2008 September 10 Wednesday
Tyler Cowen Sees Treasury Had No Choice Over Mortgage Agencies
The US government had to bail out Freddie Mac and Fannie Mae because the only other alternative was another Great Depression.
But let's say that the Treasury did not support the debt of the mortgage agencies. The Chinese bought over $300 billion of that stuff and they were told that it is essentially riskless. The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly. The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value. Most of the U.S. banking system would be insolvent. Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot. The rate of unemployment would climb into double digits and stay there. Many Americans would not have access to their savings. The future supply of foreign investment would be noticeably lower. The Federal government would lose its AAA rating and we would pay much more in borrowing costs. The deficit would skyrocket.
Oh come on Tyler, don't hold back. Tell us what you really think.
David, I don't think of those as extreme predictions! Maybe the dollar would fall only by 20 percent. If nothing else, just imagine what happens when the banks holding all that agency paper are formally belly-up, all at the same time, not to mention the effects from agency equity, which we will be seeing as it stands. Or think about how highly leveraged and thinly capitalized so many parts of American finance are. Look at what kind of assets money market funds are holding and what would happen if there was a general run on such funds. Under these scenarios the U.S. financial system shuts down for a while and that doesn't require any radical assumptions. It's another Great Depression. Abroad, the Chinese and others would be *very* surprised to take losses on agency debt. Blame it on a collective nudge-nudge, wink-wink if you want, but that is their market expectation, very much encouraged by the U.S. government, and they would view anything else as equivalent to expropriation.
Tyler's argument is that while Freddie and Fannie as semi-private government corporations are really bad ideas it is too late to basically disown those corps and let them collapse. Too much US government financial credibility was invested in their lack of risk. If we let their creditors lose their money a lot more other US government obligations would come to be seen as lacking credible backing.
Tyler says US banks have too much in Freddie and Fannie debt issues and would collapse if their debt became worth little.
1. The current operation of the money market requires ongoing faith in a variety of assets and commitments. Just try tracing through the consequences of a general "run" on money market funds, which "promise" a redemption ratio of $1 a share but on the other hand really don't make such a promise. How quickly would Merrill Lynch cry Uncle, how quickly would the Fed's balance sheet be exhausted, and how many commitments would they have made in the meantime and how many people would have to sell stocks to find cash and make margin calls? Or think about what would happen if FASB ruled that Frannie debt securities did not qualify as "ready cash" for accounting purposes. (As a general tendency I find that economists vastly underrate the importance of accounting as an economic force. I might add that many market advocates are unaware of how quickly liquidity can vanish in these markets; just look at auction-rate securities.) And those aren't even the biggest potential problems arising from a default.
Tyler thinks the US government made promises that left it with no other choices than to bail out Freddie and Fannie.
How many phone calls do you think Hank Paulson has received from the Chinese central bank since August 2007?
"Are you *sure* that paper is safe enough for us to keep on buying?"
We'll never know exactly what kind of verbal dance Paulson concocted in response, but just look at the resulting flow of purchases and the relatively slight mark-up over Treasuries over that period of time. The Chinese (among others) thought we were standing behind the securities, at least in any world-state short of federal government quasi-bankruptcy. (In fact Paulson is in a total bind once that phone call comes in. He doesn't have much incentive to just say "tough luck" and precipitate a crisis when otherwise no crisis is on the horizon.)
Note that the financial crisis is so large at this point that bad decisions by the US Treasury Secretary could precipitate a global financial meltdown and Great Depression. The stakes in this game are very high.
On the bright side, if the Chinese stopped buying our debt we would stop running a trade deficit with them as the dollar plunged in value. But that'd be a hollow victory for us as the US economy would enormously contract if the world lost faith in our debt.
So his view is that the global financial system is so fragile that two companies can bring the whole edifice tumbling down?? No. Way.
I'm not saying there wouldn't have been pain, and that people wouldn't have lost their fortunes, but the broader market would have soon recovered and moreover it would stand on a fundamentally sound footing.
As it currently stands investors are about to milk the US taxpayers for a fortune. But don't worry, those same people whose fortunes were just saved by the taxpayer will be exactly the same people who will argue that social security entitlements should be slashed because the government is in too much debt...
Screwed over yet again.
Also, his claim that the US government guarantees those companies is entirely untested. What if there is no such guarantee and its all just wishful thinking by the market? What lesson is being learnt in that circumstance? Presumably that the market can shit in its bed in the firm knowledge that the US taxpayer will happily clean it up. And not just the first time. After all, the US taxpayer did it once so logically they must be implicitly guaranteeing by their actions that they're willing to do it over and over and over again.
I bet you a penny to a pound that there's some trader out there right now pondering how he can use the 'implicit guarantee' to cover some other bullshit investment that's gone wrong.
...and another thing...
Markets run on confidence. If the government had declined to rescue and had simply let the cards fall where they may then it would have effectively injected confidence into the market. But the government intervened - its like a poker player with a twitch who all the other players can tell is betting on a weak hand.
Ultimately the market trades on long term confidence, not short term bluff.
Stephen said: "his claim that the US government guarantees those companies is entirely untested"
There is a certain lack of integrity 'implicit' in your comment (kind of reminds me of the Americans who tried to sugggest the US government not return the canal back to Panama).
It is quite clear the US government (i.e. "you", even if you did not understand this when you elected our leaders or voted for 'the other guy' or didn't even vote) did implicitly guarantee Freddie's and Fannie's debt. This was not an 'implicit' guarantee that ONLY an accountant on the 5th floor of the treasury building enderstood, it was an 'implicit' guarantee understood by the market-- agency spreads over treasuries vs. high grade corporate debt clearly reflect this belief. An 'implict' guarantee of with this broad an understanding is clearly the same thing as an actual guarantee, at least as far as a government is concerned (unless you want the US government to be considered truly trustless, somthing many of our less trustworthy citizens seem hell bent on achieving). China forced our hand on this implicit-explicit issue http://blogs.cfr.org/setser/2008/09/02/yes-virginia-%e2%80%93-creditors-do-sometimes-get-a-vote-%e2%80%a6/ . Unless you wanted either this http://www.northerntrust.com/popups/popup_noprint.html?http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/0807/document/us0708.pdf or this http://www.financialsense.com/economy/northern/kasriel/2008/us0308.pdf to happen, the US needed to come clean.
If you are suggesting Freddie and Fannie should either never have existed in the first place or that going forward they should not exist-- I might agree with you.
If you are saying the US government should in the future assume only a certain maximal total obligation for the entire system over a particular time frame (regardless of how much trouble the system gets itself into)-- I might agree with you.
If you are suggesting we eliminate ALL government guarantees to bank deposits and baskets of home mortgages IN THE FUTURE-- again I might agree with you.
But to suggest we back away from our 'implicit' committments because everyone is going to pay for the stupidity of a few is simply wrong on so many levels.
What happened to integrity in this country??
Thai, there is no guarantee. A guarantee is an express thing, and appending 'implicit' to it is just another way of saying, "Oops, I just assumed..." What really happened is that the market bet that the two coys were too big to be allowed to fail (especially in an election year) - they appear to have been right.
"Too big to fail" is entirely different from "Guaranteed".
To quote from the article linked by Hal K:
FreedomWorks President Matt Kibbe commented, "The prospectus for every GSE bond clearly states that it is not backed by the United States government. That's why investors holding agency bonds already receive a significant risk premium over Treasuries."
Stephen is an Australian. He had no influence on the US government leadership selection.
You live in a country like the US that has a legal system that is based on English Common Law. No, not all legally binding guarantees are explicit.
But you miss the point: If the US government behaves in a way that implies guarantee and then the US government withdraws the implied guarantee then the US government (and the rest of us) has to suffer the consequences when the world discovers it will withdraw a guarantee of this sort. Tyler is arguing that the consequences would be very severe. I think Tyler is correct. I also trust Tyler's judgment on this sort of issue.
How did the US government "behave in a way that implies guarantee"? Aside from the repeated bald assertion of its existence I've not seen anyone list the factors that demonstrate the offer of a guarantee. On the other hand, there's plenty of evidence supporting the view that there never has been any such guarantee, that the US has always expressely excluded any such guarantee, and that the market understood that there was no guaruantee by pricing in a higher risk return.
I don't miss Tyler's point. I just disagree with it (as do many of Tyler's fellow economists). If you accept Tyler's cascade of consequences, then you need to be very worried because the global financial system appears is totally susceptible to two companies who deal in house mortgages. I.Dont.Think.So. As I said earlier, people would have been hurt, the recession would have been deeper (but perhaps shorter), but the market would have soon recovered and the fundamentals would have been much better.
The way things now stand: The wolf at the door growled and was fed. It will grow stronger and become hungrier still. Soon it will return to the door demanding even more food.
Stephen, I absolutely agree with you: 'yes', the 'wolf' growled and we fed it and 'yes' the wolf will growl again. This is true of everything so 'so what'? Unless we find an endless source of new funding, If we don't want to stop borrowing to fund our Hummbers-4000 sq.foot McMansions lifestyle 1 hour from where we work so we can all live on 2 acres, the wolf is going to eat us one way or another. Integrity is an entirely different issue. Randall is absolutley correct, English common law does suggest implicit can also be the same as explicit.
That America wanted to create an SIV (Fannie and Freddie) on its national balance sheet to play games with it's own accounting-debt and has finally been caught in its hypocrisy is really a discussion about our national integrity.
Randall, do you have a way of setting on this blog an email forwarding so that when people post comments on a discussin thread, they can be forwarded to one's personal email?
We Yanks have been aware of this issue for a long time. The American political process has been a very effective tool at preventing reform on the Freddie- Fannie implicit-explicit issue LONG BEFORE the issue actually came to a head (and I say this regardless of which party or whomever one choses to personally blame within the political process for the obstruction).
We all knew the wolf would growl long before it actually did.