Housing Doom

twist -

You are bringing up a good point here. You will recall that retired (and sorely missed) St. Louis Fed President Bill “The Butcher” Poole has been sounding alarm bells on this for many years. Just after 9/11 he started worrying at the concept of too big to fail. At this point he is tacitly implicating the GSEs in his worries by placing them right after his TBTF discussion.

The statutory responsibility of the FDIC extends only to the first $100,000 of deposits held by a particular individual in all accounts at a depository institution. However, as a consequence of the bailout of Continental-Illinois Bank in 1984, it became clear that in practice the government was following what the market usually calls a “too big to fail” policy, but which is more properly called a “too big to liquidate quickly” policy. Whatever term is used, the policy means that for large banks all deposits, and not just insured deposits, may be guaranteed; clearly though, shareholders and managements are vulnerable to loss. The extent of this de facto extension of government insurance of depository liabilities beyond the statutory provisions has never been precisely defined. In the event of problems at another large bank, the markets will be uncertain of the extent to which the government will cover losses that large, uninsured depositors might suffer.

Another class of financial intermediaries is government-sponsored enterprises, or GSEs. These are instrumentalities of the federal government and not fully private. They are established and chartered by the federal government to accomplish specific policy goals. However, they may have private shareholders who receive dividends and enjoy most of the rights of fully private firms. The mission of the housing GSEs-including Fannie Mae (originally named the Federal National Mortgage Corporation), and Freddie Mac (originally the Federal Home Loan Mortgage Corporation) and the Federal Home Loan Bank System-is to facilitate the flow of credit to mortgage borrowers. In addition to the housing GSEs, other financial GSEs include the Farm Credit System, the Federal Agricultural Mortgage Corporation (Farmer Mac), the Financing Corporation and the Refinancing Corporation (both set up to resolve failed savings and loans in the early 1990s), and the Student Loan Marketing Association (Sallie Mae). There are also non-financial GSEs such as the Post Office and the Tennessee Valley Authority.

All of the financially oriented GSEs together controlled financial assets of $2.125 trillion at the end of the second quarter of 2001, with the lion’s share accounted for by the three housing GSEs. A major activity of the housing GSEs is to purchase mortgage loans from originators like commercial and mortgage banks, and then package them in the form of mortgage-backed securities, which are guaranteed and sold to investors. The pool of outstanding government-related mortgage securities amounted to $2.636 trillion at the end of the second quarter of 2001. This figure includes mortgage-backed securities from Ginnie Mae, the Veterans Administration, and the Federal Housing Authority, which are not GSEs but instead are agencies of the federal government carrying the full faith and credit of the government.

Poole had sharpened his thoughts on this by the time he gave this late 2004 speech in Prague, when he addressed the GSE issue head-on.

Unchecked, growth of financial firms deemed too big to fail will steadily increase the risk of financial crisis. To some extent, the risks can be mitigated through enhanced regulation. However, in my view the solution to the problem will require a change of doctrine, from “too big to fail” to “too big to liquidate quickly.” Such a change would reintroduce risk to those who provide capital to these firms and therefore change the incentive structure in the market. I do not believe, however, that regulation can ever be a complete substitute for a proper incentive structure in the financial markets.
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Another troubling issue in the United States is that the GSEs by law are not subject to normal bankruptcy procedures. Creditors’ rights in the event of a GSE insolvency are, therefore, unclear as are the procedures that would be followed to resolve a bankrupt GSE. This problem is correctable, and should be corrected promptly.

Some readers may recall my Doomish “movie review” of “Debt in the Afternoon” (2005), starring the American Enterprise Institute’s Peter Wallison. In that recorded seminar, AEI’s banking gurus examine in depth the need they see to put Fannie and/or Freddie into bankruptcy if things get too hairy. At present, as Bill the Butcher pointed out, there is no legal way the GSEs can go into bankruptcy (it’s an issue in the reform legislation moving frantically through congress ahead of the election — and catastrophe).

As a regular reader of Slashdot.com, I believe you need to add the tag “Sudden breakout of common sense”