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.