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The cost of mortgage agency bailouts
I've read varying estimates of the cost of the mortgage bailout, including a sum of $1 trillion mentioned in The Wall Street Journal. I have no idea what the number will be (and I'm not ruling out zero, or close to zero) but here is how to think about the costs:
1. Reimbursing agency debt holders is a transfer, not an economic cost. No resources are destroyed by the reimbursement.
1b. The previous bad lending involves a cost -- in this case too many homes -- which already has been incurred. This is not a cost of the bailout per se.
2. If government taxes the citizenry to raise money for the bailout, those taxes involve a deadweight loss. Maybe 20 percent of revenue raised is a decent estimate of this cost.
3. Bailing out debt holders means that future lenders won't be as careful as they should be. This problem dates from LTCM, or even further back, and it gets worse each time. The result is excess leverage and leverage of the wrong kind, namely to "too big to fail" institutions, which then become even bigger and more leveraged. I haven't seen a back of the envelope estimate of how much that really costs, much less a careful estimate, but this is a very important magnitude for calculating the net cost.
4. Often in these plans equity holders are (nearly) wiped out. So beware all the talk of moral hazard. The real moral hazard is on the side of future creditors, not the current, possibly-soon-to-be-extinguished equity holders. They really are getting burned.
5. If the government dallies in executing the bailout, borrowing costs for the entire economy will rise. A bailout has to be swift and decisive, assuming you want to do it. Yet a swift and decisive bailout will likely involve errors of detail.
6. Doing a justified bailout this time makes it harder next time to avoid an unjustified bailout. The bailout mentality is contagious in the political arena.
7. The transfer to the debt holders is generally regressive, at least under the likely assumption that the marginal taxpayers are less wealthy than the debt holders. Of course some of the debt holders are foreign governments, which adds another element to the mix.
8. When it comes to the mortgage agencies, there is no real choice but to bail out the debt holders. The alternative is a run on the dollar and collapse of faith in U.S. government securities and the end of the world.
Posted by Tyler Cowen on July 28, 2008 at 06:13 AM in Economics | Permalink
Comments
The end of the world? What probability would you assign to number 8? Because right now it sounds like you are presenting it as a certainty, which seems far too extreme to me.
Posted by: Todd at Jul 28, 2008 7:09:45 AM
#1; then the cost already came and went and is in the future. Value was destroyed when people allocated capital and resources unwisely. Moral hazard will destroy future value. Is not the moral hazard here that lenders are too lax with lending standards?
#4; If equity holders are wiped out, who isn't? So, do these bailouts just discriminate against property owners?
#8; again, all this faith stuff is a short-term thing. Should or shouldn't there be faith? If next time is worse, then a lack of faith is smart, and value has already been destroyed, and won't the future fall just be from a higher cliff?
Why is there not a market for bailouts? Oh, yeah, there is one. Why not just sell debt at a really high interest rate, which staves off, but almost assures future bankruptcy, but allows time to unwind the counter-party...mistakes.
It's kind of funny that this whole thing seems to be about leverage, yet noone is really striking at that root. Isn't another big part of this the accounting rules that force re-estimates of debt values? Why not postpone those rules? How much are we hurrying up to slow down here?
Posted by: Andrew at Jul 28, 2008 7:20:13 AM
Run on the dollar caused by AVOIDING the bailouts?
From where I'm sitting (UK), the bigger risk seems to be that the US Government will carry on trying to bail out failed institutions until it has to default on its debt.
At that point, the Euro and the Yuan get to play a game of "who wants to be the new reserve currency?"
Posted by: Mark Harrison at Jul 28, 2008 7:26:17 AM
The funds used for the transfer might otherwise have been put to productive use, so there is an economic cost. How large a cost can be debated...
Posted by: Leslie at Jul 28, 2008 8:22:51 AM
(and I'm not ruling out zero, or close to zero)
That's quite the panglossian view. About 15% of Fannie/Freddie's retained and guaranteed book of business is
subprime (2.5%) and Alt-A (12.5%). Some $800 billion in total.
Posted by: marmico at Jul 28, 2008 9:33:08 AM
marmico
It's actually "subprime mortgages made up 9.2 percent of the companies' combined portfolio, while Alt-A represented about 5.8 percent, Ofheo said."
From http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=ajmUanw85QRc
Keep in mind though that those aren't the mortgages themselves, rather senior trances of pools backed by sub-prime and alt-A paper.
Posted by: nelsonal at Jul 28, 2008 11:07:35 AM
"Often in these plans equity holders are (nearly) wiped out. So beware all the talk of moral hazard. The real moral hazard is on the side of future creditors, not the current, possibly-soon-to-be-extinguished equity holders. They really are getting burned."
The moral hazard is that we have rewarded upper management with huge bonuses for taking large, unchecked risks and that there are no mechanisms to clawback those ill-gotten gains (and yes, they were ill-gotten).
No matter what regulations are enacted, if we continue to place huge incentives on what is essentially gambling, we will continue to see this same phenomenon.
Leverage only magnified an existing problem.
Posted by: meter at Jul 28, 2008 11:24:11 AM
Reading this post, and number 6 in particular, reminds me of a quote from someone you've all certainly heard of:
It is not sufficient to contrast the imperfect adjustments of unfettered enterprise with the best adjustment that economists in their studies can imagine. For we cannot expect that any State authority will attain, or will ever wholeheartedly seek, that ideal. Such authorities are liable alike to ignorance, to sectional pressure and to personal corruption by private interest. — Pigou A., Wealth and Welfare 1920, p. 296
Posted by: happyjuggler0 at Jul 28, 2008 1:35:11 PM
#1 & #2: I'm sorry, but the way economists treat transfers is just plain wrong.
When you yank resources away from one person, and give them to another, yes, there is a sense in which
wealth simply moved and was not destroyed. And yep, as wise economists, we can't make a single moral judgment
about who is more deserving of that stuff, no. sir. ree. [sic]
Yet from the long-term perspective, you simply cannot ignore the question of who truly *deserves* those
resources. For example, if the transfer is away from the person who generated those resources, the long-term
impact is the clear message: "Hey, discount for the very real risk that your stuff will get yanked away
when you decide to actually be productive, so maybe ditch a few of these resource-creating activities here."
So no, Tyler, you can't look at anything as a "mere transfer".
The OTHER problem is with the concept of a deadweight loss: I just don't see how you can consider any cost,
to be one such that "someone lost, no one gained". In *any* change in policy *someone* gains. Higher taxes?
Hey, that benefits me as an accountant in helping people look harder for ways to avoid the tax. So looking
for a true deadweight loss is rather pointless.
Posted by: Person at Jul 28, 2008 1:38:37 PM
Oops, I forgot. Hat tip to Gabriel Mihalache for that quote. His blog is here, although it doesn't link to the post where I lifted this quote a few weeks ago.
Posted by: happyjuggler0 at Jul 28, 2008 1:40:30 PM
nelsonal: I don't mean to hijack the thread but the 2007 OFHEO Report was released last week. The Bloomberg article you referenced links to the 2006 report.
From slide 24 of Fannie's Q2.08 Investor Presentation, subprime exposure is $51.2 billion, Alt-A exposure is $344.6 billion of a total book of $2.7 trillion. Presumably, Freddie has similar exposure.
Isn't it a distinction without difference to separate the retained book from the guaranty book to determine the credit loss exposure?
Weil at Bloomberg postulates that the agencies are insolvent and former Fedhead Poole (who knows more about the situation than you, Cowen or I combined), who got the ball rolling estimates the bailout at $200 billion.
Hence, my scepticism that Cowen assigns a probability that there will no or a de minimus cost.
Posted by: marmico at Jul 28, 2008 2:34:03 PM
Doesn't it bother you that various Important Figures reassure us everything is fine, if only we pass their emergency bailout measures? We're one piece of legislation away from the End of the World as We Know It, but otherwise, everything is fine...
Couldn't we at least wind down Fannie and Freddie as obvious failures and leeches on the Treasury? Couldn't we give bondholders at least a 5% haircut, just to prove that "not backed by the Treasury" means something?
And don't you think that if housing nationwide goes down 20%, some of those MBS or actual mortgages held by FNM and FRE are going to take a hit? How is zero cost to the taxpayer even still a possibility? They don't have the
funds to handle even a 1% loss on their portfolio, right?
Posted by: Michael at Jul 28, 2008 4:02:31 PM
I have no idea what the number will be (and I'm not ruling out zero, or close to zero)
That's not true - the cost will always be more than zero. The taxpayers are forced to take a risk for which they will not be adequately compensated or compensated at all. That is a very real cost. Why do people persistently forget to factor in risk?
Doing a justified bailout this time makes it harder next time to avoid an unjustified bailout. The bailout mentality is contagious in the political arena.
Fine, but we will be bailing out the same institutions in years to come. The need for the bailout comes from the fact that government created this monster of socialized risk and private profit and then took bribes from its lobbyists to ignore all constraints. Fannie and Freddie became casinos where all games were negative expectancy for the taxpayers. Of the government subsidy meant to reduce mortgage rates, 60-70% went to shareholders and reduced mortgage rates by only a few basis points. Hardly a great trade-off. The new bailout will give them a new regulator to put in their pocket. Either privatize them and set them free or nationalize them and be done with it. There is no justification for what's going on now.
Posted by: Methinks at Jul 28, 2008 9:02:42 PM
Couldn't we give bondholders at least a 5% haircut, just to prove that "not backed by the Treasury" means something?
Fannie Mae and Freddie Mac have enjoyed artificially low borrowing costs precisely because of the implicit government guarantee. If this was removed, they would have to pay a higher interest rate -- not merely the considerably higher rate they should have been paying all along, all these decades, if there truly was no implicit guarantee, but an even much higher rate to reflect their current extremely elevated level of credit risk with enormous leverage.
Since Fannie Mae and Freddie Mac are practically the only major sources of financing still standing for mortgages nowadays, most people getting a new mortgage would pay a much higher rate, starting immediately. And since people tend to buy houses by figuring out how much monthly payment they can afford and then working backwards to figure out what house price they can pay, this means that real estate prices would tumble quite a bit further.
Any further falls in real estate prices would put further pressure on the already crippled financial sector. Basically, the credit crunch doesn't stop until real estate prices hit bottom. Count on a bunch more regional banks to go under, and Lehman and Washington Mutual too.
So, the silliest thing you could do is to impose a symbolic 5% haircut on the agency bondholders. The cost would enormously outweigh any gain. Either pay in full, or default in a really big way. The latter is really no solution at all, since foreign governments (read: China) which are big buyers of agency debt are also (as Brad Setser has convincingly deduced) practically the only remaining buyers of Treasury debt, and shaking their faith in the creditworthiness of the United States would be the surest way to achieve a balanced budget, the hard way.
At some point we might end up like Argentina in 2001, with nothing but terrible choices. Perhaps we're already there.
Posted by: at Jul 28, 2008 9:31:13 PM
Yep am sure the many PhD economists from places like Yale, MIT, and like Tyler from Harvard on staff at the two GSES also offered up all mannter of rationales and analysis that led to Freddie and Fannie being the great exemplars of capitalism
and insights of economics at their best.....Common Tyler--you are smarter than just repeating items from a microeconics text and using to explain or justify everything in the good ol U.S.A as being just hunky dorry. Hell, Fannie even ran a couple of Housing Econ Journal with all the usual BS of why these are the best of times and the wonder of markets!!! Tyler Pangloss Cowen over there.......
Posted by: Roberteconomist at Jul 29, 2008 3:38:53 AM
person describes exactly a deadweight loss (moral hazard arising from transfers), then says there never can be a deadweight loss.
of course there is loss, if we go and blow up every oil field in the world, thats a loss.
you can use resources efficiently for human needs and wants, or you can use them inefficiently. the difference between the two is a loss.
Posted by: c8to at Jul 29, 2008 5:55:03 AM
c8to: A moral hazard arizing from transfers is not the same thing as a deadweightloss. Inefficient use of resources is not necessarily a DWL either. For it to be a DWL, there must be a loss corresponding to no one's gain, and certainly, some people do experience a gain, even from the broad perspective, from a bailout. Since someone gained, it's not a DWL.
Posted by: Person at Jul 29, 2008 11:20:30 AM
"Bailing out debt holders means that future lenders won't be as careful as they should be."
I think it's a serious mistake to look at this as an institutional issue. Future lenders will be operated by individuals who stand to make staggering personal gains in the form of salary and bonus. They make the deals, garner what to most folks is great personal wealth, then take their money and go live the good life. They don't care if the institution fails; those days a long gone. CEO's, CFO's, loan officers, they all got their money. They won't lose a dime, so where's their incentive to do anything but write the loans?
And I won't go into the in-house pressures faced by anyone who does not get on the bandwagon and write those loans.
This stuff didn't happen because faceless "lenders" didn't do their homework. It happened because at every step along the way, everyone involved stood to make a lot of money that they'd get to keep even if the deals went bad.
Posted by: zak822 at Jul 29, 2008 5:53:59 PM
Per my post above, there needs to be a way to clawback bonuses *and* to prosecute this kind of behavior in civil and in some cases criminal courts.
It mystifies me why white collar crime is so often shrugged off when the impacts are many orders of magnitude far-reaching than most other types of crimes.
Posted by: meter at Jul 29, 2008 10:07:55 PM
Taking risk is not a crime, even taking reckless foolhardy risk with other people's money, provided there isn't fraud involved. So if you're looking to prosecute the CEO's, you're going to have to start passing new laws.
Posted by: Tom at Jul 30, 2008 12:17:21 PM
There is and was fraud involved, and if you think things have suddenly gotten better, read this at Calculated Risk:
http://calculatedrisk.blogspot.com/2008/07/fraud-in-2008-mortgage-vintage.html
Heads should be rolling...
Posted by: meter at Jul 30, 2008 12:31:46 PM
If I were a MER shareholder I'd be calling the SEC asking for an investigation into Thain's statements. Luckily I am not.
How that's characterized as anything but fraud just goes to show you how much the legal system protects white collar criminals.
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