Arnold Kling  

Not Fannie Mae!

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Speculator of Last Resort?... Another Parable...

Brad DeLong writes,


If I were Treasury Secretary Hank Paulson, I would spend the weekend building a legislative vehicle to introduce Monday morning on an emergency basis to give Fannie Mae the resources and the mission to undertake this mortgage rescue operation, and I think Fannie Mae is the right institution for the task: why does it have its government-sponsored status and guarantee if not to be used for purposes like these at times like these?

With all due respect to Brad, this is a horrible, horrible idea.

Granted, it appears that the market loves Treasuries and hates mortgage-backed securities (MBS), and this is causing a lot of indigestion on Wall Street. But tasking Fannie with making a big bet on MBS would be an extreme example of privatizing profits and socializing losses.

If the bet pays off, Fannie Mae shareholders will take the profits. If the bet goes bad, taxpayers will take the hit.

I would rather see the Fed make the bet on MBS. If there is a profit opportunity in shorting Treasuries and buying MBS, then the Fed is in a great position to take advantage of it. The Fed has lots of Treasuries on its balance sheet that it can swap for MBS.

Those of us who think that the spread between MBS and Treasuries is an anomaly should be careful, however. The spread consists of both anomaly and option value. A mortgage has two valuable options--a prepayment option and a default option. The lender is short both of those options, which explains why MBS ought to have a higher rate than Treasuries.

The default option becomes more valuable as house prices become more volatile, which they have. The prepayment option becomes more valuable as interest rates become more volatile, which they have.

Finally, our political leaders in their infinite wisdom have added a third option, which is "neither pay your mortgage nor default, but instead wait for us to come up with a 'plan' to reduce your interest rate, your loan balance, or both." This "play-the-victim" option is yet another legitimate reason for the MBS-Treasury spread to be wider than it has been in twenty years.

I continue to be a liquidationist. Get the unqualified borrowers out of their houses, and let the underlying housing market start to function.


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COMMENTS (5 to date)
liberty writes:

It seems to be - ignorant though I am on this topic - that it is another area where conventional economics has gone wrong through its use of static models. If you looks at Brad's graphs, they are reasonable. There is something that government can do that might work. Not sure that it not only "rescues the financial system but makes money for the taxpayer" but whatever, lets say that's true.

That is a picture made up of only one frame of the movie. When you freeze the world you can move things around, redistribute, find a better Pareto optimal solution, abracadabra!

And then you wake up.

The defense is that, while redistribution via taxation and social programs is ongoing and hence can distort prices and incentives, this is a really important one-time thing, where government has to bail out the economy to prevent a collapse of one sector destroying the whole rest of the economy.

So, there are two parts, they argue its (1) really important, and (2) a one-time thing.

As to (1), they make the same argument about health care and all kinds of other things. Externalities, effects on other sectors, etc. But the more important it is, the *less* you want government to handle it, if government can't do a good job. So, this argument depends on already having another argument to show how government won't screw this up.

(2) says that, while the hangover from other interventions comes when incentives are distorted, this won't happen here because its a one-time thing. But, when economists start looking to past recessions to see what government interventions worked best during those periods, you have to wonder whether *all* of them were one-time things?

Anthony writes:

"I continue to be a liquidationist. Get the unqualified borrowers out of their houses, and let the underlying housing market start to function."

What about sale-leasebacks? Get the mortgage companies out of the business of being landlords, and get creditworthy individuals who can work one-on-one with lessees into that business.

These high LTV mortgages given to low credit score individuals work out to be not much different from rental agreements. Add in negative amortization and it's even closer. But mortgage servicing companies don't have enough staff to act as landlords, and with the way MBS is traded (and the government interventions taking place) they don't have the incentives either.

Dr. T writes:

The commenter with the ironic handle of 'Liberty' does not seem to understand that freedom also means freedom to fail.

The proposed 'one time' bailout of part of an industry that, through its own greed-driven reckless behavior, is now facing massive financial losses, would be a disaster. We already have seen 'one time' bailouts of a failed auto manufacturer, failed banks, and homeowners and businesses who failed to secure adequate flood or disaster insurance. The message the federal government is sending is that financial irresponsibility will sometimes be rewarded by taxpayer-funded bailouts. This rewards reckless behavior and thereby encourages more. I agree with Arnold Kling: let the reckless lenders and borrowers (and not the taxpayers) pay the price and let the rest of us move on. The economy won't die because some lenders go bankrupt.

liberty writes:

Dr. T,

Mine was an argument against such a bail-out, in part because it would not be a one-time thing. I think you must have jumped to react before reading the comment carefully.

R. Richard Schweitzer writes:

For major effect, the best move would be to absorb (nationalize formally) Fannie & Fredie into the GNMA format.

That would put the nature of the backing behind a large body of mortgage assets at greater verity.

With one body of assets having a clearer baseline for "valuation," many others would begin to fall in line. How much would the nationalization cost right now at market prices for their shares? Less thna other forms of backing? Probably!

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