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Are Fannie and Freddie Too Big to Fail?

September 17, 2008

Tags The FedFree MarketsOther Schools of Thought

On Sunday, September 7, 2008, the US government seized control of mortgage finance companies Fannie Mae and Freddie Mac. According to the government's statement, the financial health of both Fannie and Freddie (FF) had deteriorated to such an extent that it could have posed a serious threat to the US economy.

Congress established the FF in order to provide support for the housing market by keeping money flowing in the mortgage market. (Fannie Mae was established in 1938 as part of Franklin Delano Roosevelt's New Deal; Freddie Mac was established in 1970.)

The FF market share of all new mortgages reached over 80% early this year. From this one can infer that a deterioration in FF financial health, which undermines their ability to keep the flow of money going to the mortgage market, is likely to hurt the housing market and the economy. Hence most experts have concluded that the seizure of the FF by the government was a responsible act, one which could restart the flow of money to the mortgage market, reviving the housing market and in turn the rest of the economy.

How Fannie and Freddie Keep the Mortgage Market Going

The key to FF operations is the buying of home loans from mortgage originators such as banks. The FF then bundle the loans they purchase into mortgage-backed securities (MBS), which are sold, with a guarantee of payment to investors. (The FF guarantee that the principal and interest on the underlying loan will be paid back regardless of whether the borrower actually repays.) The FF makes money by charging a guarantee fee on loans that it has purchased and securitized into MBS. By buying mortgages and repackaging the loans for resale via MBS, or by owning mortgages outright, the FF have provided banks and other financial institutions with fresh money to make new home loans.

Due to an implied government guarantee, the FF were able to raise funds relatively cheaply by selling their debt to investors. This in turn enabled them to pay higher prices to the originators of mortgages than potential competitors could pay. On average, between January 2000 and August 2008, the yield on the 10-year Fannie Mae debt was 0.589% above the yield on the 10-year Treasury debt. In contrast, the yield spread between AAA corporate debt and the 10-year Treasury debt stood at 1.446%. This means that on average, from January 2000 to August 2008, the Fannie cost of funding was below the AAA corporate by 0.857%.

Given the fact that the debt issued by FF was considered almost as good as Treasury debt, they could attract money from around the world. In 2007, foreign holdings of US Government Sponsored Enterprise debt (the FF are part of the GSE) stood at $1.304 trillion — an increase of 33% from the previous year and an increase of 165% from 2002. (Note that in 2007, China's investment in the GSE debt comprised 29%, Japan's 17.5% and Russia's 5.8%.)

As a result, the FF have become the dominant force in the housing market. The combined assets of the FF jumped from $160.2 billion in Q1 1990 to $1.77 trillion by Q2 2008. The two companies own or guarantee $5.4 trillion in outstanding home-mortgage debt.

The Real-Estate-Market Crisis and the Demise of Fannie and Freddie

In response to a fall in home prices, coupled with a growing number of home foreclosures, the FF have been required to write off some of the MBS held on their balance sheets. They also had to pay out on guaranteed mortgages that defaulted. As a result the FF have reported nearly $14 billion in losses in the last four quarters. The yearly rate of growth of the FF net worth fell to negative 17.3% in Q2 from negative 23.2% in the previous quarter. Net worth as percentage of assets fell to 3.1% in Q2 from 3.4% in Q1.

As the housing market continued to deteriorate, it started to put pressure on FF stock prices. After increasing to 35.8% in June 2007, the yearly rate of growth of the Fannie stock price fell to negative 89.6% by the end of August this year. Year on year, the price of Freddie's stock fell by 92.7% in August after falling by 85.7% in July. (Note that in May last year, the yearly rate of growth stood at 11.2%.) This made it difficult for the FF to raise capital. The deterioration in their solvency raised the risk that the FF would not be able to secure funding through selling their debt to large buyers such as various central banks. As a result, the prospects for the FF to buy mortgages from lenders and supply fresh funds to the mortgage market were severely hampered.

Will the US Treasury Plan Cause Banks to Lift Mortgage Lending?

So how then can the government seizure of FF fix the problem? According to the plan, the government will inject up to $200 billion over time into the FF and it will also engage in the active buying of MBS from various financial institutions that are currently trying to get rid of these assets. By buying MBS, the Treasury aims at pushing their prices higher and arresting the asset-price deflation.

Also, by injecting money into the FF, government officials hope to restart the flow of money to the mortgage market and bring things to normality. By "normality," they mean that the FF can start buying mortgages from the banks and, after bundling them into the MBS, sell them to the market as before. Treasury officials and various experts are hoping that this will lift home prices and, in turn, lay the foundation for the improvement in consumers' wealth. Subsequently, this will revive the pace of economic activity, so it is held. (Remember that the increase in mortgage lending results in more money being directed to the housing market. This means more money per house, i.e., higher house prices.)

But why should banks consider lifting the pace of mortgage lending? According to a Federal Reserve July survey of loan officers, in excess of 80% of banks have reported that they have tightened their lending standards on residential mortgages. In the previous survey, this figure stood at 72%. Observe that in the July survey last year, the figure stood at 37%. In August, the yearly rate of growth of commercial bank home loans stood at negative 2.2% after being negative at 1.6% in July. This was the third consecutive monthly decline in home loans by commercial banks.

At present, the major concern of most US banks is to improve their net worth, i.e., to strengthen their solvency. This means that the volume of lending is not going to increase if the quality of borrowers does not meet the more stringent standards. According to the Federal Deposit Insurance Corporation (FDIC), commercial banks' and savings institutions' net worth fell by $10 billion from Q1 to Q2. This was the first decline since the data were made available in Q2 2000.

Also, it is questionable that various investors who are at present trying to dispose of MBS would all of a sudden welcome them back into their investment portfolios. We suggest that the FF will have difficulty finding willing buyers of MBS. However, one could argue here that, since the US government guarantees MBS, investors might find them attractive — after all, it is held, the US government cannot default on their debts. From this perspective, one may conclude that the US government plan to take over Fannie and Freddie is a great idea and might work. (Most experts, including the Fed Chairman, are of the view that this is a great plan.)

Confusing Capital with Money

It seems that most experts are confusing capital with money. Treasury officials and Fed policy makers give the impression that they have a hidden pool of resources that can be employed in emergency cases. This is not the case. Neither the Treasury nor the Fed has any real resources as such. All that they can do is redistribute the existent wealth by means of taxes or by means of printing money. (Remember that it is real savings that makes real economic growth possible and not money.)

The act of real wealth redistribution can only weaken wealth generators and make things much worse. Pushing more money into the FF cannot set in motion an increase in lending if the pool of real savings is under pressure. After all, the essence of credit is not lending money as such but lending real stuff. Lending amounts to a transfer of real savings from a lender to a borrower by means of the medium of exchange, i.e., money.

The existence of banks enhances the use of real savings. By fulfilling the role of middleman, banks make it easier for a lender to find a borrower. When a bank lends money, it in fact provides the borrower with the medium of exchange that can be employed to secure real stuff that is required to maintain people's lives and well-being. It is therefore futile to urge banks to lend more if real savings are not there. Likewise, it doesn't make much sense to suggest that the Treasury or the Fed could somehow replace nonexistent real savings. Again all that such actions will produce is the depletion of the existent pool of real savings.

The guarantee that the Treasury is going to assume for the mortgages could be very costly to the taxpayer if the housing-market slump continues. We suggest that if the pool of real savings is declining, then the real economy will follow suit irrespective of various plans by the Treasury and the Fed. In these conditions, even if banks follow the Treasury plan and renew lending, this would be an exercise in futility. A falling economy and decreasing real incomes will reduce individuals' ability to service their debt. Consequently, the government (i.e., the taxpayer) will have to foot the bill.

However, we suggest that, if the pool of real savings is falling, the banks are likely to curtail their lending as a result of a diminished number of viable borrowers. Now, if the pool of real savings is still OK then there is no need for the Treasury plan. The growing pool of real savings will fix the problem.

The Fallacy of "Too Big to Fail"

Most experts are in total agreement that the government seizure of the FF was a necessary act since it has most likely averted a massive economic disaster not only in the United States but worldwide. It is held that, if the FF were allowed to go belly up, this could have inflicted heavy losses on foreign investors in FF debt, which, it is held, could also have eroded foreigners' willingness to invest in US government debt.

The view that some institutions are far too big to be allowed to go under is another fallacy. According to the popular way of thinking, if a large institution is allowed to go under, this could cause severe damage to the economy, since the failure of a large institution would generate large disruptive shocks. Since everything in an economy is interrelated, this means that a major shock could end up in a massive disaster.

In a market economy, a business that reaches the state of bankruptcy is most likely pursuing activities that do not contribute to real wealth but rather squander wealth, i.e., activities that make losses. Since such activities cannot support themselves, it means that real savings must be taken away from activities that do generate real wealth.

The longer a losing activity is allowed to stay alive, the more damage is being inflicted on real wealth generators. So, on the contrary, the liquidation of a losing activity cannot cause more damage; rather, it is going to arrest the damage inflicted on wealth generators. Once the losing activity is gone, the wealth generators with more real savings at their disposal can start expanding wealth-generating activities and lay the foundation for healthy economic growth.

The proponents of the "too large to fail" argument maintain that allowing a large institution to fail will lead to a sharp increase in unemployment and unacceptable human suffering. This is true. However, the reason for the hardship is not a loss of jobs as such but the erosion of the pool of real savings. The erosion of the pool means that there is not enough funding to support various economically nonviable activities. Allowing such activities to stay alive only weakens the pool of real savings further and leads to the further erosion of people's real incomes and makes things much worse. Furthermore, activities of a large entity absorb in absolute terms more scarce savings than a smaller entity, both directly and indirectly. We can infer from this that a large misallocated business is too big to be kept alive rather than too big to be allowed to fail, as the popular thinking has it.

The argument that the government seizure of the FF prevented the downgrading of US Treasury debt by foreigners is suspect. The key factor that has been providing the high rating to US government debt is the perception that the US economy is still very wealthy. Every investor implicitly or explicitly holds that, without support from private-sector wealth, US Treasury debt would have been worthless.

As long as the economy still generates wealth, the government debt will be considered safe. Once the pool of wealth starts to shrink, foreign buyers of US government debt are likely to abandon the sinking ship, irrespective of government "rescue" plans. If the US pool of real savings is falling and the housing market remains depressed, then this will result in the US Treasury incurring large losses in order to maintain so-called credibility, i.e., by not allowing the FF to go under. Needless to say, this is likely to further undermine the pool of real savings and the process of wealth formation. We suggest that a less wealthy US economy is going to hurt all other economies through the channel of international trade.

Allow the Market to Fix the Current Credit-Market Crisis

An alternative solution is to allow the FF to go belly up and allow the market to allocate in the best way scarce real savings. The free market will eliminate nonproductive, wealth-consuming activities and promote wealth-generating activities. The fact that Fannie and Freddie have reached the stage of bankruptcy is the manifestation of a severe misallocation of scarce savings. (In addition to being able to secure cheap money, the FF was given a boost by the extreme loose-interest-rate stance of the Fed between January 2001 and June 2004.)

Allowing the FF access to cheap money has resulted in far too many houses being built, relative to peoples' ability to fund them. This misallocation has robbed the wealth producers of real savings and has impaired their ability to generate real wealth and promote true real economic growth (please don't confuse it with the GDP rate of growth).

Again, allowing various misallocated structures to go under will stop the bleeding of wealth generators. (Note again that the misallocated structures must be funded all the time. This means that wealth generators will have less real funding than they could have had at their disposal as long as these structures are allowed to exist.)

The US government and the Fed could learn from the Japanese experience: schemes to fix the economy don't work if the pool of real savings is not there. In order to lift banks' lending between 2001 and 2003, the Bank of Japan (BOJ) had been aggressively pumping money into the financial system. The average rate of growth of monetary pumping, as depicted by the bank holdings of balances at the BOJ, had increased by 93% during that period. In April 2002, the yearly rate of growth stood at 293%. Yet bank loans had continued to fall. The average yearly rate of growth of loans from 2001 to 2003 stood at negative 4.5%.

Conclusion

We suggest that the seizure of Fannie Mae and Freddie Mac (FF) by the government cannot help the housing market or the economy. Most people hold the mistaken view that the government has extra real resources that can be used in emergencies. This is erroneous. The government is not a wealth generator; it can only consume and redistribute real wealth. What is needed to revive the economy is a growing pool of real savings.

Neither the US Treasury nor the US central bank can create real savings. In order to keep the failing FF going, the taxpayers will be forced to foot the bill. This means a further squandering of the already depleted pool of real savings. Only wealth generators can revive the economy by accumulating enough real capital. In this regard, no government or central-bank policies can replace wealth generators.

The only way wealth generators can act effectively is when they are not disturbed, i.e., in a free-market environment. The sooner the government allows them to move ahead, the sooner we will have economic improvement. Any government or central-bank policies that are intended to improve on the free market — in particular during difficult economic times — are likely to make things much worse and prolong the economic crisis.


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