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Question re Fannie/Freddie:

As I understand it, the common and preferred shareholders are basically being wiped out, but the government is backing Fannie and Freddie's existing debt, the value of which therefore rose. So here's my question: if Fannie and Freddie were heading for bankruptcy but for the government's intervention, why didn't the Treasury Department bargain hard with major holders of their existing debt (such as the Chinese government), and threaten to let Fannie and Freddie go bankrupt unless the debtholders agreed to write down the value of the debt? After all, there was no explicit guarantee of such debt, and Treasury still could have agreed to explicitly guarantee FUTURE Fannie and Freddie debt.

The way the bailout is structured, it seems that Fannie and Freddie shareholders, and the American taxpayer, are paying the price, but holders of the GSE's debt get made whole at the latter's expense. Why?

J. Aldridge:

Given their history of innovation in mortgage-backed securities, why do Fannie and Freddie now generate such substantial concern? The unease relates mainly to the scale and growth of the mortgage-related asset portfolios held on their balance sheets. That growth has been facilitated, as least in part, by a perceived special advantage of these institutions that keeps normal market restraints from being fully effective.

The GSEs' special advantage arises because, despite the explicit statement on the prospectus to GSE debentures that they are not backed by the full faith and credit of the U.S. government, most investors have apparently concluded that during a crisis the federal government will prevent the GSEs from defaulting on their debt. An implicit guarantee is thus created not by the Congress but by the willingness of investors to accept a lower rate of interest on GSE debt than they would otherwise require in the absence of federal sponsorship.

--Alan Greenspan, February 2004
9.9.2008 1:41am
Order of the Coif:
The Saudi royal family must own a bunch. And the Emir of the UAE, the whatever of Kuwait, etc.

You know, the "owners" of America.
9.9.2008 1:44am
DavidBernstein (mail):
Well, investors may have concluded this, and they could have turned out to be wrong. The government could explicitly guarantee FUTURE GSE debt, thus keeping the mortgage markets functioning, while refusing to fully guarantee past debt where there was no such guarantee. True, the Chinese and others may have bought such debt expecting the government to stand behind the debt. But the shareholders of Freddie and Fannie bought their shares expecting that Freddie and Fannie were conducting themselves in an honest and responsible manner. When you invest based on bad information, you pay the price. This should apply to the debtholders as well as the shareholders.
9.9.2008 1:45am
neurodoc:
It may be that there wasn't time for protracted negotiations with debt holders; that the debt holders might have been willing to let it go to bankruptcy, while the Treasury wasn't; that the possibility of a Mexican standoff was feared; that there were countervailing diplomatic considerations; that all would have been made worse if it landed in the courts; etc. Dunno, but those are my anateurish speculations.

["made hold," or "made whole"?]
9.9.2008 1:45am
RSF677:
If you play hardball with regard to the existing debt, you may run into trouble getting these people to buy future government and GSE debt.
9.9.2008 1:46am
Nate in Alice:
Wait, I thought the taxpayers were already funding Fannie and Freddie....isn't that what Sarah Palin, the most experienced VP candidate ever according to Jim Lindgren said?
9.9.2008 1:47am
J. Aldridge:
To follow up from above... I guess the answer is there is also a "implicit guarantee" to shareholders even though it does not exists in writing!
9.9.2008 1:47am
J. Aldridge:
[b]Nate in Alice[/b]: Wasn't she speaking of the present and not the past?
9.9.2008 1:51am
DavidBernstein (mail):
If you play hardball with regard to the existing debt, you may run into trouble getting these people to buy future government and GSE debt.
I don't see why that should be, when one is explicitly backed by the full faith and credit of the U.S. gov't, and the other was not. And GSE debt, as I recall, was a bit more expensive than U.S. gov't debt, so there was some recognition that it might not be quite as secure.
9.9.2008 1:58am
neurodoc:
When you invest based on bad information, you pay the price. This should apply to the debtholders as well as the shareholders.
Shareholders lose before debtholders, don't they, with the former in the game for potentially greater gains or greater losses, the latter for the lesser of both, but with more security, ne c'est pas?

The Treasury's preoccupation was not to soften the landing for shareholders. It wants others continue lending to Fannie and Freddie, which they might not be so willing to do if the Treasury let them be burned now, notwithstanding government guarantees of new debt.

"Equity" in the sense of justice or fairness was not the pre-eminent consideration in this; rather, stopping an economic meltdown was.
9.9.2008 2:00am
Eli Rabett (www):
You planning on retiring some day. Look where your money is.
9.9.2008 2:02am
Christopher Hagar:
If retail and investment banks hold this debt, a significant loss to them is a significant loss to the already battered balance sheets which represent much of the wealth of Americans. Preventing such a precipitous loss is the purpose of the Fed's and Treasury's actions up to this point.

The American taxpayer already held the bag for these losses, in his IRA and in his savings accounts, he just doesn't know it because the assets were and are marked to artificially high values.
9.9.2008 2:05am
DavidBernstein (mail):
Yet the debt is worth MORE today than it was Friday, so the Treasury didn't just preserve existing assets, it inflated their value.
9.9.2008 2:07am
neurodoc:
I think I read in one place today that Fannie and Freddie avoided sub-prime mortages and in another that they did buy sub-prime securities. Which was it?
9.9.2008 2:09am
Nate in Alice:
J. Aldridge,

She said: they "had gotten too big and too expensive to the taxpayers."

That's the past tense, I believe.
9.9.2008 2:10am
neurodoc:
Yet the debt is worth MORE today than it was Friday, so the Treasury didn't just preserve existing assets, it inflated their value.
Would it have been better if the debt were worth LESS today than it was Friday? I don't think so.
9.9.2008 2:14am
Christopher Hagar:
The Treasury is happy to raise the value of the assets of banks. The assets were not worth what they were valued on Friday, and they are worth what they are valued today only because they are supported by a long-term mortgage on tax revenue. The U.S. banking system is already insolvent but for the Federal Reserve.
9.9.2008 2:20am
Nathan_M (mail):
No one has quoted Tyler Cowen, who probably knows more than all of us combined on this, so I will. He doesn't pain a rosy picture.

But let's say that the Treasury did not support the debt of the mortgage agencies. The Chinese bought over $300 billion of that stuff and they were told that it is essentially riskless. The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly. The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value. Most of the U.S. banking system would be insolvent. Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot. The rate of unemployment would climb into double digits and stay there. Many Americans would not have access to their savings. The future supply of foreign investment would be noticeably lower. The Federal government would lose its AAA rating and we would pay much more in borrowing costs. The deficit would skyrocket.


He doesn't explain why though, but it's scariness makes up for being conclusatory.

I can't explain all of it, but much of the banking system would be insolvent because banks hold a lot of their reserves in debt issued by Fannie and Freddie because it was regarded as so secure. (Along with treasury bonds paper from Fannie and Freddie was one of the few assets regarded as secure enough for banks to pledge as security for overnight loans from the Fed.) If they default they will take a lot of banks down with them.
9.9.2008 2:22am
DWAnderson (www):
The post raises a fine question. As far as I can tell it was a combination of (i) not wanting to undermine other present and future impicit federal guarantees, and (ii) FNMA dent is held by a variety of financiial institutions, which could have been left severely undercapitalized had the Treasury played hardball (this would raise the spectre of other financial crises). For better or worse, the whole point of the takeover was to prevent a bailout to stockholders while avoiding many potentially the nasty side effects of a default on FNMA debt.
9.9.2008 2:24am
kdonovan:
My understanding is that the risk of contagion to banks holding the debt is why the government decided to honor it. Still a modest haircut for debt holders (5-10%?) or interest payment holiday might have been a good idea for equity sake and to reinforce the idea that institutions that make bad investment decisions will bear (some of) the pain when they fail.
However the other (and much bigger) problem is how foreign investors perceive the issue - it would be a VERY bad precedent if the US government even got a hint of a reputation for repudiating (what are perceived as its) debts.
The self-dealing of the GSEs, their management, their lobbyists, and many congressmen etc. has been known for years but no one cared enough about the issue to fix the problem.
9.9.2008 2:30am
DavidBernstein (mail):
Would it have been better if the debt were worth LESS today than it was Friday? I don't think so.
Yes, if there had been an agreement with the largest debtholders to write down, say, 15% of the debt. Taxpayers could then be largely off the hook, and U.S. gov't in future couldn't get away with creating hybrid monstrosities like Fannie and Freddie. Tyler is probably right that actually allowing the GSE's to default would be a bad idea; but getting the investors in their debt to share a fraction of the pain still seems to me like good policy. (And, for the record, I don't own shares of either company, except probably a bit through mutual funds, and I intentionally avoided buying anything that held their debt).
9.9.2008 2:32am
DavidBernstein (mail):
KD is probably correct, that this is an extra bailout for irresponsible banks, disguised as a GSE bailout.
9.9.2008 2:35am
kdonovan:

"Wait, I thought the taxpayers were already funding Fannie and Freddie....isn't that what Sarah Palin, the most experienced VP candidate ever according to Jim Lindgren said?"


Sarah Palin? Being up in Alaska she is the least blame worthy of the 4 candidates - not having been in the Senate while this mess percolated over a decade or more. It is Biden's (bi-partisan) buddies on the Senate Banking committee and their House counterparts over the last decade who have allowed this mess to fester and fought back against any attempt to clean things up.

It's not like everyone hasn't known that Fannie Mae and Freddie Mac are a cesspool of congressionally sanctioned corruption and repeated accounting scandals who liberally spread around lobbying money and campaign contributions (plus specious arguments that they were supporting low income housing and other community reinvestment scams) to all but bribe congressmen and senators to allow their chicanery to continue.
9.9.2008 2:43am
Jay Myers:
David, the reason the feds are backing the existing debt is because dollar-denominated debt instruments are already at a significant disadvantage due to the weakness of the US dollar, which has caused most of the 'usual suspects' who buy US debt to shy away from making any more purchases.

Those who then stepped in to the gap to buy US debt (such as China) are experiencing their own economic stability that makes is far less feasible for them to continue to buy US debt, which not only finances our mortgage system, but also our massive federal debt.

In other words, we don't want to do anything that might make them even less likely to lend us additional money or else we will find ourselves unable to raise enough money to cover our annual deficits and might have to confront the fact that our federal government is insolvent due to decades of reckless spending on bread and circuses.
9.9.2008 3:50am
Tom Hanna (www):

allowing the GSE's to default would be a bad idea; but getting the investors in their debt to share a fraction of the pain still seems to me like good policy.


Isn't that still a possibility, with the entities in conservatorship?

I had read somewhere that the common and preferred shareholders were not going to be entirely wiped out. Banks also hold a substantial amount of common and preferred shares, as well as the debt securities. The shares lost 80% of their value Monday, which is still not 100% and we're told markets are pretty good at predictions. I gather that a big part of the pain for shareholders is going to come in the form of dilution as the government's "investment" ends up dwarfing the existing capital.
9.9.2008 3:55am
RE:
Isn't this just an example of a "transitional gains trap" (see Buchanan and Tullock - I think...)? Because the rules of the game created such perverse incentives, there are no good solutions, no good way out of the mess because the rules of the game have to be changed in the middle of the game ("fixing" social security is similar in this respect). And it is a lot easier to spread the costs around millions of anonymous pocketbooks (taxpayers) than identifiable bondholders.
9.9.2008 4:44am
A. Zarkov (mail):
"The Chinese bought over $300 billion of that stuff and they were told that it is essentially riskless."

Who told them that? This is one of the problems with writing in the passive voice. Whoever told the investors that the "stuff" (this means their debt I suppose) is "riskless" is guilty of malfeasance. Normally I read the prospectus before I invest and if it says "not guaranteed" I assume it means exactly that and act accordingly. If a bond has a return greater than a T-Bill you can be sure there is risk somewhere because that's why its selling at a discount.
9.9.2008 7:28am
Modus Ponens:
David,

From the WSJ:

Foreign central banks had been among those voicing concerns in the weeks ahead of the government's seizure of Freddie and Fannie. The banks had steadily reduced their holdings of debt in the two firms in recent weeks as the turmoil around the firms worsened.

China's four biggest commercial banks, too, pared back their holdings in agency debt, with Bank of China Ltd., the largest holder of Fannie and Freddie securities among these banks, saying it sold or allowed to mature $4.6 billion of the $17.3 billion it held as of June 30, down from more than $20 billion at the end of last year.

Does the U.S. gov want these banks to continue to roll-over this debt, or would it prefer that they take their ball and go home?

Negotiating a write-down under the threat of bankruptcy would push credit spreads for mortgage-related debt through the roof and scare away foreign central banks (of which there are comparatively few, remember, relative to shareholders) which would in turn further stifle mortgage financing.

A U.S.-backed guarantee of future debt would lower these spreads, it's true, but it's unclear to me whether foreign banks would find this move attractive. "Why don't I just buy Treasuries?" they might ask.

Also worth quoting from the above-linked article:

Like many investors, foreign governments, particularly central banks and sovereign-wealth funds, believed the U.S. government implicitly stood behind Fannie and Freddie and would prop them up to prevent a failure. ...

In his public comments Sunday, Mr. Paulson said the "ambiguities" in the firms' congressional charters led foreign central banks and investors in the U.S. and around the world to believe the firms' debt was "virtually risk-free."

"Because the U.S. government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings," Mr. Paulson said.

To paraphrase: a "reasonable belief" trumps the "freedom of contract" when foreign banks and sovereign funds are on the hook ;-)
9.9.2008 8:00am
A. Zarkov (mail):
Tyler Cowen does not give us the probabilities for his chain of causes and effects. Is he asserting his dire consequences are certain? Here's is another scenario. What happens if the US Treasury can't support a major wave of mortgage defaults without printing money or putting the Treasury bonds at risk of default? Then the the US credit rating does fall from AAA as a result of the bailout. It's a perverse policy to put the the bonds the government explicitly backs at risk in order to support agency bonds it explicitly states it doesn't back.
9.9.2008 8:27am
DavidBernstein (mail):
In his public comments Sunday, Mr. Paulson said the "ambiguities" in the firms' congressional charters led foreign central banks and investors in the U.S. and around the world to believe the firms' debt was "virtually risk-free."

"Because the U.S. government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings," Mr. Paulson said.
This is the first time I've heard ANYONE claim that there was any ambiguity that would suggest that the debt was guaranteed, as opposed to just a feeling that, as turned out to be correct, the U.S. gov't would ultimately step up in Fannie and Freddie were in trouble. Every article I read until now suggested that there was no LEGAL guarantee of this debt, and if I knew that, the Chinese et al. should have as well.
9.9.2008 9:15am
TCO:
It's political. They don't want the embaressment of a bankruptcy and possible ripple bankruptcies. It will end up costing the US taxpayer as he bails out debtholders. Also, it will have minimal impact on future debt raised by Fannie/Freddie (sunk cost theory, need for new gaurantees for new money).
9.9.2008 9:49am
ejo:
nate, nate, nate-they are costing taxpayers. certainly, you are wrong to imply that they are private companies just like any other. again, did the S&L collapse not cost the taxpayers money because they were private companies?
9.9.2008 10:30am
wm13:
It's a benefit to a government (or anyone else) to be able to give implicit guaranties and have the market assign them significant value. The price of that benefit is that you have to make good on the guaranties except in the most dire of circumstances. (Like a killer asteroid strike, or losing a war and suffering a major annexation of territory.) If you renege on an implicit guaranty in the midst of a garden variety credit crunch, your future implicit guaranties won't have any market value. I think Paulson et al. make the right decision, that this isn't the right moment to throw away (or cash in on, if you prefer) the United States government's credibility.
9.9.2008 10:35am
Rabia (mail) (www):
"This is the first time I've heard ANYONE claim that there was any ambiguity that would suggest that the debt was guaranteed, as opposed to just a feeling that, as turned out to be correct, the U.S. gov't would ultimately step up in Fannie and Freddie were in trouble"

Of course there was ambiguity. Read this report, which was presented to Congress, from the state department website.

fpc.state.gov/documents/organization/107216.pdf
9.9.2008 11:16am
Deoxy (mail):

J. Aldridge,

She said: they "had gotten too big and too expensive to the taxpayers."

That's the past tense, I believe.


Yes, but's it's a reference to the blank check given to them a couple of months ago - basically, that the government was going to "prop up" FM &FM.

Essentially, we were already "on the hook" for them, but they were free to choose how to spend the money - that's been the strong implication from the government for years, but they made it official a couple of months ago.

So, I am running a business that is "private" in terms of what I can do with the company's money, but "public" if we run out of money? Yeah, there's a recipe for success... all reward, no risk. Oddly enough, the executive took the money and ran.

I'm shocked, SHOCKED to discover... oh nevermind.
9.9.2008 11:19am
Rabia (mail) (www):
Maybe I should clarify -- there was obviously no legal guarantee. But to deny that there was ambiguity, as to the real actions of the federal government if and when the GSEs should need to be bailed out, is silly, especially considering that this is exactly what happened.

As to your question about why the Treasury Department is not "bargaining hard" with the holders of Fannie and Freddie's debt... Even Nouriel Roubini, who has been one of the few commentators who are critical of this bailout plan is not suggesting that they do this since the last thing anyone wants is for these foreign investors to flee the agency market.

The question you should be asking is why the bailout plan contains intentions to buy an unspecified number of mortgage back securities through December 2009.
9.9.2008 11:23am
neurodoc:
It's not like everyone hasn't known that Fannie Mae and Freddie Mac are a cesspool of congressionally sanctioned corruption and repeated accounting scandals who liberally spread around lobbying money and campaign contributions (plus specious arguments that they were supporting low income housing and other community reinvestment scams) to all but bribe congressmen and senators to allow their chicanery to continue.
I would like to know more about the alleged "corruption," "repeated accounting scandals," and "chicanery."

Is "corruption" supposed to mean that which could be prosecuted as crime (a la Enron), or is it to be understood as the more commonplace venality and deception? If the former, I would be most interested in hearing the details, in particular the "what," "who" and "how." ("When" not critical, and "why" self-evident.) If the latter, would be interest again in the "what," "who," and "how," but a bit less so.

"Repeated accounting scandals." I am aware that a few years ago there were accounting "issues" at Fannie that led to the sacking of Raines and unsuccessful attempts to get back bonuses paid to him, and that Freddie too manipulated their numbers and their top management was canned. Also, I read that when the Treasury and invited outsiders looked at Freddie's books recently, they were dismayed to find things worse than anticipated, Freddie's capital overstated because securities they were holding hadn't been marked down to reflect what they were really worth. So my question...how much of the current mess is traceable to accounting shenanigans, or were accounting shenanigans more or less incidental to what we have now? If only regulators had known, they would have acted and this catastrophe would have been avoided? If housing prices had not cratered, this wouldn't be happening, would it?

"Chicanery." Same questions as above about "corruption" and "accounting scandals." More "chicanery" on the part of Fannie and Freddie than other major players, or everybody was engaged in the same dangerous game?

A short time ago, the accounts I was reading were condemnatory of those running Fannie and Freddie for getting caught up in the "foolish exuberance" of these markets before they crashed, Congress for pushing the two to lend when they shouldn't have, regulators for not riding herd on them, etc. Now, what I am reading seems to be less condemnatory and more "understanding," with Paulson sounding like this was a natural disaster rather than one attributable to clearly identifiable parties. Do others share my impression, that is that less blame is being handed out now than before? Is what we are reading, especially "official" utterances by Paulson, Bernacke, et al., infused with politics and colored by a need to reassure, so we are getting less than truly objective assessments?
9.9.2008 12:47pm
hey (mail):
nero - yes paulson is being reassuring so as not to spook the horses. corruption - executives were manipulating earnings to inflate their compensation; these executives gained their roles through political connections (Raines,Goreick, Johnson) and looked to maintain FM^2's privileges through the employment of congressional relations, political donations, and a large lobbying effort.

You could hvegone after the corruption and such when FM^2 were doing fine, but to do so in a paniced market would be excessively destructive.
9.9.2008 1:19pm
neurodoc:
hey, so "corruption" in the venal sense, nothing frankly criminal?

"manipulating earnings to inflate their compensation" - that was a few years back, wasn't it, and how would it relate to this catastrophe? Wasn't that financial finagling about "managing" earnings and their timing so as to push up the stock value and reap outsized, unearned bonus for Raines and others, rather than about overstating capital reserves, which are so fundamentally important now?

"these executives gained their roles through political connections (Raines,Goreick, Johnson)" - the same Johnson, a Washington "outsider," upon whom Obama was going to rely so heavily until he was called out on it?

"looked to maintain FM^2's privileges through the employment of congressional relations, political donations, and a large lobbying effort." - also through large charitable contributions, especially in the Washington, DC area.

"You could hvegone after the corruption and such when FM^2 were doing fine..." - but my questions remains how much true "corruption" contributed to this disaster. If Raines et al. hadn't screwed with the financials so as to feather their pockets, would that have made any difference? It had nothing to do with the cratering of home prices and the disasterous economic consequences that has brought. You could say that the reckless pursuit of profits got Fannie and Freddie into that which should have been avoided, but is it informative to call that "corruption"? There is a difference between misfeasance and malfeasance, isn't there? Any malfeasance in the picture here?
9.9.2008 1:45pm
K:
At this point there was no sense in letting the Mae's fail.

Those failures would just trigger failures of banks and enrage foreign governments and investors who hold large quantities of the securities. Over time that would be worse than taking over control.

As for the stockholders. First they made the decision to buy the most least secure of equities. You win and lose. But now stockholders have a chance that the government intervention will be successful and the stock will gain value.

The government did not seize ownership, they seized operational control. Given the performance of those replaced I think that is probably best for stockholders.

IMO both companies were totally corrupt and hundreds should be prosecuted. But that is a guess. No one can know at this point. And almost certainly there will be no serious investigation.
9.9.2008 4:46pm