […]
Posted by: Fannie and Freddie Get Naked « Uncharted Territory | July 16th, 2008 at 5:25 pm | Report this comment[…] Evidence that the opinion of Willem Buiter is:Yes “Fannie and Freddie ought to have been nationalised.”From FT.com: […]
Posted by: Willem Buiter - Should Fannie Mae and Freddie Mac be nationalized? | July 16th, 2008 at 7:01 pm | Report this commentI think Prof. Buiter is being a bit harsh. There are several moving parts here and each must be treated separately. First, if Fannie Mae and Freddie Mac were to go bankrupt and default on their mortgage guarantees, the entire banking system in the U.S., and in much of the rest of the world, would grind to a screeching halt. Then the USG would have to honor its FDIC obligations which would be orders of magnitude more expensive than bailing out the mortgage insurers. The same goes for their securities. It’s not just the Chinese who are holding these things.
Second, this is actually a short term problem. 7% or so of subprime mortgages are re-setting this month. By the end of the first quarter of next year, that number will be down in the 4% range. Plus, the quality of the underlying loans will be better. So if Fannie and Freddie can get through the next six months or so, the potential losses will drop. If it goes under, there will be only losses with no new stream of premiums to help balance them. This is the problem with the SSR idea. In addition, these institutions have served the U.S. economy well. If you unwind them, it will be necessary to re-invent them.
Posted by: Anon | July 16th, 2008 at 9:19 pm | Report this comment7% or so of subprime mortgages are re-setting this month
Posted by: Anon | July 16th, 2008 at 9:19 pm
Subprime portgages are not the main issue at this stage. There’s still a tsunami of Alt-A resets and recasts to come.
Posted by: Carlomagno | July 17th, 2008 at 9:22 am | Report this commentWell, if no one on this Kool-Aid-drinking blog of yours is going to challenge you, I will:
Your statements: 1) that there has always been a de-facto government guarantee for these securities, and 2) that the recent actions of the Treasury expose it to additional contingent liabilities, are contradictory. If there was a de facto guarantee, then there were by definition always contingent liabilities. You attempt to reconcile the contradiction when you go on to say that the posting “private financial instruments” such as “illiquid RMBS with material default risk” (subprime) will significantly increase the “quasi fiscal contingent burden” (good heavens–brevity Professor, please!) to the taxpayer. You never mention what percentage of said illiquid securities are actually subprime, and never mind the fact that time–precisely what the Treasury is buying here–can be a remedy for illiquidity as you know.
It is worth noting that no capital has yet been lent; no equity purchased by the Treasury. Only the nature of “implied backing” has become more explicit.
I’m not trying to be sanguine. This certainly isn’t the best of situations, but we’re not in banana republic territory yet (I’ve lived in southern Europe, so I know what a banana republic is). If the Treasury manages to conserve the agencies’ ability to issue debt on favourable terms thereby subsidising residential mortgages, the US mortgage market and economy will be better off than than that of the UK, as it has been since WWII. Anyone who has financed a home purchase in both countries will know this is the case, and it is another trade-off US borrowers receive in return for–must we say it?–”quasi fiscal financial burdens”.
Since you wrote the above, time has been well spent for the two institutions. Although fortunes can admittedly change quickly, capital has been lent, but not by the Treasury, as has been evident in the agencies two successful debt sales, with foreign central banks buying more than usual and spreads narrowing.
One can now begin to ask: Would the Buiter “ring fencing & outright nationalisation” plan have worked better than the “Hankie and Feddie” plan. Only time will tell. At the moment, your analysis looks a hasty. I am saving, in any event, several of these shrill, sneering, name calling posts of yours so that should the US emerge in anything but Utter Fiscal Obfuscation, we can sit down in 10 years, have a calm, English cup of tea, and set the venerable old Professor straight.
By the way, you bloggers are far too slavish. You must have all gone to LSE.
Posted by: Dave the American | July 17th, 2008 at 11:56 pm | Report this commentFannie and Freddie ought to have been nationalised?. I do not think so. Nationalization of Banks means government of them by political interest, not financial interest. At the end it does not work. Salvador Trinxet. Banco Internacional de Investimentos. www.bancoii.com
Posted by: Banco Internacional de Investimentos | July 18th, 2008 at 2:12 am | Report this commentFreddy and Fannie should never have been created?. I think is not a bad idea, it worked well, in fact they do not have sub-prime mortgages, but all the US financial and real estate system suffer, so they suffer. Salvador Trinxet. Banco Internacional de Investimentos. www.bancoii.com
Posted by: Banco Internacional de Investimentos | July 18th, 2008 at 2:15 am | Report this comment[…] took the unusual step of making an announcement on the Sunday (13th July), of what has been called a “rescue” of the two companies. I suggest it was nothing of the sort. Rather it was a statement of […]
Posted by: Pricking the Oil Bubble?: Bush, Fannie and the Ayatollahs « Uncharted Territory | July 21st, 2008 at 8:42 pm | Report this comment“The continuing corruption of the Fed’s mission through its growing use as a quasi-fiscal agent of the US government is deeply worrying.”
Worrying, but also inevitable, given the financial and economic position the US government now finds itself in.
Which is bad enough, but when one recalls the arrogant, self-righteous “advice” doled out by that same government during the emerging markets crisis of the late ’90s, or during Japan’s banking crisis of the mid ’90s, one begins to understand why so many regard America and Americans as the biggest bunch of hypocrites on the planet.
Posted by: Peter Principle | July 27th, 2008 at 9:34 pm | Report this comment