Stiglitz; “Fannie’s and Freddie’s free lunch”

When commentators as diverse as Willem Buiter, Marc Faber, and Joseph Stiglitz (to name a few) agree on something, whatever their shared opinion is probably merits consideration.

In this case, it’s a cause near and dear to most readers’ hearts, namely, that the rescue efforts orchestrated by the officialdom are poorly designed. They treat taxpayers shabbily, let current shareholders and incumbents off too easily, and have moral hazard written all over them.

Stiglitz’s comment today in the Financial Times argues forcefully that the Federal rescues this year are fundamentally flawed. He believes that taxpayers should have the opportunity for upside from having put funds at risk. However, his solution is a defacto debt restructuring, since the new Federal funds would be senior. Some economists have called for nationalization of the GSEs without giving ideas for the mechanics; by contrast, Nouriel Roubini has contended that a debt restructuring is a viable solution and would not even require government assistance (although he acknowledges that his proposal is a non-starter).

From the Financial Times:

Much has been made in recent years of private/public partnerships. The US government is about to embark on another example of such a partnership, in which the private sector takes the profits and the public sector bears the risk. The proposed bail-out of Fannie Mae and Freddie Mac entails the socialisation of risk – with all the long-term adverse implications for moral hazard – from an administration supposedly committed to free-market principles.

Defenders of the bail-out argue that these institutions are too big to be allowed to fail. If that is the case, the government had a responsibility to regulate them so that they would not fail. No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to “self-regulation”. But that is what we have done with the financial system.

Even if they are too big to fail, they are not too big to be reorganised. In effect, the administration is indeed proposing a form of financial reorganisation, but one that does not meet the basic tenets of what should constitute such a publicly sponsored scheme.

First, it should be fully transparent, with taxpayers knowing the risks they have assumed and how much has been given to the shareholders and bondholders being bailed out.

Second, there should be full accountability. Those who are responsible for the mistakes – management, shareholders and bondholders – should all bear the consequences. Taxpayers should not be asked to pony up a penny while shareholders are being protected.

Finally, taxpayers should be compensated for the risks they face. The greater the risks, the greater the compensation.

All of these principles were violated in the Bear Stearns bail-out. Shareholders walked away with more than $1bn (€635m, £500m), while taxpayers still do not know the size of the risks they bear. From what can be seen, taxpayers are not receiving a cent for all this risk-bearing. Hidden in the Federal Reserve-collateralised loans to JPMorgan that enabled it to take over Bear Stearns were almost surely interest rate and credit options worth billions of dollars. It would have been easy to design a restructuring that was more transparent and protected taxpayers’ interests better, giving some compensation for their risk-bearing.

But the proposed bail-out of Fannie Mae and Freddie Mac makes that of Bear Stearns look like a model of good governance. It sets an example for other countries of what not to do. The same administration that failed to regulate, then seemed enthusiastic about the Bear Stearns bail-out, is now asking the American people to write a blank cheque. They say: “Trust us.” Yes, we can trust the administration – to give the taxpayers another raw deal.

Something has to be done; on that everyone is agreed. We should begin with the core of the problem, the fact that millions of Americans were made loans beyond their ability to pay. We need to help them stay in their homes, including by converting the home mortgage deduction into a cashable tax credit and creating a homeowners’ Chapter 11, an expedited way to restructure their liabilities. This will bring clarity to the capital markets – reducing uncertainty about the size of the hole in Fannie Mae’s and Freddie Mac’s balance sheets.

The government should set a limit to the size of the bail-out, at the same time making it clear that, while it will not allow Fannie Mae and Freddie Mac to fail, neither will it be extending a blank cheque. There may need to be a drastic reorganisation. There should be a charge for the “credit line” (any private firm would do as much) and, given the risk, it should be at a higher than normal rate.

The private sector knows how to protect its interests; the government should do no less. As long as the credit line is extended, no dividends should be paid. To ensure that the government is not simply bailing out creditors who failed in due diligence, at least, say, 25 per cent of any notes, loans or bonds coming due that are not lent again should be set aside in an escrow account, to be paid only after it is established that taxpayers are not at risk. Any government loans should be cumulative preferred debt: the taxpayers get paid before any other creditors receive a dime. To discourage moral hazard the interest rate should be at a penalty rate and, reflecting the rising risk, increase with the amount borrowed. Finally, the government should participate in the upside potential as well as the downside risk: for instance, by taking shares (which it might later sell) or, as it did in the Chrysler bail-out, warrants.

We should not be worried about shareholders losing their investments. In earlier years, they were amply rewarded. The management remuneration packages that they approved were designed to encourage excessive risk-taking. They got what they asked for. Nor should we be worried about creditors losing their money. Their lack of supervision fuelled the housing bubble and we are now all paying the price. We should worry about whether there is a supply of liquidity to the housing market, so that those who wish to buy a home can get a loan. This proposal provides the necessary liquidity.

A basic law of economics holds that there is no such thing as a free lunch. Those in the financial market have had a sumptuous feast and the administration is now asking the taxpayer to pick up a part of the tab. We should simply say No.


Originally published at Naked Capitalism and reproduced here with the author’s permission.

3 Responses to "Stiglitz; “Fannie’s and Freddie’s free lunch”"

  1. RealThink   July 25, 2008 at 8:02 pm

    From a physical reality-based, Hubbert’s Peak-aware perspective, the critical consideration of any proposed solution is not about whether current Agency debt should be backed by the Treasury/Fed or not. It is about whether new Agency debt should be created or not. No new Agency debt would certainly mean very few new mortgages which would cause a sharp drop in new home construction. Which, from a Hubbert’s Peak-aware perspective, is exactly what the doctor orders.Because construction of more suburban and exurban McMansions is just digging further in the already deep hole most of the US population is in, as inevitably higher fuel prices will turn those homes into traps for their occupants. The US would be much better off if labor and (ever more scarce) resources were employed in a massive wind farm construction plan like Al Gore proposed recently.Related to this, the cars-on-natural-gas part of T. Boone Pickens plan is nonsense. Cars should go electric or at least Plug-in Hybrid (that’s why the US needs so much wind power). Natural gas should be reserved for cooking and heating.