What Happens Next to Fannie and Freddie?

Insolvency of the Fannie and Freddie Predicted Two Years Ago. What Happens Next? Or How to Avoid the “Mother of All Bailouts”
By Nouriel Roubini
2008-7-11

A pretty good article from Nouriel Roubini. A choice quote below, then on to the article.

“Privatizing profits and socializing” losses may dominate the policy outcome. Financial institutions love a system where they gamble recklessly, pocket the profits in good times and let the fisc (taxpayer) pay the bill when their reckless behavior triggers a financial crisis; this is socialism for the rich. That is why you already hear the whole Wall Street Greek chorus moaning for a bailout of the GSEs.

Two years ago in July and August of 2006 this author first presented here his analysis of why the U.S. would experience its worst housing recession of the last 50 years, why home prices would fall at least 20%, why the collapse of mortgages would start with the “subprime” ones (a term that at that time was unknown to 99.9% of the public including most investors) andhow this housing bust would lead to a severe banking crisis and a credit crunch that would tip the U.S. economy in a recession by 2007. My timing of the recession call was off by six months – as the recession started at the end of 2007 rather than mid-2007 as then predicted – but all the other predictions turned out to be correct.

At that time this author also predicted that this housing bust and mortgage bust would lead to a bust of the two government sponsored enterprises (GSEs) in the mortgage market, Fannie Mae and Freddie Mac. Predicting the insolvency of Fannie & Freddie was the obvious logical implication of the prediction of the worst housing recession in decades. So no wonder that this week headlines are all about Fannie and Freddie being insolvent and the systemic consequences of such insolvency.

Let me now elaborate on those insolvency predictions, discuss what happens next when Fannie and Freddie go belly up and discuss why they should not be fiscally bailed out; rather – on top of wiping out their shareholders – their creditors/bondholders should also take a haircut to avoid the “mother of all moral hazard bailouts” …

As a starting point of the analysis note that the insolvency of Fannie and Freddie is no news to regular readers of this forum. In August of 2006 I wrote the following:

“the gambling-for-redemption behavior…are not the exception in the mortgage industry; they are instead the norm. There are good reasons to believe that this is indeed the norm as lending practices have become increasingly reckless in the go-go years of the housing bubble and credit boom.

If this kind of behavior is – as likely – the norm, the coming housing bust may lead to a more severe financial and banking crisis than the S&L crisis of the 1980s. The recent increased financial problems of H&R Block and other sub-prime lending institutions may thus be the proverbial canary in the mine – or tip of the iceberg – and signal the more severe financial distress that many housing lenders will face when the current housing slump turns into a broader and uglier housing bust that will be associated with a broader economic recession. You can then have millions of households with falling wealth, reduced real incomes and lost jobs being unable to service their mortgages and defaulting on them; mortgage delinquencies and foreclosures sharply rising; the beginning of a credit crunch as lending standards are suddenly and sharply tightened with the increased probability of defaults; and finally mortgage lending institutions – with increased losses and saddled with foreclosed properties whose value is falling and that are worth much less than the initial mortgages – that increasingly experience financial distress and risk going bust.

One cannot even exclude systemic risk consequences if the housing bust combined with a recession leads to a bust of the mortgage backed securities (MBS) market and triggers severe losses for the two huge GSEs, Fannie Mae and Freddie Mac. Then, the ugly scenario that Greenspan worried about may come true: the implicit moral hazard coming from the activities of GSEs – that are formally private but that act as if they were large too-big-to-fail public institutions given the market perception that the US Treasury would bail them out in case of a systemic housing and financial distress – becomes explicit. Then, the implicit liabilities from implicit GSEs bailout-expectations lead to a financial and fiscal crisis. If this systemic risk scenario were to occur, the $200 billion fiscal cost to the US tax-payer of bailing-out and cleaning-up the S&Ls may look like spare change compared to the trillions of dollars of implicit liabilities that a more severe home lending industry financial crisis and a GSEs crisis would lead to.

The main, still unexplored issue, is where the risk from mortgages is concentrated: among the sub-prime lenders (as I worried about…) or among commercial banks or among hedge funds and other financial intermediaries that purchased mortgage backed securities(MBSs) or among the GSEs (Fannie and Freddie)? Commercial banks claim that they have transferred a lot of their mortgage risk to other financial intermediaries – such as asset managers, hedge funds or insurance companies – who purchased large amounts of MBSs. But banks have still lots of mortgages on their books and, on top of it they have tons of consumer debt exposure (credit cards, auto loans, consumer credit) that may go really bad in a recession. If part of the housing risk has been off-loaded to hedge funds, the risk is not just of some of these hedge funds going bust but also their prime brokers (i.e. large investment banks) getting into trouble; counterparty risk will become serious once the hot potato of mortgage risk is pushed from one counterparty to the other. And finally, a large part of the housing risk is also in the hands of Fannie and Freddie. How much are the GSEs at risk is a complex issue…”

So, what was written two years ago has by now unfolded as predicted, including the now evident coming bust and insolvency of the two GSEs. The issue now is: what happens next to Fannie and Freddie given that they are effectively insolvent?

The conventional answer is that their shareholders get fully wiped out but that their creditors (those holding the $5 trillion of these agencies’ debt and their other liabilities) are made whole as the U.S. government cannot afford reneging on the implicit guarantee of the liabilities of Fannie and Freddie and it cannot risk a collapse of the mortgage and housing market that defaulting on part of the liabilities of Fannie and Freddie would imply. Unfortunately, the conventional wisdom may turn out to be right; but it could also turn out to be wrong.

First notice that, as discussed previously in this column, the farce that Fannie and Freddie were “private sector” firms was obviously a farce as investors always expected that the liabilities of the two GSEs would be eventually backed by the U.S. government. And in spite of the decade long rhetoric by Fed, Treasury, the Bush administration, conservative government-bashing hawks and a slew of other regulators that Fannie and Freddie were private firms, that investors should not assume that they would be bailed out if these firms turn out to be insolvent and that the moral hazard deriving from perceptions of an implicit guarantee should be stomped as hard as possible, the reality was different: these were effectively public institutions – not private ones – used by the government (especially this administration) to pursue public policy goals. The hawkish rhetoric about the “moral hazard” the from implicit guarantees that Greenspan, Bernanke, Paulson, Bush and the administration peddled for eight years was thrown out of the window the moment the housing and mortgage bust started. Instead, for the last few months the GSEs – that were already bleeding and becoming insolvent on their own portfolio – have been used by the government to back stop the mortgage markets: their portfolio limits were raised, their regulatory capital was reduced and the limits to what conforming mortgages (that the GSE can repackage/insure) are were raised from $420k to over $720k. So much for barking in public about “moral hazard” and then going ahead and using already distressed GSEs to bail out the mortgage market and make them even more insolvent. Now this “the emperor has no clothes” farce has been revealed to be what it always was: a high-flatulin “moral hazard” farcical rhetoric with zero substance and credibility.

To minimize the financial cost of this farce the administration should stop pretending that these are private institutions and go ahead and take them over and nationalize them since they are going to bail them out anyhow. The financial costs of this farce include the $50 billion of subsidy that the GSEs bondholders/creditors are receiving every year as the spread of the agency debt over Treasury is now close to 100bps (100bps on $5 trillion of liabilities is equal to $50 billion). Today the market prices the debt of the GSEs as if there is a meaningful probability that – once bankrupt – these firms will be treated as private firms and their bondholders will take a loss. But if the government is going to bail them out – because the consequences of a capital levy on their bondholder will destroy the mortgage and housing markets – the government should at least make this implicit liability (the guarantee of the $5 trillion debt of the GSEs) explicit and thus save the U.S. taxpayer that $50 billion subsidy that is given every year to the creditors/bondholder of Fannie and Freddie. An implicit liability that is not made explicit is the worst of all worlds as fat cats on Wall Street and around the world get a 100bps spread relative to safe Treasuries ($50 billion subsidy) on their holdings of agency debt and they know they will be anyhow bailed out if Fannie and Freddie go bust. Saving those $50 billion will not make Fannie and Freddie solvent as their insolvency hole is too big to be filled but it would at least reduce the fiscal bailout bill – that could be as high as $200-300 billion – that their insolvency and government takeover will imply.

Leaving aside now the “positive” issue of how the government will deal with the insolvency of Fannie and Freddie, let us consider the “normative” question of not what it is most likely to be done (an issue that involves more politics than sound economics) but rather what should be done in an ideal world? The simple answer is that we need to limit as much as possible the moral hazard of a bailout of Fannie and Freddie. Such a bailout of the creditors/bondholders of the two GSEs would result in the “mother of all maoral hazard-laden bailouts” in terms of its size and consequences. And such a bailout is neither necessary, appropriate nor desirable.

Of course most of Wall Street, domestic and foreign investors and Congress are already screaming and begging “Bail us out, bail us out!” as their $5 trillion holdings of agency debt will take a significant hit if the insolvency hole of the GSEs – after the shareholders are wiped out – is filled not with public bailout money but rather with an haircut on the bonds held by Fannie and Freddie creditors. On top of bondholders not wanting to take a hit almost every politician – including McCain that in a former life was one of the shamed and corrupt members of the Keating Five club when he facilitated the S&L scam – is now clamoring for a bailout of Fannie and Freddie under the argument that not rescuing them would lead to a collapse of the mortgage and housing markets. But these screams of “the sky will fall” if we don’t rescue Fannie and Freddie are vastly exaggerated and incorrect for a number of reasons.

First, notice that the hit that bondholders will take will be limited in the absence of their bailout. With a debt/liabilities of about $5 trillion and expected insolvency – as of now and in the worst scenario of $200 to $300 billion – the necessary haircut is relatively modest: either a reduction in the face value of the claims of the order of 5% (if the mid-point hole is $250 billion) or – for unchanged face value – a very modest reduction in the interest rate on their debt after it has been forcibly restructured.

Second, a 5% haircut is much smaller than the 75% haircut that the holders of Argentine sovereign bonds suffered in 2001-2005, much smaller than the haircuts that holders or Russian and Ecuadorean debt suffered after those sovereign defaults, and much smaller than the 30% haircut that holders of corporate bonds suffer on average when a corporation goes into Chapter 11 and its debt is restructured. So why should Uncle Sam – i.e. eventually the U.S. taxpayer – pay that $250 billion bill when investors in the U.S. and around the world can afford it? The same investors are getting a fat subsidy of $50 billion a year (whose NPV is much bigger than $250 billion) for holding claims that now provide a 100bps spread above Treasuries and are under the implicit guarantee of a full bailout.

Third, of the two options we need to pick one: either we formally guarantee those claims and start paying the Treasury yield on that debt saving the tax payer that $50 billion subsidy; or if we maintain the subsidy a credit event in the form of a small haircut because of insolvency would be the fair cost that such investors pay for earning the extra spread over Treasuries.

Fourth, while the haircut would reduce the market value of such agency debt and inflict mark to market losses to investors such losses are already priced by the fact that the widening of the agency debt spread relative to Treasuries – from 10bps to about 100bps – has reduced the mark to market value of such agency debt. So, in the current legal limbo of insolvent GSEs whose debt is however not formally guaranteed the persistence of the spread would lead to those $250 billion mark-to-market losses regardless of a formal default, restructuring and haircut on that debt. We may as well resolve that insolvency and restore the positive net worth of the GSEs by doing the haircut.

Fifth, a haircut on the debt of the GSEs does not need to destroy their business, the mortgage market or the housing market. The best debtor is a solvent debtor that has restructured and reduced its unsustainable debt burden: that is why firms coming out of a Chapter 11 process that reduces their debt burdens are viable businesses ready again to produce goods and services in a viable and profitable way. The worst thing that can happen to the GSEs is to remain as zombie comatose insolvent institutions whose debt burden is not restructured and who are barely propped by an implicit government lifeline. Do we really believe that GSEs with unrestructured debt kept alive in a zombie government “conservatorship” (the solution now most likely preferred by the U.S. administration) could function properly and continue their service of supporting the mortgage and housing market? Lets instead clean them up first and make them financially viable – after an out-of-court Chapter 11 style debt reduction – so as to ensure that they keep on providing the public goods that they are alleged to give.

Sixth, the existence of GSEs and the implicit subsidy that they provide to the housing sector and mortgage market is a major part of the overall U.S. subsidization of housing capital that will eventually lead to the bankruptcy of the U.S. economy. For the last 70 years investment in housing – the most unproductive form of accumulation of capital – has been heavily subsidized in 100 different ways in the U.S.: tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures.

The reality is that the U.S. has invested too much – especially in the last eight years – in building its stock of wasteful housing capital (whose effect on the productivity of labor is zero) and has not invested enough in the accumulation of productive physical capital (equipment, machinery, etc.) that leads to an increase in the productivity of labor and increases long run economic growth. This financial crisis is a crisis of accumulation of too much debt – by the household sector, the government and the country – to finance the accumulation of the most useless and unproductive form of capital, housing, that provides only housing services to consumers and has zippo effect on the productivity of labor. So enough of subsidizing the accumulation of even bigger MacMansions through the tax system and the GSEs.

And these MacMansions and the broader sprawl of suburbian/exurban housing are now worth much less – in NPV terms – not only because of the housing bust and the fall in home prices but also because: a) the high oil and energy prices makes it outrageously expensive to heat those excessively big homes; b) households living in suburbian and exurban homes that are far from centers of work, business and production that are not served by public transportation are burdened with transportation costs that are becoming unsustainable given the high price of gasoline. So on top of the housing bust that will reduce home values by an average of 30% relative to peak high oil/energy prices make the same large homes in the far boonies of suburbia/exurbia worth even less – probably another 10% down – because of the cost of heating palatial MacMansions and because of the cost of traveling dozens of miles to get to work in gas guzzling SUVs. Thus, it is time to stop this destruction of national income and wealth that a cockamamie decades long policy of subsidizing the accumulation of wasteful and unproductive housing capital has caused.

So, all the above economic arguments and the need to control the moral hazard from the activities of the GSEs suggest that the creditors/bondholders of Fannie and Freddie should not be made whole, i.e. bailed out, once the insolvency hole of these institutions emerges. The optimal policy response would be to have such creditor take a haircut that is financially affordable and substantially desirable from a social point of view. The cost of borrowing for the GSEs after such haircut will be certainly higher but that is an outcome that is economically desirable: it will induce less unproductive and subsidized accumulation of wasteful housing capital.
Will this optimal policy solution – an haircut for bondholders – be undertaken? Most likely not as the political economy of housing, mortgages and of “privatizing profits and socializing” losses may dominate the policy outcome. Financial institutions love a system where they gamble recklessly, pocket the profits in good times and let the fisc (taxpayer) pay the bill when their reckless behavior triggers a financial crisis; this is socialism for the rich. That is why you already hear the whole Wall Street Greek chorus moaning for a bailout of the GSEs. But the financial costs of this financial crisis – the worst since the Great Depression – are mounting so fast that any bailout will become fiscally extremely expensive.

Indeed, my initial estimates of $1 to $2 trillion dollars of losses from this financial crisis did not include the bailout of Bear Stearns’ creditors, the bailout of the GSEs bondholders, the fiscal costs of the Frank-Dodd bill, the fiscal costs a severe U.S. recession that is mushrooming an already large fiscal deficit, the fiscal cost of bailing out – a’ la Bear Stearns – the last four remaining major independent broker dealers (as the time for such independent broker dealers is now gone as – given their wholesale overnite funding – they are subject to bank-like runs much more severe than for banks), the cost of bailing out the Federal Home Loan Bank system (another GSE system that pretends to be private and that has been happily propping up or bailing out – to the tune of hundreds of billions of liquidity support – illiquid and insolvent mortgage lenders). Switching the informal guarantee of GSEs debt to a formal government guarantee would by itself increase the US gross public debt by $5 trillion and effectively double it.

Thus, soon enough, if we fiscalize all of these losses the U.S. may fast lose its AAA sovereign debt rating and eventually end up like an insolvent banana republic. It is thus time to put a stop to the coming “mother of all bailouts” starting with a firm stop to the fiscal rescue of Fannie and Freddie, institutions that have behaved for the last few years like the “mother of all leveraged hedge funds” with their reckless leverage and reckless financial activities.

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