July 27, 2008
Anyone who cares about the health of the US economy should welcome the enactment of the Treasury’s rescue plan for Fannie Mae and Freddie Mac, along with other measures to support the housing market. While there is room for argument about details, the risks to the financial system were too great to allow delay.
No one should suppose, however, that the issue is now satisfactorily resolved, even for the short term. Emergency legislation was necessary because market participants were unwilling to buy Fannie and Freddie’s debt; investors doubted that the government-sponsored enterprises were healthy enough to repay it and did not draw sufficient reassurance from the implicit guarantee of federal support. If their debt proves easier to place now, it is only because this guarantee has been strengthened, not because anything has changed at the GSEs.
This, to put it mildly, is a highly problematic posture for policy. While I strongly supported the Federal Reserve’s policy response to the crisis at Bear Stearns because it was necessary to avoid systemic risk, it is easy to sympathise with those who fear that bailouts inhibit market discipline. Consider how much more problematic the Bear Stearns response would have been had policymakers signalled their commitment to back the company’s liabilities without limit; left management in place with no change in the business model; and allowed dividends to be paid and shareholders to keep going with hope for a better tomorrow. Yet all of these elements are present in the cases of Fannie and Freddie.
To see the temptation and danger inherent in a situation of this kind, one need only look back to the mismanagement of the savings and loans crisis during the 1980s. Policymakers protected depositors, allowed institutions to operate even when their fundraising depended on government support, and suspended regular standards in order to attract private capital. With gains privatised and losses socialised, taxpayers ultimately ended up with a $300bn-plus bill measured in today’s dollars.
Allowing the clearly undercapitalised GSEs to continue operating within their current paradigm carries similar risks. The principal difference is that the GSEs are much larger than the thrift institutions, while the housing crisis is more serious than anything we have seen since the Depression.
To be sure, if one supposed that the GSEs’ problems were all issues of confidence and was certain of their underlying financial health, there might be a case for government guarantees with no onerous conditions. But almost every outside observer agrees that pre-crisis, the GSEs could only borrow because of their implicit government guarantees. Since the crisis their position has sharply deteriorated, and will deteriorate further.
There is no question that we need the GSEs to be highly active in support of the housing market and financial system in the months ahead. If the authorities can see a path to their being able to play such a role in a framework where it can honestly be said that their borrowing is based on confidence in their financial position rather than primarily on federal guarantees, then this is obviously the preferred alternative. But after what we have seen, such a judgment cannot be based on the GSEs’ own claims, the understandable desire of government officials to maintain confidence and attract private capital, or the fact that they are able to borrow – which only reflects the strength of federally provided credit assurances.
If this preferred alternative is, as I fear, not realistic given the state of GSE finances, the government should use its new receivership power to protect taxpayers and the financial system. In the process, payments to stock holders, holders of preferred stock and probably subordinated debt holders would be wiped out, conserving cash for the benefit of taxpayers. The GSEs’ borrowing costs would fall considerably, helping prospective homeowners.
In this scenario, the government would operate the GSEs as public corporations for several years. They would then be in a position to extend credit where appropriate to support resolution of the current housing crisis. Once the crisis has passed, the federal government would divide their functions into government and private components, the latter of which would be sold off in multiple pieces. The proceeds could be used to fund the low-income housing support activity that was previously mandated to the GSEs.
With this approach, the federal government would be in a position to support the housing market in the years ahead without encouraging dubious financial practices or denying financial reality, as is the case today. In the longer term, it would provide an opportunity to rebuild the housing finance system on far stronger foundations.
A major concern is that receivership would endanger the financial health of the US by taking on to the federal government’s balance sheet all the liabilities of the GSEs. This argument confuses appearance with reality. Recent statements by the Treasury and the Fed have removed any doubt that the US will stand behind the senior debt of the GSEs. Surely everyone should have learned by now that keeping liabilities off balance sheets does not make them any smaller or less real.
The stakes here are high. The choices made in the coming months will bear on the housing market, future taxpayer burdens, the credibility of US financial authorities in times of crisis and the integrity of the political system. It is a time for decisive action.
The writer is Charles W. Eliot university professor at Harvard and a managing director of D.E. Shaw & Co
Copyright The Financial Times Limited 2012.