The Bailout

[Bando]

Yesterday, the government nationalized Fannie Mae and Freddie Mac. This was probably inevitable and definitely necessary (either of those companies collapsing would have destroyed the housing market). Thoughts, everyone? HiFi, would you like to denounce those socialist bastards in the Bush administration?

Also, just to stir the pot, apparently Palin didn't know how Freddie and Fannie work

[DrumsGoBang]

Damn Commies

[HealyHoya]

While it's difficult to call this a good move -- there's really little good about the housing and attendant industries at this point -- it is the correct move in the short-term. The immediate downside seems to be restricted to investors who hold stock in either entity. Frankly, in my opinion, individual and/or institutional investors who still held significant positions in Fannie or Freddie as of COB Friday were aware of the immense speculative risk they were taking.

In the near term, this will boost the housing and stock markets. By bolstering confidence in the debt held by Fannie and Freddie, the Feds have made a strong move to lower interest rates.

I think the more interesting issue is how the government deals with the two entities in the long term. Should they steward them through these difficult times and then shrink them? Or should they be returned to their former size albeit, one would assume, with new and more extensive regulations. Either way, it would seem that this model of a government chartered company which reports to shareholders and pays its executives based on performance needs to be amended.

[Filo]

I am sure Libertarians everywhere are rejoicing

Common holders will get the shaft, with close to the same treatment for preferred holders. Debt holders are bailed out, and the housing / mortgage market doesn't completely implode (for now).

I don't see what other alternatives there were in this case, given how Fannie Mae and Freddie Mac were allowed to get themselves in this position in the first place.

[Bando]

Fannie Mae was a government-owned company until 1968, I don't see why it ever has to go back into private hands. If a company is going to sell itself by claiming an implicit backing by the US treasury, I don't see any reason the government should have a controlling interest in it.

[SFHoya99]

I'm fine with them being private with better oversight. The question is, will/can that happen with a private entity.

The "Too Big to Fail" discussion is a tough one. Long term, you should probably let some of these entities fail, have other, stronger entities take their assets and customers. Short term, that can lead to disaster, and sometimes you can't live in the long term.

[PushyGuyFanClub]

First of all, this is a total utter debacle.

Second, the best course here would not to have gotten into this mess in the first place. And while there is lots of blame to go around in that regard, FNM and FRE are two culprits when it comes to the divorcing of risk from the concept of risk capital (which is essence what they ended up encouraging). In that sense, the Treasury needs to see these two beasts into run-off and then close them out. They were just a stupid idea to begin with and became even more untenable as they got bigger and bigger.

The essence of loanmaking is for a a creditworthy bank to borrow money at one rate (let's say 5%) and then lend it to someone else at a higher rate (let's say 7%) with both loans having the same time to maturity with the bank keeping the spread as payment for properly assessing the risk of the borrower for default, right? Well, when the bank is told that it can package up all of its loans and send its risk on to someone else, what incentive does the local bank have to do thorought research to determine the proper risk spread needed to compensate the ultimate owner of the loan for having lent money to a less that creditworthy person? In fact, because of the very existence of FNM and FRE, their incentive is to write as much book as possible banking underwriting fees while also earning the good graces of the government for promoting home ownership, or as it's been called for these last few uber-embarrassing years, "an ownership society."

Mortgage brokers, and anyone who writes loans or insurance policies or what have you, need to be on the hook for the ultimate outcome of that book. That's the only way to ensure that risk is being properly assessed and priced. And if that means that some people in this country have to rent because they can't afford a 30-year 15% fixed rate mortgage yet, so be it. Personally, I don't think there are such overwhelming advantages to home ownership that we need to subsidize it so heavily. Moreover, it probably has some drawbacks in the sense that it does not encourage a flexible labor market.

That said, we simply could not allow the credit markets to freeze up entirely. That would have crippled the economy. And this will be an incredible success if the government's moves help people move beyond this mess. After all, there is a lot of potential liquidity out there in terms of corporate cash balances, sovereign wealth funds, and the like. It's just become incredibly risk averse. Hopefully, with a Treasury-supplied cash cushion, it becomes a bit more rationale.

So, do I like to see the government intervene to bailout two poorly run companies that eventually subsidized decades of work by unquaified mortgage brokers who ignored the concept of risk when that's essentially all they are paid to do? No. Is it fair to let people renegotiate IO or ARMs when I and many others have been dutifully paying the fixed-rate loans (that's interest AND principal) we took out? Absolutely not. But is this better than destroying the access of businesses around the world to debt-financing, a move that would take down the stock market and trillions in retirement funds? Certainly.

So it goes.

[HealyHoya]

Roger all of that, Pushy.

Further, the big banks have complained for decades that Fannie and Freddie exerted a disproportionate dominance in the mortgage market thanks to their government subsidized ability to undercut private banks and their borrowing rates. I do believe that Fannie and Freddie are too big to be allowed to fail, though clearly not too big to fail, but yet too far beyond the pail for the private markets to right these ships.

Fifteen months from now will these entities still exist? I believe they will. Will they ever have the same/similar share of the mortgage market? No.

I would keep a close eye on BofA and their handling of Countrywide. If they can make that work -- and their performance in the market today suggests that observers think they can -- I believe you will see other big banks get involved.

Utter debacle may be an understatement. The situation must be dire when Bush, McCain and Obama agree on the basic solution.

[FewFAC]

As a concept, a bailout of FRE and FNM is a good idea. As executed, it leaves a lot to desire. Basically, this is nothing more than all of the rest of late-term, lame duck window dressing coming out of Washington in an attempt to appear as though the government (republicans) are providing solutions. In reality, it is likely to be another in a long list of missteps that will lead to the death of Reaganomics.

Short-term, this provides a great deal of confidence to the Bill Grosses of the world who have been getting hammered as asset prices deflated. What this does in practice, however, is nothing more than shift even more risky assets onto the federal balance sheet like the Fed's magic piggy bank. What I don't understand is why Freddie and Fannie didn't just do like all of the other smart guys and continue making questionable loans, slicing them into D tranches and exchanging them at the temp window for treasuries.

The Fed was almost never going to move rates through the election (and probably through the first 100 days), and the deflationary asset price bubble in combination with core CPI inflation doesn't really give the Fed much operating room other than jawboning.

What the government should have done was taken advantage of the opportunity to do a massive reorg, merging the two orgs, though the efficiency/redundancy reduction wouldn't exactly help their short-term pr image of "doing something" while jobs would have been lost.

Instead, we got socialized home ownership (is this the "ownership" GWB had in mind?), and another massive entitlement on the federal balance sheet, with no cost offsets = massively ballooning budget deficit/federal debt. I don't even want to look at the numbers yet because it's gonna be very, very ugly.

[PushyGuyFanClub]

The numbers are going to be ugly, I agree, but for now the math is in the "too hard" pile. There is a sunny day scenario here where credit loosens up, housing prices stabilize, and because of that, some of the securities FRE and FNM are holding don't get put into the NPL trash. Even though these values are being written down, the option to hold them to maturity is still there as long as folks don't go under. That could mitigate some of the near-term cost in the long run, if we're willing to be patient (probably not).* The warrants probably expire worthless. Who's buying the shares?

Folks should remember this incident the next time they say something like, "You know what? I think this would work a lot better if the government were involved." The government got worked like a chump here because FNM and FRE were never asked to be competitive. They got fat on implicit government backing, gained a competitive advanage by virtue of access to low interest rate money, and were staffed by underqualified analsyts and executives (as compared to the real Wall Street financial firms).

Bill Gross is a happy man today. He's solvent, and his "Booyah, Hank" commentary from last Thursday looks frighteningly prescient.

*Within a year I bet the government is selling mortgage securities to newly established run-off companies run by guys like JC Flowers (see what ESGR does with insurance) at substantial discounts to fair value. The government gets some cash, gets out of the mortgage management business, sticks the writedown to the taxpayers, and these newly established mortgage run-off companies of the world do very well by actually paying attention to the loans they put in their portfolios.

[PushyGuyFanClub]

For the record, I wouldn't hold Palin accountable for not knowing how FNM and FRE work (I haven't seen the quote). Not only do they not work (so how could she know?), but it puts her on the side of 99.999999% of Americans (and people love voting for people who are like them).

As an aside, for all of the good things this set of candidates brings to the table, they are actually to a letter all extremely weak on financial issues. Obama 1)Denies the realities of free trade and actual rational ways to deal with it 2)Has no concept that lower capital gains tax rates actually increase government revenue (by incenting people to harvest more gains) and 3) Has on multiple occasions referred to the stock market as something akin gambling, including in his nomination acceptance speech. And then he has this bizarre plan detailed in the WSJ today by one of his surrogates about how we can make some enormous sum of money, lower oil prices, and increase our security by swapping out light crude for heavy crude in the SPR.

McCain, on the other hand, at least admits he's no financial whiz. so I'm not sure I need to cite anything to overturn his own opinion, but that whole episode blaming "speculators" for oil prices was absurd. There are two people on each side of trade, right? For every person who speculates and profits, someone else gets served. Now, if speculators were hoarding oil, then fine, that's artificial. But I certainly don't have a warehouse in my backyard full of raw crude.

And then you have Biden and Palin. But at least we're getting good deals in the market as a result of all this uncertainty.

[FewFAC]

It isn't that there isn't a scenario where the loans become profitable--they will--unfortunately, we learn once again that when we leave the market to its own free devices, in the long run we're all dead. The government is gonna sell off the pieces like a SWF--at steep losses--and essentially go from a $5T surplus to a $12T deficit funded by broke foreign governments. GWB's final act of office should just be to go Argentina/Russia and repudiate the debt to complete the circle.

Of course that money didn't just disappear, and Main Street will discover that, once again, Washington "regulators" stuck Main Street with a $17T bill to enrich the already wealthy, sophisticated investors who should have known better at the expense of ordinary people. All the while, completely debilitating every federal agency along the way with the misfortune of coming into contact with it, necessitating deeper cuts. It's almost brilliant, smaller government through bloat, until you remember the facts.

But of course, the personal story is so much more important, without a hint of shame at the disgrace being created and the ability to say with a straight face that a continuation represents best policy. This might be the year (though it won't) that fiscal conservatives finally get the backbone to gonna punish storytellers incapable of owning responsibility.

I'd call it a dead cat bounce, and would expect a very motivated Congress to demonstrate some displeasure and wrath.

[FewFAC]

Also, Reaganomics has pretty much demonstrated its value the last 8 years: capital gains and income tax cuts at the top end + fiscal stimulus package + war spending + bailouts for the wealthy = $14Trillion loss to American taxpayer, incentivising moral hazard + hoarding = massive job losses.

You'd think that given the credit crisis, a smarter move would have been to bailout homeowners with upside down mortgages, but of course, that never even entered into the conversation.

[hoyatables]

Pushy (and everyone else) - thanks for all of the time and thought put into these posts -- this is very interesting and educational reading!

[Bando]

Sept 8, 2008 21:38:17 GMT -5 hoyatables said:

Pushy (and everyone else) - thanks for all of the time and thought put into these posts -- this is very interesting and educational reading!

Agreed. Huzzah!

[TC]

How much chance is there that McCain or Obama honor Paulson's plan? Unless McCain has completely gone over to the dark side, it seems like either of them would have a lot of reason to rewrite this plan and make it more palatable. Or is this just wishful thinking?

[PushyGuyFanClub]

How much chance is there that McCain or Obama honor Paulson's plan?
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You have to remember what this plan does. It.
1. Has removed the company CEOs and senior managers and put them under government conservatorship with handpicked, government supported execs.
2. Has given the U.S. government warrants with the right to dilute existing shareholders and purchase up 79.9% of the companies, while noting that the government has no intention of exercising the warrants.
3. Has implicitly backed their liquidity so they can continue purchasing, packaging, and most importantly, backstopping the quality of existing security products that have been sold into the market.

In other words, there is no going back, and if the next administration did, it would be a signal to the world that even the US government could not cope with the losses coming out of these products, which would be a bad sign.

The question for the next government is what we do with Fannie and Freddie after the credit markets have returned to a degree of normalcy. I think we all agree Fannie and Freddie were too big and too accommodating to poor lending practices. But what happens to them going forward will ultimately be determined by what we believe is the relative importance of home ownership in this country.

If we believe that everyone ought to be able to buy a house, then Fannie and Freddie need to be reconstituted in some way. The rub is that it's hard to make them have the desired effect of encouraging widespread home ownership without making them huge. That's because mortgage security products are a lot like healthcare insurance. In healthcare, an insurer can't write policies for old people (who presumably get sick a lot) without writing policies for young people (who presumably don't as much). That's why you see state-run healthcare proposals mandate that everyone be on the rolls. While they say that's for "universal coverage," it's actually just to balance risk. Many of the uninsured in this country are younger people (20 to 30) who don't buy healthcare because they don't think they need it and don't want to pay for it. Heck, when I got out of college, I had not interest in having $75 deducted from each one of my paychecks.

Similarly, the government can't just subsidize housing (by implicitly guaranteeing the quality of loans) for poorer people. These people are credit risks. Without non-credit risky folks balancing out the security product, you end up with a garbage product that doesn't have a lot of worth (because the risk inherent in it is being underpriced relative to the potential return). Now, what was supposed to happen is that in FNM and FRE's products, the good loans were to balance out the bad loans making for an investable product. But lots of good loans ended up being bad for a lot of reasons, including wrong incentives, bad underwriting practices, interest rates that were too low following 9/11, etc.

So, if the next administration decides that the government does need to participate in the housing market, then I foresee it being extremely difficult to reconstitute these GSEs without dredging up the same issues. Similarly, we don't want the government involved at all because due to political pressures, I believe the Treasury would end up giving out low interest money to every consumer regardless of their ability to pay it back. (Flash forward to campaign 2016: My opponenet would raise the interest rates you pay to buy a home. I would lower them!) That's a disaster. The market will determine the proper risk/return rate if you let it (the math is not hard), and then consumers can decide if they want to pay it or not. Of course, that will prevent segments of people from being able to afford homeownership.

Personally, as I wrote before, I don't see homeownership as some kind of untouchable good worth this degree of market distortion, which ultimately has a fallout like this one thanks to our penchant as human beings for exploiting any and all opportunities at profit. Thus, I think the government should get out of backing mortgages, and that's the tack I'd hope the next administration would pursue. It would deplete homeownership numbers, Edited off homebuilders, and cause property appreciation rates to rationalize close to the 2% or so where they've been historically, but landlords would step in and buy properties and then rent them and reasonable rates since the rental market would open up. (By the way, Editeding off homebuilders would be the best since it would finally disincent them from building horribly ugly McMansion developments.)

In other words, without a GSE, the bank making a loan would be left to either 1) hold it on its own books (and then you know it would do the legwork to ensure quality on the front end, though banks wouldn't then be able to make as many loans since there capital would be tied up in 20 or 30 year mortgage products) or 2) package up its own loans and sell them (an option only available to nationwide banks such as Bank of America). This is why Bank of America stock was up sharply yesterday. With its acquisition of Countrywide, it's one of the few companies in a position to stand into the void left by GSEs that are put into run-off and closed down. If it can write good mortgages (a big "if" given Countrywide's heritage), then it does have the geographic reach to write a broad enough variety of mortgages to spread out risk and create mortgage security products that would be compelling for an investment bank to own.

To sum, McCain and Obama don't have much choice about the decision to put Fannie and Freddie under conservatorship, but they will be tasked with deciding what to do with them. Since the government has said it does not intend to exercise it warrants, that indicates to me they're looking at shutting these bad boys down. But that could change. In my opinion, the GSEs should get out of the mortgage biz since homeownership isn't that important for people (how many of you rent/have rented and are/were happy with it?), and then companies such as Bank of America will fill the void albeit at a somewhat slower rate but with a clearer and more accurate focus on risk assessment.

Thanks for listening.

[Bando]

Again, Pushy Guy, your expertise here is quite educational. Thanks.

When you talk about reducing the emphasis on homeownership, I assume you're talking about eliminating all sorts of tax credits and other subsidies. Do you really think Obama or McCain could get these passed in Congress given the public outcry likely to result? Rather than ideally, politically what's the best we can hope for, and would the candidates differ in their approaches to this?

[EasyEd]

Thanks, Pushy, for your excellent discussion. I'd like to add two more points.

First, Presidents and Congresses over time have touted how home ownership was up and both branches have attempted to claim that as something good, no matter how it was done. They have been a part of the problem.

Second, home buyers willingly took out these loans. No one forced them to do so. They also must shoulder their share of the cause.

This is in no way intended to disagree with anything Pushy and others have said, merely to add to it.

[PushyGuyFanClub]

Bando asked: When you talk about reducing the emphasis on homeownership, I assume you're talking about eliminating all sorts of tax credits and other subsidies. Do you really think Obama or McCain could get these passed in Congress given the public outcry likely to result? Rather than ideally, politically what's the best we can hope for, and would the candidates differ in their approaches to this?
------
Obviously, we do a lot to subsidize home ownership in this country. It starts with Fannie and Freddies, but includes the ability to itemize and deduct mortgage interest, capitalzie renovation expenses, etc. None of thes perks are available to the renter. Politically, you're right that it would be near impossible to take away homeownership subsidies. That said, there's a way to keep tax credits in place for homeownership, but instead of allowing landloards to deduct mortgage interest (which they shouldn't be able to do since it's presumably an investment), renters should be able to deduct rent from that property in lieu of owning. I think that's a strong talking point, one that makes fiscal sense, and one that encourages wealthier landlords to pay a fairer burden of income tax (without hiking their rates) while granting some income tax reprieve to lower income folks who can't afford to own houses. The problem is, there isn't a strong lobby for renters, so it will take some sort of Maverick and or Change-oriented politician to get it done. In other words, I think this could be an interesting proposal for the next president to pursue. They'll certainly have some flexibility to remake the housing market given current circumstances.

As for the candidates, I'm not sure how they differ. Neither is really strong on these types of issues and both seem to be avoiding speaking on this issue in any kind of detail before they get a firm handle on it and how far it stretches. (Indeed, even the State Department has to get involved since sovereign wealth funds are big investors in Fannie and Freddie debt. If we default on that debt, we're going to have a lot of unhappy allies.) That said, I imagine McCain would favor a more market-based approached, while Obama has said he'd like them to remain under some government support but be "smaller and smarter." Both solutions have merits, but again, I'd favor letting the market take over here because I believe it can price risk. Moreover, as I said earlier, I don't think it's possible for Fannie and Freddie to be smaller and smarter AND be government run because they'll just get stuck with lots of uncreditworthy borrowers at charity rates (due to political pressures). Barney Frank has said the solution is as easy as banning subprime loans, but then you're just telling brokers that they need to portrary everyone as being prime. Then he says that we should have some recourse if brokers pass of subprime loans to the government as prime loans, but that gets into issues of he said/she said culpability. The broker says, "I trusted the tax returns they gave me." The borrower says, "The broker told me to alter my tax returns." Who do we believe? Who gets punished. The government certainly doesn't seem willing to punish borrowes even though, as easyed points out, they absolutely share blame here.

easyed said: First, Presidents and Congresses over time have touted how home ownership was up and both branches have attempted to claim that as something good, no matter how it was done.
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Absolutely true. It's a statistic that gets trotted out to show how far our economy has come. But like so many statistics, in an of itself, it's meaningless. After all, there are times (like 2000 to 2003) when it makes way more economic sense to rent. In DC, a house that was renting for $1,700 a month was selling for (assuming a 30-year fixed) $2,300 a month. I mean, that's a no-brainer arbitrage. Rent the house, drop the $600 in the stock market, and you're far outearning any equity value you were building up (especially since house values have since retreated). But this is just an indictment of Washington. We decide certain things are good and pursue them without any regard to how they fit in the broader picture.