July 16, 2008
The financial crisis in the United States and worldwide entered a new phase this week, as Fannie Mae and Freddie Mac, the two huge US home-loan institutions, began what appears to be a “death spiral” similar to that which claimed Bear Stearns four months ago. Fannie and Freddie are unique institutions and will almost certainly be bailed out by the long-suffering taxpayer. However, for the first time, the specter has been raised of a general financial meltdown, such as the US managed to avoid in 1933 but Sweden succumbed to in 1991.
Sweden’s financial meltdown of 1991 involved the government guaranteeing the obligations of the entire Swedish banking system, and recapitalizing the major banks, with the sole major exception of Svenska Handelsbanken. The total cost of the rescue to Swedish taxpayers was around US$10 billion, equivalent to about $1 trillion in the context of today’s US economy. The causes of the crisis would be familiar to most Americans today: misuse of off-balance sheet securitization vehicles to invest excessively in real estate and mortgage lending.
It is thus not impossible for the entire US banking system to implode. It didn’t happen in 1933 (though about a quarter of US banks failed) because US banks in the 1920s had been relatively conservative in their lending, with many banks requiring a 50% down payment for home mortgage loans, for example. Stock margin lending got way out of control in 1928-29, but relatively few banks were involved significantly in that.
The main problem in 1932-33 was quite simply liquidity; the Fed failed to supply adequate reserves to the banking system, so crises of confidence in individual banks led to panic withdrawals of deposits that caused the banks themselves to fail.
This time around, the problem is the opposite. Whereas the Fed had been appropriately cautious in the late 1920s, so only in the area of stock margin lending did the banking system get out of control, this time around the Fed has been hopelessly profligate in monetary creation for over a decade. The initial result of this profligacy, the tech bubble of 1999-2000, caused only modest problems in the banking system through telecom losses. The more recent profligacy and the housing bubble it caused have had much more serious consequences, mirroring those in Sweden leading up to 1991. The additional loosening since September has distorted the financial system further, producing a commodity price bubble that itself seems likely to have substantial further adverse consequences.
Fannie and Freddie are probably toast, and about time too. Federal Reserve Board chairman Ben Bernanke’s statement on Friday that the two companies can discount paper with the Fed may prolong the inevitable, but also increases its likely huge cost to taxpayers.
There can be no economic justification for the government guaranteeing the great majority of the nation’s home mortgages, and the spurious “government-sponsored enterprise” structure of Fannie and Freddie merely hid the likely consequences of their default. Their senior employees have been paid as if they were counterparts of Wall Street high-flyers for performing a function that was economically entirely unnecessary, and they have survived for more than 50 years simply through their ability to offer lucrative consulting contracts to ex-congressmen and other politically well-connected people.
It is thus necessary that any “rescue” for Fannie and Freddie be a euthanasia not a lifeline. They have extracted their rents from the market for too long and have encouraged the growth of a securitized mortgage market that has proved entirely unsound because of its perverse incentives. Simply providing them with $100 billion or so of extra capital at taxpayer expense, probably structured as some economically unjustified form of subordinated debt so that the shareholders are left undiluted and allowing them to continue operating, doesn’t solve the problem; it exacerbates it.
The simplest from of euthanasia for Fannie and Freddie would be a takeover by the Office of Federal Housing Oversight (OFHEO), their regulator, on the grounds that they were no longer able to operate independently. In Freddie’s case that could be carried out at any time, since the company has failed to follow through on a promise to OFHEO to raise $5.5 billion in new capital – which at Thursday’s closing share price would dilute existing shareholders by 55%. In any case, further declines in their share prices and withdrawal of funding by the bond markets are likely to cause a sufficient crisis in the next few weeks to make such a takeover inevitable if a rescue is not organized (which it shouldn’t be.)
Following a takeover, Fannie and Freddie would need to continue performing their current functions of guaranteeing home mortgages, as without such guarantees home mortgages are currently impossible to obtain. However, changes must be made to recognize the revised nature of the business.
Since the new guarantees would be direct government obligations (OFHEO being an arm of the government) rather than simply implied obligations, the fees for obtaining them should be jerked sharply upwards, perhaps to 1.5% per annum on the outstanding amount of the mortgage. That would allow mortgage finance to remain available at a cost that is still reasonable in current markets (Fannie Mae paper already pays a 0.75% premium over the government for its borrowings), but as markets recovered it would make Fannie/Freddie guaranteed mortgages highly uncompetitive against direct home loans, by far the healthiest way for housing to be financed.
Together with the salary reductions outlined below, it would also begin to reimburse the unfortunate taxpayer for the gigantic costs of this non-rescue operation.
Treasury Secretary Hank Paulson has called for “covered bonds” similar to the German pfandbriefe to be used to finance housing. Since pfandbriefe, bonds issued by German banks to finance housing, remain on German bank balance sheets and retain the bank guarantee, allowing the banks only to escape the funding risk of lending for 30 years at a fixed rate, they avoid the moral hazards of the securitization markets, and are thus an attractive alternative.
To encourage their use, and to reduce the capital cost to banks of holding mortgages on balance sheet, the Basel 1 bank regulations, currently being phased out, should be retained; they allowed mortgages to carry only a 4% capital charge as against 8% for regular loans. By this and other means, the private banking sector would be encouraged to make sound home loans directly, without the unnecessary Fannie/Freddie guarantees.
The objective would be over a five-10 year period for Fannie and Freddie to become insignificant participants in the mortgage market, after which they could be closed altogether. Meanwhile, costs in Fannie and Freddie could be cut drastically, particularly on the staffing side.
Since Fannie and Freddie staff would now be government employees, they should be paid on the GS (government) payscale, with the chief executive, as a GS-15, receiving appropriate remuneration between $115,317 and $149,000, according to his years of service. Even if the chief executive officer was able to argue himself onto the SES (senior executive service) pay scale – after all, he has excellent congressional contacts – he would be limited to about $205,000 in the Washington area.
Naturally, many Fannie/Freddie employees would be outraged at this cut in their living standards and would attempt to find alternative better-paid employment; I venture to suggest that few would succeed in doing so. That way, redundancy payments would be avoided while salary costs were slashed.
There would be a devastating effect on the Northern Virginia housing market, where many senior Fannie/Freddie employees have overextended themselves with giant home mortgages for vulgar McMansions, but that problem too is probably survivable. More important, the now-disgruntled employees would perform their job poorly, making applying for a Fannie/Freddie guarantee a bureaucratic and uncertain process, similar to negotiating with the Inland Revenue Service. That too should hasten the disappearance of the firms from the housing market.
Fannie and Freddie do not represent the entire US finance sector, far from it. Nevertheless their insolvency would further erode confidence in the rest of the sector, very likely leading to a cascade of death spirals among other institutions. After all, the best-run large non-global US bank, Wachovia, has itself got in trouble by its insanely foolish acquisition of the California mortgage lender Golden West Financial at the peak of the market in 2006, while Bank of America, the largest retail-oriented US bank, voluntarily took on more of the mess by its purchase of the diseased and probably criminal Countrywide Financial as recently as last January.
Citigroup is in deep trouble in a number of areas, particularly relating to its over-enthusiasm for the discredited technique of securitization, while JP Morgan Chase chief executive Jamie Dimon wrecked his credibility in May by announcing that the financial crisis was “mostly over” – presumably wishful thinking in the light of his huge holdings of dodgy Bear Stearns paper.
Only Goldman Sachs appears serenely above the fray, but don’t forget that at May this year its “Level 3” assets were $78 billion, more than twice its capital. Level 3 assets, you may remember, are those for which there is no market, so can be valued only by the internal mathematical models of the institution concerned. Since this arcane highly illiquid paper is the most likely to suffer catastrophic erosion of “value” in a downturn, Goldman Sachs, like Jamie Dimon, must be keeping fingers crossed that somehow this nightmare must end soon.
It mustn’t; from past experience of such follies it probably has at least another year to go. Thus a total collapse of the US financial system, while not inevitable, is a contingency which should now be planned for.
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