The No-Bailout Option
By Arnold Kling
The U.S. has just missed a golden opportunity to credibly signal to the world for decades to come that “no guarantee” means “no guarantee.”
Suppose that we describe a miniature Fannie Mae as follows.
One year from now, it is supposed to receive $100 in interest and $2000 in principal from people to whom it has lent money. However, it only expects to receive only $1800 in principal, because some people are likely to default. If it is lucky, it will get more, maybe even the full $2000. If it is unlucky, and more people default than expected, it will get less, possibly much less.
It has $1800 in debt coming due. It needs to “roll over” the debt, meaning that it has to pay the $1800 now due and immediately borrow another $1800 to be repaid in a year.
If it can borrow at an interest rate of 5 percent, it will owe $90 in interest and $1800 in principal. If repayments go according to expectations, it will receive $1900 and pay out $1890, leaving a $10 profit.
If it has to borrow at 6 percent interest, then it will owe $108 in interest and $1800 in principal, and if all goes as expected it will have an $8 loss.
If the government guarantees its debt, it will be able to borrow at 5 percent and expect to earn a profit. If the government says “no guarantee means no guarantee,” then investors will demand 6 percent (or more), and Fannie Mae is busted.
If Fannie Mae is busted, then all sorts of financial institutions that hold Fannie’s debt (and in the real world we are talking hundreds of billions of dollars, not $1800) have to write down the value of those securities, and so now they are busted. And pretty soon just about everybody, including the folks who pay Bryan’s salary, has to mark down their portfolio, because every firm in which they have invested is busted. That’s what a meltdown means.
In contrast, what is going to happen is that Fannie Mae’s debt-holders are going to receive a windfall. They charged Fannie a risk premium, meaning an interest rate a little bit above the Treasury rate, to factor in the possibility that Bryan might be named Treasury Secretary. So now they are getting U.S. government guarantees on debt that pays a higher rate than Treasuries.
If the world were completely fair, then the debt-holders would not make out quite so well. In practice, you can’t make the world completely fair.
In practice, the folks at Treasury figure that by doing this now, rather than waiting, at least they stop Fannie and Freddie from issuing debt that pays a risk premium when the Treasury knows that it’s the taxpayers who will end up paying that risk premium. So the existing debtholders’ profits are grandfathered in, but the hope is that you’re not going to keep handing out money to the buyers of new GSE debt.
The moral of the story is that Barney Frank’s idea of a financial system, in which a very forgiving government-sponsored lender makes low down-payment loans in the name of “affordable housing,” only works for a while. Eventually, it uses up a lot of money and a lot of time and effort on the part of the civil servants trying to put Humpty-Dumpty back together.