« Wal-Mart and obesity | Main | Glen Whitman update »
Did we *really* need that bail-out?
The highly-praiseworthy-but-ever-so-occasionally-totally-wrong Bryan Caplan suggests that Paulson should have simply let the debt securities of the mortgage agencies go. In addition to the fact that he favors The End of the World, Bryan is underestimating at least two points:
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.
2. In essence we already agreed to the bail out some time ago. Have you ever spent $17,000 on a car and asked the dealer what the warranty for the car "really meant"? Well, the Chinese spent $340 billion on agency debt and probably asked the same question at least once or twice. They live in a world of secret agreements with leaders, not transparent democratic arrangements. So when it comes to the U.S government decision, we're not just starting from scratch here. 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.)
So should we try this: "Oh, is that what you thought? Guaranteed? Did we use that word? Sorry, try reading our signals better next time. We love you. Great job with those Olympics. And when it comes to those Treasury Bills, we really do still mean it. And don't forget to support us on Iran and North Korea."
The libertarian critique of the mortgage agencies is, in my view, very much on the mark. But still the error has been made and we must pay up. As Steve Chapman points out, the bailout is a necessary evil, but with emphasis on the word "evil."
Posted by Tyler Cowen on September 10, 2008 at 04:27 PM in Economics | Permalink
Comments
Look, I understand what you are saying, but then why the spread between T-Bills and Fannie and Freddy? They got the benefits of the increased rates with the guarantee of payment? It seems like Fannie and Freddy weren't too big to fail, but the creditors were too big not to pay. That is a major problem and foretells the end of America as we know it. China now controls enough of our debt and the value of our currency that we must do their bidding. Game over boys, we are in the control of a totalitarian state.
Posted by: Seth Burn at Sep 10, 2008 4:51:44 PM
You're assuming that they were currently in crisis and the choices were bailout or massive default. This is not a valid assumption. Their regulator said they met capital requirements. They had so far had been successful in rolling over their debt. The stock went to 0.7 from 7 after Paulson's plan, not before. The GSE's weren't in great shape, but they weren't in some imminent crisis either.
This can be argued, but a number of people thought that the result of no action by Paulson would have been the GSE's muddling along and gradually getting healthier as new good business replaced the more iffy guarantees from 06 and 07. The stock was so low partially because of political risk, which turned out to be a valid concern.
Posted by: mgunn at Sep 10, 2008 4:56:39 PM
Have you ever spent $17,000 on a car and asked the dealer what the warranty for the car "really meant"?
No, and I would fully expect the dealer to fully renege on any verbal backroom deal and point to the signed and written warranty contract.
Posted by: JordanT at Sep 10, 2008 5:58:34 PM
Seth, isn't part of the spread because home mortgages can be paid off at any time [called] but T-bills cannot? Or is this just obsolete information stuck in my head?
Posted by: ZBicyclist at Sep 10, 2008 6:01:19 PM
Without a lot more evidence, I am very skeptical of your emphasis of the role of China in this nationalization. I don't doubt that the Chinese expressed their opinion clearly, but that's not the same as the administration being moved by that opinion.
The administration had plenty of purely economic reasons for fearing a GSE default. The administation has not shirked back in the past from doing what it wanted in the face of Chinese, and indeed even worldwide, opposition. The Chinese clearly had no legal recourse, and probably wouldn't threaten military recourse. The only realistic and frightening threat they could make would be to stop buying T-bonds, but given their merchantilist growth strategy based on US consumption(not to mention what that would do to their own T-bond holdings), that's not really a credible threat.
If you want to convince me that China is the key here, you'll have to get Paulson in an interview saying "we were planning to let the GSEs fail, but then I got a call from W. saying the Chinese were threatening to fire ICMBs at Washington, and the Pentagon was saying they couldn't stop them".
Posted by: David Wright at Sep 10, 2008 6:04:52 PM
ZBicyclist: Perhaps, but I think the spread was based on risk, as with bonds and other liquid assets.
Posted by: Seth Burn at Sep 10, 2008 6:04:55 PM
ZBicyclist:
I believe the GSEs guaranteed their paper against prepayment risk as well as default risk.
But even if I am wrong about that detail, the spread between GSE debt and treasury debt had increased by over 100 bp over the past few months, which means some new risk -- default risk -- must have developed over that time.
Posted by: David Wright at Sep 10, 2008 6:11:17 PM
Yeah, but every once in a while you really do have to shoot one to encourage the others. GM and/or Chrysler, maybe?
Posted by: Alan Gunn at Sep 10, 2008 6:14:18 PM
How many more rich people do we have to save before we are safe?
Posted by: lxm at Sep 10, 2008 6:19:48 PM
Ditto what David Wright said. I'm not even going to be the know-it-all on this one. I'm lost.
Exactly what verbal dance did Paulson have to do? Why couldn't he have just said, "nah, we wouldn't save
'em. If you want security, buy treasuries, not Fannie" ? And more importantly, why not tell the, you know, truth
about the backroom deals with China? Why must China buy GSE bonds instead of government bonds?
And yes, as with lxm, it is exactly this kind of thing that triples whatever latent resentment I might have
had of those wealthier than me. None of us average people could expect to be bailed out like this. Yet when
people who are wealthy enough to retire several times over, go and make mistakes you and I are expected *not* to make
because that would be stupid, and yet they get bailed out? Well, what the hell was the big salary for? Why not just
pay me the millions of dollars to make decisions of value indistinguishable from a dice roll?
Posted by: Person at Sep 10, 2008 6:58:56 PM
"But still the error has been made and we must pay up."
Um... *I* did not make any error, so I do not see why *I* should have to pay up.
What's that? You say the alternative is the collapse of the global something-or-other, and it would ultimately hurt me, too? Well thank you so much for your concern, but I will gladly take my chances.
I am getting a tired of all this "we" talk. As near as I can tell, the only time people I do not know use that word is when they are trying to pick my pocket.
Posted by: Nemo at Sep 10, 2008 7:03:55 PM
The Truth is that every one of these securities says, in bold, all-capital, print, on the face page of the prospectus, that it is not guaranteed.
see: http://market-ticker.denninger.net/uploads/Fannie.png
This particular certificate face is from July of this year.
If they wanted government backed mortgage securities, they should have bought ginnie mae.
(see http://www.ginniemae.gov/about/about.asp?Section=About).
Posted by: at Sep 10, 2008 7:15:53 PM
Thanks to the policies of the Federal Reserve, we are already in no man's land. Sadly, it seems as though the next bubble -- after Nasdaq, after housing -- is insanity, which is clearly through the roof.
The bailout is going to destroy the dollar and create more inflation -- more than we already will be facing, which is quite a bit. I would rather suffer the financial/economic consequences of letting them die rather than death by hyperinflation. While neither option is pretty, and while both are immensely painful, I think a "let them die" approach to Fannie and Freddie is ultimately healthier for the economy and more "just" in the sense of letting those who took improper risks bear the greater portion of the calamity.
Of course, the ultimate problem is the Fed, and any real solution to our pending economic/monetary crisis begins with addressing that issue.
Posted by: Simit Patel at Sep 10, 2008 7:17:16 PM
Not to pile on, but the housing market is already a shambles. So, worst case (not counting nuclear attack by the Chinese) we can't get loans for a while, right? Are home loans what we need right now, or any time in the near future?
We already had malinvestment in homes. We are working our way out. When would be a better time for mortgage companies to kick the bucket? These are people collecting money from consumers based on inflated home prices. What if they didn't?
The lending money would go somewhere, now it's going to the government. Even those clowns can't spend all the money in the world. Wouldn't spill-over seek alpha from somewhere, namely corporate bonds in industries that were neglected during the housing run-up? I'm sure I'm underestimating many things, but I'm not seeing why such a scenario wouldn't be good for the economy, short and long-term, assuming of course we avoided the promised fire and brimstone Nostradamus scenario. Eventually people would start buying mortgages again, at higher rates, and they'll be a fine product.
Oh, and as for the sort of guaranteed debt, people made malinvestments based on government misinformation? I seem to recall some theory that makes a big deal about that.
Posted by: Andrew at Sep 10, 2008 7:54:38 PM
I think that those who differ with Tyler here ought to imagine themselves in Paulson's place when he gets that phone call from the Chinese - back when things didn't look particularly perilous for Fannie and Freddie.
Posted by: Bernard Yomtov at Sep 10, 2008 8:48:21 PM
First, why not address the liquidity head on? If liquidity is the problem, address it directly. The Fed can act as lender of last resort when Merill has liquidity problems. If assets fall in response to some sort of panic or "run," then Fed provide short term liquidity until assets return to fundamentals. In fact, that's largely what they were created to do, but failed to do at the onset of the Great Depression.
Second, on what authority is this "guarantee" you speak of made? If there's no (legal or constitutional) authority, then the Chinese and others believe p<1 that the guarantee is worth anything. Hence, the guarantee is not a guarantee.
I think Prof. Caplan has good reason to underestimate your two points.
Posted by: Scott Wentland at Sep 10, 2008 9:26:23 PM
In most areas, I'm as libertarian as they come. But there's something to positive feedback loops of exuberance and pessimism overshooting the correct value of assets in a free market economy. In 05-06, the Chinese and others with capital backed MBS's because everybody agreed with each other that there was no housing bubble. Subprimes and even A-1s were a small part of demand for housing and the 30-year fixed loans had always been nearly default-proof before.
It works the same the other way. What exactly would happen if Freddie had no choice but to declare Chapter 11? In a perfect world, some T. Boone Pickens would go bargain-hunting with thier billions the next second to counteract the precipitous drop in asset prices. But that doesn't happen in the real world. In the real world, people in a downturn go 1990's Japan and horde money, except for buying nice safes of course.
Before the FDIC and better financial regulation, booms were much higher and busts were much deeper. The crash was just the largest bust followed by the largest boom. While FDR did prolong his depression with his socialist and unionist policies, the new financial regulation helped America achieve relative stability until the late-70's when inflationary policies came home to roost.
Similar to the 1920's, the financial innovation and increased globalization post-2000 gave way to an unfounded rise in asset prices. But those that do hold capital must soften the landing using minor one-time inflation instead of the alternative of depression.
Posted by: Matt at Sep 10, 2008 9:43:41 PM
"First, why not address the liquidity head on? If liquidity is the problem, address it directly. The Fed can act as lender of last resort when Merill has liquidity problems. If assets fall in response to some sort of panic or "run," then Fed provide short term liquidity until assets return to fundamentals."
Isn't that pretty much what the US is doing with Fannie and Freddie? I can't see any difference between bailing out Merill and bailing out Fannie, other than the latter is much bigger.
Posted by: Matt at Sep 10, 2008 9:47:19 PM
Dear Tyler,
Four things:
1. You're using the word "we" incorrectly. I never made a commitment to the Chinese buyers and neither, I suspect, did you. If it happened, it was the actions of a few individuals. You can't even argue that those individuals had the legal authority to promise full faith and credit. They didn't. (For more on the misuse of "we," see my "Who is We?" http://www.antiwar.com/henderson/?articleid=7889
2. You make a good point about converting our money market funds at par. But so what. If we took a haircut on those, it would be a couple of percentage haircut. So if you have $20K in a MMF, you lose $400 to $600. No catastrophe here.
3. You're confusing a wealth loss, which, I agree, would happen, with a contraction of the money supply. To make your case, you would have to argue that the money supply would contract.
4. If your argument is that the money supply would contract, that would increase the value of the dollar, not decrease it as you said in your previous post.
Best,
David
Posted by: David R. Henderson at Sep 10, 2008 10:02:00 PM
We are on the road to systemic collapse. This path is paved by the false belief in "lenders of last resort". There is no such thing as a lender that cannot/will not fail. By indulging in this false belief, we create ever bigger "too big to fail" financial institutions. 10 years ago it was LTCM, now it is Fannie and Freddie, tomorrow it will be all the big banks like JPM, Citibank, and Bank of America all at once, then it will be the central bank of Japan or Great Britain. We are creating a systemic mechanism of financial collapse. We are being foolish.
Posted by: Yancey Ward at Sep 10, 2008 11:23:02 PM
It's disturbing how many people seem to be saying, in effect, "Bring on the Argentina moment and let the chips fall where they may". Do you really want to live in a world where essentially no one can buy a house except for cash upfront? A world where the US budget needs to be balanced more or less overnight? Maybe we're headed there anyway, but buying time is surely a better option.
Do you seriously think that China would meekly continue buying Treasuries after a Frannie default, because they supposedly have no choice? Generally speaking, in the Chinese way of doing business, personal relationships still count for a lot more and written contracts count for considerably less. Invoking "nothing personal, it's just business" doesn't go over well, because it's always personal -- if it wasn't personal, there wouldn't have been a deal to break in the first place. Tyler is absolutely correct that as the crisis unfolded over the past year, China must have sought ironclad personal assurances from the very top and would consider that to trump the letter of any written contract. They would not have bought such high levels of GSE debt otherwise, and would react with absolute fury at what they would consider deception and a very personal betrayal. Decisions made in a state of fury often do not correspond to rational self-interest.
China has been working with the US to sustain an unsustainable status quo, because an abrupt realignment of the world's financial tectonic plates will bring great pain for everyone when things inevitably finally snap -- but this is precisely the sort of thing that will trigger the snap. Foreign central banks would consider a GSE default equivalent to a US government default (whether you or legal scholars or anyone else agrees with that is irrelevant), and would act in accordance with that belief. The myth of risk-free US government debt would be forever shattered and interest rates on Treasuries would rise sharply and permanently. US sovereign debt would follow in the footsteps of Fannie and Freddie, from unimpeachably rock-solid to shaky in a hitherto inconceivably short time. Unthinkable is not the same as impossible.
One "interesting" retaliation option for China would be to confiscate US intellectual property -- trademarks, patents and copyrights. There is precedent for this: in 1994, Bayer had to pay $1 billion to buy back the US rights to its name and trademarks, which it lost during World War I.
Posted by: at Sep 10, 2008 11:36:05 PM
The person who posted at 11:36:05 p.m. but didn't leave his name begs the question. That is, he assumes that catastrophic consequences would follow if the U.S. government didn't nationalize Fannie and Freddie. But that is precisely the question we're discussing. Some people may relish an Argentine moment. I don't. I also think that Tyler has made extreme predictions with little basis. When I pushed him earlier on this thread to justify his predictions, he simply negotiated down his prediction of the fall in the value of the currency. Still missing is any clear, step-by-step reasoning about how these bad consequences would follow.
Best,
David
Posted by: David R. Henderson at Sep 10, 2008 11:43:37 PM
One thing is abundantly clear, now- no amount of financial risk is too much- indeed, the bigger the bets, the less risk there actually is. If your bets win, you make billions, if your bets lose, you get bailed out. If I were running a large financial firm, I would make the "riskiest", most profitable bets I could possibly devise. Anyone care to take a shot at where the next failures are going to show up and why?
Posted by: Yancey Ward at Sep 10, 2008 11:56:16 PM
How many phone calls do you think Hank Paulson has received from the Chinese central bank since August 2007?
So, let's throw Paulson (and who ever else made implicit guarantees) in Sing Sing for a few months to teach leaders to never do it again. Here's the problem, the CEO's of Fannie/Freddie and Paulson screwed up royally. However, it doesn't matter to them because they've made millions, and the CEO's of Fannie/Freddie will get a nice golden parachute for their troubles. If the CEO's knew that they could get hard time for nearly bringing the US economy to its knees, we'd have a bit more due diligence.
Posted by: JordanT at Sep 11, 2008 12:02:52 AM
You're assuming that they were currently in crisis and the choices were bailout or massive default. This is not a valid assumption. Their regulator said they met capital requirements. They had so far had been successful in rolling over their debt. The stock went to 0.7 from 7 after Paulson's plan, not before. The GSE's weren't in great shape, but they weren't in some imminent crisis either.
With all due respect, this is sheer revisionism. The writing was very much on the wall. For instance:
Aug. 20 (Bloomberg) -- Fannie Mae and Freddie Mac's success in repaying $223 billion of bonds due by the end of the quarter may determine whether they can avoid a federal bailout. [...]Rolling over the debt "is the single most important factor to their ability to remain liquid," said Moshe Orenbuch, an analyst at Credit Suisse in New York. "So far, they've been able to do that."
At the end of August the picture had become clearer. By September 2, Brad Setser, who follows Chinese purchases of Treasuries and Agencies more closely than just about anyone else, noted the ongoing reduction of central bank demand for Agencies, in particular drawing attention to the very bad August datapoint showing strong flight into Treasuries, and commented with understatement (via Naked Capitalism):
If these trends continue for much longer, US Treasury Secretary Paulson will be forced to show his hand. The Agencies won’t be able to rollover their debt — at least not at a spread that works for them. The US government will then either have to step or let the Agencies fail. And, well, letting the Agencies fail, in the sense of default on their debt, is probably more than the US government is willing to consider right now. Any restructuring though would likely be bad for the holders of the Agencies common equity.
The game was up: the buyers' strike (and probably a few overseas phone calls) made it clear that the debt would not be rolled over successfully at the end of September. That is what forced Paulson's hand. The fact that he commendably acted a few weeks before the absolute deadline is now being spun by some into the fantasy that it was not necessary for him to act at all.
It was an open secret that the common shares were going to zero. So why were Fannie common shares actually up (to $7) on the Friday before? Chalk it up to a combination of wary professional traders burned by the short squeeze triggered by the SEC's July restrictions on shorting financial institutions and fearing a repeat intervention of some sort, and naive retail investors who probably thought that the word "bailout" actually implied good news for the common shares.
Posted by: at Sep 11, 2008 1:49:45 AM
