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September 07, 2008


Afraid between Ramadan and my over riding fascination in watching the American mortgage giants Freddie Mac and Fannie Mae melt down, little time for reflexion.

I should say that I am fascinated by the particularly American approach to nationalisation in this instance. This is going to have no small impact globally, perhaps when I have blood sugar I shall try to ponder.

Posted by The Lounsbury at September 7, 2008 07:03 PM
Filed Under: Blog Notes - Admin

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Do you know Roubini? He's very popular with us lefties, what with predicting the downfall of capitalism...

A joke. His take, though:

Details on the US government bailout of the two GSEs – as well as the bailout of the other GSEs, the Federal Home Loan Banks that recently wasted hundreds of billions by lending to troubled mortgage lending institutions - are still partial but the overall picture is not pretty. This bailout plan has mostly lousy features that exacerbate the moral hazard of this government intervention and the overall fiscal costs of such intervention. Specifically consider the following ten flawed features of the plan:

First, common shareholders instead of being fully wiped out –as they do deserve – will only be diluted and hold about 20% ownership of the GSEs. There is no justification for this even partial bailout of the common shareholders as the two GSEs are insolvent.

Second, the government will inject capital – possibly and eventually hundreds of billions of dollars – in the form of preferred shared, not common shares. So instead of wiping out current shareholders that deserve to lose their entire capital such shareholders will be still technically speaking the owners of these firms. And the fiscal cost of this bailout will be very expensive: we estimated in June that the eventual losses for the government from this bailout could be as high as $200 to $300 billion, an estimate that is now shared by former Fed Governor William Poole. This is a huge figure on top of the other trillion dollar plus of fiscal costs of bailing out the financial system that will occur once the current systemic financial and banking crisis takes its full toll.

Third, the current preferred shareholders will not be fully wiped out –as they should be – and it is not even obvious whether they will take any haircut on their preferred shares; so they may be bailed out too. The government decided not to fully whack the preferred shareholders as this group includes many smaller and regional banks and insurance companies. But this additional bailout action exacerbates moral hazard and the fiscal cost of the bailout of the two GSEs.

Fourth, the subordinated debt holders and the unsecured debt holder will not be subject to a haircut. Thus, since preferred shareholders are second in absorbing losses (after common shareholders) the preferred shares of the government are junior to such debt holders.

Fifth, while not hitting the unsecured debt holders may have made some sense (as a lot of the agency debt is held by foreign central banks, sovereign wealth funds and other investors who would have fled the agency market if they had been subject to a haircut) not touching the subordinated debt of the GSE makes no sense; that is another additional bailout of a category of agency creditors that adds to the fiscal cost of the bailout.

Sixth, a number of authors including myself, Bill Ackman and Josh Rosner had argued that the proper way to recapitalize (and reduce the excessively high debt to equity ratio of) Fannie and Freddie and put them on sound and sustainable long run footing was to hit the agency debt holders with a haircut and convert part of the agency debt into equity. Instead having the government injecting capital in the GSE (as the Treasury plan does) does not resolve the problem that these are zombie giant institutions that are currently not viable and that need to drastically changed and scaled down to reduce their systemic risk and allow them to provide appropriate services to the mortgage market.

Seventh, the government plan includes the provision of credit lines – of an amount that is not specified but is potentially as high the Treasury wants – to Fannie and Freddie and to the other 12 FHLBs. The Treasury statement does not clarify whether these credit lines will be senior to other subordinated and unsecured agency debt or not. Since this provision of credit is a form of debtor in possession financing – like IMF lending to countries under distress – it should be de jure senior to the debt issued by the GSEs; it should also be senior to the mortgage claims that the GSEs have guaranteed. Instead, the Treasury’s silence about this matter suggests that these credit lines will not have any seniority compared to the unsecured debt of the GSEs.

Eighth: Treasury will purchase mortgage-backed debt issued by the GSEs in the open market. This is another form of government intervention and manipulation of the MBS market that is totally unwarranted.

Ninth, the GSEs will increase their MBS portfolios through the end of 2009 as a way to prop the mortgage market. In order to limit the moral hazard from this action that further increases the size and roles of the GSE the Treasury plan claims that the GSEs will reduce by 10% a year their portfolios from 2010 on. However, the short term increase in the portfolio of the GSEs is reckless and a further waste of taxpayers’ money. The problems of the GSEs mounted as they increased their activities and portfolios; and the decision earlier this year to increase their portfolios, reduce their capital requirements and increase the limit for conforming loans accelerated the demise of Fannie and Freddie. Thus, for the government to now say that their portfolios will be further expanded until 2009 is to add insult to injury. Their portfolios should have been reduced years ago and should be reduced now; it should not be reduced – a wishful statement with little substance as it can be reversed any time in the future – two years from now.

Tenth, the Treasury plans says nothing about how the two GSEs will be eventually restructured, downsized, split into smaller institutions that are truly private, competitive, not sources of systemic risk and not a further drain on the taxpayers’ money. This plan does nothing to restore the long term viability and efficiency of such institutions. It is just a very expensive taxpayers’ funded bailout of the shareholders and creditors of these institutions. Like the action taken in the Bear Stearns case and other recent government interventions and bailouts of private and quasi private financial institutions this is a form of privatization of profits and socialization of losses; it is socialism and corporate welfare for the rich, well connected and Wall Street.

Posted by: Klaus [TypeKey Profile Page] at September 9, 2008 10:08 PM

Meanwhile, back in the USSR (United States Socialist Republic) ...

Posted by: Roger Bigod at September 10, 2008 07:47 PM

I never did like Roubini, and the above is just another nail in that coffin for me.
The US housing market has been partly socialized since frontier days, when the USG encouraged settlement of the West with the backing of the US military, and with grants of "empty" land at very low prices.
In the modern era, Fannie and Freddie backed conforming loans, which artificially lowered their cost. After that, the "homeowner" (actually a holder of a 30-year lien on the property, which restricted severely what could be done on said property, for the obvious reason that a 30 year loan is a huge risk) got real estate tax and mortgage interest deductions against his federal tax. The former could formerly be justified as relieving the condition of having a "tax on a tax", until during the Reagan admin the sales tax deduction that everyone used to be able to take was repealed, making it blatantly obvious that to be a renter was to be a loser.
And that, folks, is when the real estate bubble in the US, at least, began. Speaking personally, I can tell you that once you attained a modicum of success, it became fiscally (household finance-wise) stupid to continue to be a renter. All you were doing was subsidizing your smarter friends who bought a house and got hold of all those juicy deductions, while paying off a risky 30 year loan at a subsidized rate.
In short, the failure of the GSE's is NOT a market failure. It's a failure of socialism, and as in all such cases, the only thing that fixes it in the short term is more socialism, while the only thing that can fix it in the long term is returning to simple common sense, where the buyer of a house realizes he's taking on a leveraged investment that can just as easily go down as up.
In short, Roubini is an economic illiterate, and completely ignorant about his economic history, to boot.

Posted by: pantom at September 11, 2008 02:22 AM

And that, folks, is when the real estate bubble in the US, at least, began.

When was this exactly?

Posted by: Klaus [TypeKey Profile Page] at September 13, 2008 09:52 PM

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