The No-Bailout Option
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.
Sep 9 2008 at 5:41pm
“to factor in the possibility that Bryan might be named Treasury Secretary.”
Way to lighten my mood, Professor Kling. Very nice.
Sep 9 2008 at 7:08pm
This non-economist seems to be missing something in your explanation. The hundreds of billions of dollars in loans don’t disappear. There is value in the houses and properties purchased with the mortgages. The true losses will be only a small fraction of the total loans: a small percentage of mortgages will go unpaid, and the recovery rate at foreclosure might be only 70% of the amount owed. So, if 5% of loaned money ends up in foreclosures, the total loss of loaned money will be only 1.5%. That hardly seems like a meltdown. My stock portfolio lost 15 times that much in the past 9 months, but my family still eats and still has a home.
Sep 9 2008 at 7:44pm
Imagine that you had loans coming due next week, equal to the value of your home equity plus your portfolio–plus $5000.
That’s where Frannie’s sitting.
The devil’s in the margins…
Sep 10 2008 at 12:03am
Most of us that hate the idea of bailouts with the burning fire of 1,000 hells tend to agree on this being necessary. As much as you’d like to you can’t go back in time and make the necessary changes to avoid getting to this point. Hopefully this will make it harder for the Franks of the world to set up systems that are destined to fail in the long run. But I’m not optimistic.
I disagree, though, with the notion that debtholders are due their spreads for taking Caplan risk. Buyers made that bet with the GSE and there is no reason in my mind for the Treasure (read “taxpayers”) to pay up. The bailout should have dropped all debt to treasury rates in exchange for giving them treasury risk. This would time consistent with the idea that debtholders also provide discipline without violating the implicit guarantee. If the expected return were
prob(survive)*promised return + prob(gov takeover)*t-rate
prob(Caplan is not named Treasury Sec)*promised return
then the promised return would have to rise quickly when the prob(survive) falls. Future GSE-types would blow up a lot faster, saving us (read “taxpayers” again) a lot of money. This is the real opportunity lost.
Sep 10 2008 at 8:04am
what I don’t understand is that the government seems to be able to do whatever it wants to the equity holders, but the bond holders either get all or nothing. Why couldn’t they have said that they are taking over fannie and freddie and paying off the bondholders 99 cents on the dollar. Bill Gross might not have liked it, but it doesn’t seem like it would have killed anyone, and it would have saved the taxpayers a lot of money.
Sep 10 2008 at 8:50am
I still wonder what kind of back room deals were struck between the US Treasury and foreign countries like China that hold large chunks of GSE debt. Were we told what some of the conditions would be?
Sep 10 2008 at 10:23am
Nice explanation of the situation.
Is it Barney Frank who deserves the blame, or maybe Bush? (link)
Sep 11 2008 at 10:07am
Is it Barney Frank who deserves the blame, or maybe Bush?
Ah, Mike Oxley of SarbOx. Considering that Mike Oxley was one of the key members of the House preventing additional oversight of FM/FM, it’s not surprising that he’d attempt to defend himself. The WSJ has been attacking him for years, before the bailout and now.
Sep 25 2008 at 4:00am
Lets cut through the bullshit..and call a spade a damn spade. The bailout gives wallstreet another 700 billion…yes thats about a trillion to squander. The tax payers foot the bill for the bailout and the rich wallstreet powers that be get more of our money to lose again.(say 3 -5 years at best). Come on America its time to take our lumps now and stop deffering the enevitable…let the markets crash so that they can start fresh without taking on an extra trillion in debt that will now doubt be squandered.Let the global markets feel the effect of our nations woes so that they might finally appreciate what we have provided for them…( a market to trade in ).90% of us will still go to work once the (big scary boogie man) takes his toll on the markets. So nothing will really change for Mr. and Mrs. Middle to Lower class America. Notice that the only people preaching doom and destruction are the people who make more in a day than you or I do in a lifetime.
( or say 20 years). Wake Up for Christ sake!!!
Isnt anyone else tired of being whipped by Washington and Wallstreet? “Lets spend 4 billion a week to make “democracy” in muslim nations….Lets spend 700 billion and keep the status quo of the rich getting super rich and the working class going broke”…If our founding fathers could see the shit thats going on they would arm themselves and start hanging the crooks and treasonist bastards responsible for crushing our nation. They sure wouldnt hand them money to keep doing it. In case you havent read the Constitution or maybe you just dont think it applies to reality…we ( Civilian Americans) have the RIGHT to bear arms and overthrow our government when it becomes “oppressive”. If being handed a 700 billion dollar bill without being told how its going to be spent isnt oppressive than I really dont know what else to say. Imaging “Changing Washington” by removing everyone there, starting new and letting the so called financial experts that created this mess take responsibility for it. So they go broke, big F’in deal. Who isnt?
Read your history. We went to war with England for less than what we are being asked to endure.
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