Jesse's Café Américain

Fannie’s and Freddie’s free lunch
By Joseph Stiglitz
July 24 2008 18:25
The Financial Times

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.

But the proposed bail-out of Fannie Mae and Freddie Mac makes that of Bear Stearns look like a model of good governance. It sets an example for other countries of what not to do. The same administration that failed to regulate, then seemed enthusiastic about the Bear Stearns bail-out, is now asking the American people to write a blank cheque. They say: “Trust us.” Yes, we can trust the administration – to give the taxpayers another raw deal.

Something has to be done; on that everyone is agreed. We should begin with the core of the problem, the fact that millions of Americans were made loans beyond their ability to pay. We need to help them stay in their homes, including by converting the home mortgage deduction into a cashable tax credit and creating a homeowners’ Chapter 11, an expedited way to restructure their liabilities. This will bring clarity to the capital markets – reducing uncertainty about the size of the hole in Fannie Mae’s and Freddie Mac’s balance sheets.

The government should set a limit to the size of the bail-out, at the same time making it clear that, while it will not allow Fannie Mae and Freddie Mac to fail, neither will it be extending a blank cheque. There may need to be a drastic reorganisation. There should be a charge for the “credit line” (any private firm would do as much) and, given the risk, it should be at a higher than normal rate.

The private sector knows how to protect its interests; the government should do no less. As long as the credit line is extended, no dividends should be paid. To ensure that the government is not simply bailing out creditors who failed in due diligence, at least, say, 25 per cent of any notes, loans or bonds coming due that are not lent again should be set aside in an escrow account, to be paid only after it is established that taxpayers are not at risk. Any government loans should be cumulative preferred debt: the taxpayers get paid before any other creditors receive a dime. To discourage moral hazard the interest rate should be at a penalty rate and, reflecting the rising risk, increase with the amount borrowed. Finally, the government should participate in the upside potential as well as the downside risk: for instance, by taking shares (which it might later sell) or, as it did in the Chrysler bail-out, warrants.

We should not be worried about shareholders losing their investments. In earlier years, they were amply rewarded. The management remuneration packages that they approved were designed to encourage excessive risk-taking. They got what they asked for. Nor should we be worried about creditors losing their money. Their lack of supervision fuelled the housing bubble and we are now all paying the price. We should worry about whether there is a supply of liquidity to the housing market, so that those who wish to buy a home can get a loan. This proposal provides the necessary liquidity.

A basic law of economics holds that there is no such thing as a free lunch. Those in the financial market have had a sumptuous feast and the administration is now asking the taxpayer to pick up a part of the tab. We should simply say No.

The writer, 2001 recipient of the Nobel Prize for economics, is university professor at Columbia University. He is co-author with Linda Bilmes of The Three Trillion Dollar War: the True Cost of the Iraq Conflict

As regular readers know, we have been fans of Satyajit Das for some years now. His knowledge of the derivatives market is outstanding, given his first-hand experience. He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives. We have read it, and are trying to find the time to read it again in the light of what we have learned since it first appeared on the bookshelves.

The scenario he puts forward in this essay is feasible, although we expect the announcement to be less intrusive, more evolutionary, and accompanied by currency controls, selective default plans, and perhaps some geopolitical events. Domestically we will likely see the introduction of digital scrip to be used rather than dollars, as a form of rationing. Barter and black markets will flourish.

It also perhaps helps the reader to understand why the notion of a stronger dollar through debt default is a mistaken application of inappropriate examples at best, and a delusionary fantasy unto personal financial oblivion at worst.

A default on the dollar debt at this point seems inevitable. It is merely a matter of how they wrap and deliver it, and how far and wide the pain is spread.

EuroIntelligence
"We interrupt regular programming to announce that the United States of America has defaulted …"
by Satyajit Das

High levels of debt are sustainable provided the borrower can continue to service and finance it. The US has had no trouble attracting investors to date. Warren Buffett (in his 2006 annual letter to shareholders) noted that the US can fund its budget and trade deficits as it is still a wealthy country with lots of stock, bonds, real estate and companies to sell.

In recent years, the United States has absorbed around 85% of total global capital flows(about US$500 billion each year) from Asia, Europe, Russia and the Middle East. Risk adverse foreign investors preferred high quality debt – US Treasury and AAA rated bonds (including asset-backed securities ("ABS"), including mortgage-backed securities ("MBS")). A significant portion of the money flowing into the US was used to finance government spending and (sometimes speculative) property rather than more productive investments. (Allow us to print the world's reserve currency and we care not who makes the laws - Jesse)

The real reason that the US actually has not experienced a sovereign debt crisis is that it finances itself in it own currency. This means that the US can literally print dollars to service and repay it obligations.

The special status of the US derives, in part, from the fact that the dollar is the world’s major reserve and trade currency. The dollar’s status derives, in part, from the gold standard that once pegged the dollar to the value of gold. The peg and full exchangeability is long gone. The aura of stability and a safe store of value based on the strength of US economy and military power has continued to support the dollar. In 2003, Saddam Hussein, when captured, had US$750,000 with him – all in US$100 bills. The dollar's favoured position in trade and as a reserve currency is based on complex network effects.

Many global currencies are pegged to the dollar. The link is sometimes at an artificially low rate, like the Chinese renminbi, to maintain export competitiveness. This creates an outflow of dollars (via the trade deficit that in turn is driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers are forced to purchase US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flow back to the US to finance the spending. This merry-go-round is the single most significant source of liquidity creation in financial markets. Large, liquid markets in dollars and dollar investments are both a result and facilitator of the process and assist in maintaining the dollar’s status as a reserve currency. (Foreign countries must ironically liberalize their own internal policies to encourage consumption and write down their US dollar holdings significantly to break this cycle and maintain their sovereign freedom from the US financial interests. It will take the "too big to fail" debate to a new level. This is a classic prisoner's dilemma. The first country to do it will find it the easiest in the long term but potentially risky in the short term. - Jesse)

The dominance may be coming to an end. There is increasing discussion of re-denominating trade flows in currencies other than US$. Exporters are beginning to invoice in Euro or Yen. There are proposals to price commodities, such as oil and agricultural goods, in currencies other dollars. Some countries have abandoned or loosened the linkage of their domestic currency to the dollar. Others are considering such a move.

Foreign investors, including central banks, have reduced investment allocations to the dollar. The dollar’s share of reserves has fallen from a high of 72% to around 61%. Foreign investor demand for US Treasury bonds has weakened in recent times. Low nominal (negative real) rates on interest and dollar weakness are key factors.

Foreign investors may not continue to finance the US. At a minimum, the US will at some stage have to pay higher rates to finance its borrowing requirements. Ultimately, the US may be forced to finance itself in foreign currency. This would expose the US to currency risk but most importantly it would not be able to service its debt by printing money. The US, like all borrowers, would become subject to the discipline of creditors.

For the moment, the US$ is hanging on – just. This reflects structural weakness in the Euro and Yen based on deep-seated problems in the respective economies. The artificial nature of the Euro is also problematic. (Gold, perhaps along with silver, is the obvious alternative currency but the banking interests will fight it to the end - Jesse)

The dollar is also a beneficiary of the "too big to fail" syndrome. Foreign investors, especially central banks and sovereign investors in East and South Asia, Russia and the Gulf, have substantial dollar investments that would show catastrophic losses if the US were to default. The International Monetary Fund ("IMF") estimated that Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates, Qatar and other Gulf States) may lose US$400 billion if they decide to stop pegging their currencies to the dollar.

Every lender knows Keynes’ famous observation: "If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours." In history’s largest Ponzi scheme, foreign creditors must keep supporting the US. As the old observation goes: "The only man who sticks closer to you in adversity than a friend is a creditor." (Don't quickly dismiss the scenario that the elites try to present the world with an offer they cannot refuse involving global governance and a New World Order - Jesse)

Does any of this matter? Walter Wriston, then chairman of Citigroup, opined that: "Countries don't go broke". In 1982, shortly after this statement, Mexico, Brazil and Argentina defaulted inflicting near mortal losses on Citibank.

Sovereign debt crisis, especially in emerging markets, are characterised by high levels of debt, especially foreign borrowings, poor fiscal policies, persistent trade deficits, a fragile financial system, over-investment in unproductive assets and a sclerotic political system. Arturo Porzecanski (in Sovereign Debt at the Crossroads (2006)) noted that: "Governments tend to default specifically when they must increase spending quickly (for instance, to prosecute a war), experience a sudden shortfall in revenues (because of a severe economic contraction), or face an abrupt curtailment of access to bond and loan financing (e.g. because of political instability). He further observed that: "governments with large exposures to currency mismatches and interest rate or maturity risks are, of course, particularly vulnerable."

Can the status quo continue? The US must ultimately pay the piper. So what must the US do to remedy the problem? In 1989, John Williamson described certain economic prescriptions - the Washington Consensus – that became a "standard" reform package promoted for crisis-wracked countries by the IMF. The controversial, much criticised package includes: fiscal policy discipline; redirection of public spending from subsidies; tax reform; market determined and positive real interest rates; competitive exchange rates; trade liberalization; liberalization of inward foreign direct investment; privatization of state enterprises; and deregulation. Resolution of the problems facing the US requires adopting many elements of the standard IMF economic reform package for emerging markets.

Some elements, such as fiscal and monetary discipline, are politically difficult if inevitable. Reform of farm subsidies must overcome deep-seated resistance.

Markets are restless for action and do not wait. The US dollar has weakened and is likely to fall further.. This helps exporters, tourism and will ultimately attract inwards foreign investment.

Foreign investment has been slow. Weak economic growth and concerns about the US financial system have offset the effects of a lower dollar. Despite this the "closing down sale" of US assets - real estate, companies and infrastructure assets - has begun. InBev, a Belgian based brewer has launched an unsolicited bid of US$46 billion for Anheuser-Busch, the brewer of Budweiser, the quintessential American beer. Abertis Infraestructuras, a Spanish infrastructure company teamed with Citigroup, submitted US$12.8 billion, the largest bid, for the right to lease the Pennsylvania Turnpike for the next 75 years.

Increasing foreign investment is politically sensitive in America. Surveys show that most American would prefer key businesses to remain in American hands. Public concern about investment by Sovereign Wealth Funds ("SWF") reflects this financial xenophobia.

The "adjustment" may be under way. The dry measured economic prose of the Washington Consensus does not capture its human elements. It will require reductions in US real wages and living standards on a scale that those who have not experienced it first hand cannot understand. Just ask the average citizen of many Asian countries (post the 1997/ 1998 monetary crisis), Argentina and any other country that has taken the IMF’s "cure". (We like the example of Russia in the 1990's since we were doing business there and saw it first hand. - Jesse)

In the twentieth century, the US and the dollar overtook Great Britain and the Pound Sterling as the pre-eminent global economic power and currency. A similar epochal tectonic shift in global economic order may be commencing.

The shift is not inevitable. There is much to admire about the US. It remains wealthier than other nations including the new titans - China and India. America remains a science and technology powerhouse. It accounts for 40% of total world spending on research and development, and outperforms Europe and Japan. For example, between 1993-2003 America’s growth rate in patents averaged 6.6% a year compared with 5.1% for the European Union and 4.1% for Japan. America's relatively fast-growing population, secure property rights and well-developed financial markets have been attractive to investors.

However as Warren Buffett in his 2006 annual letter to shareholders observed: "Foreigners now earn more on their U.S. investments than we do on our investments abroad … In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience ‘reverse compounding’ as we pay ever-increasing amounts of interest on interest. …. no matter how rich you are, borrowing on top of borrowing is not a great long-term financial plan. I believe that at some point in the future, U.S. workers and voters will find this annual 'tribute' (of interest payment on the debt) so onerous that there will be a severe political backlash … How that will play out in markets is impossible to predict – but to expect a 'soft landing' seems like wishful thinking."

The US faces a challenge to reestablish its economic credentials. Without drastic and radical action, America’s ability to continue to borrow from foreign investors to meet its financing requirement is likely to become increasingly difficult. (Meaning increasingly higher interest rates, asset sales, and then le deluge - Jesse)

The mass hysteria and panic that followed the broadcast of Orson Welles The War of the World played on fears about an attack by Germans. It is interesting to speculate whether a broadcast on a default by the US on its sovereign debt would play on the secret fears of global markets triggering a similar panic. "We interrupt regular programming to announce that the United States of America has defaulted on its debt!"

A good friend just sent us this excerpt of an essay from a long time favorite author of ours that seems pertinent to the above, and our current state of affairs.

National Madness
Gilbert Keith Chesterton

"This slow and awful self-hypnotism of error is a process that can occur not only with individuals, but also with whole societies. It is hard to pick out and prove; that is why it is hard to cure. But this mental degeneration may be brought to one test, which I truly believe to be a real test.

A nation is not going mad when it does extravagant things, so long as it does them in an extravagant spirit. But whenever we see things done wildly, but taken tamely, then the State is growing insane...

I should, in other words, think the world a little mad if the [wild] incident, were received in silence. Now things every bit as wild as this are being received in silence every day.... For madness is a passive as well as an active state: it is a paralysis, a refusal of the nerves to respond to the normal stimuli, as well as an unnatural stimulation. There are commonwealths, plainly to be distinguished here and there in history, which pass from prosperity to squalor or from glory to insignificance, or from freedom to slavery, not only in silence, but with serenity.

The face still smiles while the limbs, literally and loathsomely are dropping from the body. These are peoples that have lost the power of astonishment at their own actions. When they give birth to a fantastic fashion or a foolish law, they do not start or stare at the monster they have brought forth. They have grown used to their own unreason; chaos is their cosmos; and the whirlwind is the breath of their nostrils.

These nations are really in danger of going off their heads en masse; of becoming one vast vision of imbecility, with toppling cities and crazy country-sides, all dotted with industrious lunatics.... "