Friday, July 25, 2008
Stiglitz specifically addresses the emerging crisis in Fannie Mae and Freddie Mac. Both are government sponsored entities that have historically stabilized the housing market by agreeing to purchase mortgages and securitize them in the form of bonds. Or, as wikipedia helpfully explains in regard to Fannie Mae:
Freddie Mac fulfills a similar role:
It is the leading market-maker in the U.S. secondary mortgage market, which helps to replenish the supply money for mortgages and enables money to be available for housing purchases. As of 2008, Fannie Mae and the Federal Home Loan Mortgage Corporation (Freddie Mac) own or guarantee about half of the U.S.'s $12 trillion mortgage market.
Both have made enormous sums of money for their investors by charging a guarantee fee on loans that it has securitized into mortgage-backed security bonds. In other words, they charge a fee to insure the purchasers of the bonds against default.
The Federal Home Loan Mortgage Corporation ("FHLMC") NYSE: FRE, commonly known as Freddie Mac, is a Government sponsored enterprise (GSE) of the United States federal government. It is a stockholder-owned corporation authorized to make loans and loan guarantees. The FHLMC was created in 1970 to expand the secondary market for mortgages in the US. Along with other GSEs, Freddie Mac buys mortgages on the secondary market, pools them, and sells them as mortgage-backed securities to investors on the open market. This secondary mortgage market increases the supply of money available for mortgages lending and increases the money available for new home purchases.
Stiglitz examines a proposed bailout of these entities with alarm:
There is great anxiety about the crisis enveloping Fannie Mae and Freddie Mac. A collapse of them could result in less money available for home purchases, as credit contracts in the absense of their market making function through guarantees, with higher interest rates as well. The collateral consequences for banks, savings and loans and homeowners would be disasterous, fewer home sales, lower home prices and even more defaults, creating a death spiral of foreclosures, bank failures and deflation throughout the economy.
Much has been made in recent years of private/public partnerships. The US government is about to embark on another example of such a partnership, in which the private sector takes the profits and the public sector bears the risk. The proposed bail-out of Fannie Mae and Freddie Mac entails the socialisation of risk – with all the long-term adverse implications for moral hazard – from an administration supposedly committed to free-market principles.
Defenders of the bail-out argue that these institutions are too big to be allowed to fail. If that is the case, the government had a responsibility to regulate them so that they would not fail. No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to “self-regulation”. But that is what we have done with the financial system.
Even if they are too big to fail, they are not too big to be reorganised. In effect, the administration is indeed proposing a form of financial reorganisation, but one that does not meet the basic tenets of what should constitute such a publicly sponsored scheme.
First, it should be fully transparent, with taxpayers knowing the risks they have assumed and how much has been given to the shareholders and bondholders being bailed out.
Second, there should be full accountability. Those who are responsible for the mistakes – management, shareholders and bondholders – should all bear the consequences. Taxpayers should not be asked to pony up a penny while shareholders are being protected.
Finally, taxpayers should be compensated for the risks they face. The greater the risks, the greater the compensation.
All of these principles were violated in the Bear Stearns bail-out. Shareholders walked away with more than $1bn (€635m, £500m), while taxpayers still do not know the size of the risks they bear. From what can be seen, taxpayers are not receiving a cent for all this risk-bearing. Hidden in the Federal Reserve-collateralised loans to JPMorgan that enabled it to take over Bear Stearns were almost surely interest rate and credit options worth billions of dollars. It would have been easy to design a restructuring that was more transparent and protected taxpayers’ interests better, giving some compensation for their risk-bearing.
Stiglitz provides what is an essentially reformist solution, one that is fundamentally optimistic about our ability to positively influence the future. If we just shared the risk fairly between public and private participants in transparent rescue transactions, the financial system will heal itself, and the crisis will slowly recede in the rear view mirror. The global economy will then proceed along a path of more sustainable growth, absent the speculative excesses generated by subsidized credit.
It is certainly an alluring prospect. But what if Stiglitz is mistaken? Has fraud and speculation within the global financial system become so pervasive that there is no way out other than the destruction of capital and asset values on a scale not seen since the 1930s, and possibly even since the 1870s? What if the Federal Reserve and the US Treasury lose the ability to preserve the viability of the giants at the center of the financial system? What happens then? Or is this just another one of those episodes where I am too predisposed to alarmist thoughts? Turmoil is, after all, one of the essential features of capitalism.