Arnold Kling  

The Risk Disclosure Problem, Revisited

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Ricardo Caballero writes


no institution is immune to panics, as long as it is providing its socially useful liquidity transformation and intermediation role.

Thanks to Tyler Cowen for the pointer. This is very consistent with the view I put forth in The Risk Disclosure Problem, where I used Freddie Mac as an example of a firm that used to handle it correctly.

Freddie and Fannie, until very recently, enjoyed low costs of raising debt and equity. The low cost of debt was mainly due to a perception that the government would not allow them to fail. The taxpayers are silent shareholders, so to speak.

The low cost of equity was due to a perception that they were using their low cost of debt to achieve tremendous profits. As long as their profits were sound, they could raise capital from normal shareholders, rather than depending on the silent shareholders.

The equity advantage is no more. Investors are no longer convinced that the firms are solidly profitable. Freddie and Fannie stock prices are not going to return to their highs. Under any policy response. It does not matter whether you are sympathetic with their shareholders, as Caballero is, or whether you are hostile to their shareholders. The stocks are Monty Python's parrot. They are Humpty-Dumpty after the fall. You cannot put them back together.

My instinct is to prop them up somewhat, but to allow other firms to grow in the mortgage market. As I wrote today, if the playing field were level, then banks could do more.

If the government takes over Freddie and Fannie, I see more downsides than upsides. One downside is that you will have the mortgage market operating on the basis of the government's credit rating. For now, that may seem like a good thing for mortgage borrowers, giving them cheap rates. Before long, it may seem like a horrible thing--imagine what would happen if the U.S. Treasury lost the confidence of investors the way that Freddie and Fannie did.


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COMMENTS (3 to date)
Gary Rogers writes:

Is the scenario you describe for Fannie and Freddie that much different than what has happened with the US Government as a whole? Everyone assumes that the United States has infinite resources so they are willing to loan us money at very low interest rates. When you dig deeper and see trillions of dollars of debt with no forseeable ability to balance our budget, the investment becomes less attractive. I was hoping we could prove that we could balance our budget in a period of prosperity before this realization became common knowledge. If we have to prove that we can balance our budget during a severe recession, we will be thrown back into the bad policies of Herbert Hoover and Franklin Roosevelt.

As far as the solutions you propose for Fannie and Freddie, I agree.

Dr. T writes:

There never was a good reason to form Freddie Mae or Fannie Mae, and they should be dissolved with the losses spread among the shareholders. Banks and other mortgage lenders can acquire the existing loans at face value (the good loans) or at negotiated discounts (the subprime loans). Let's take all our lumps now instead of dragging out the recovery process for years.

Lord writes:

Do you really think we won't see this sometime, perhaps not this decade, perhaps not this century, but eventually? Seems inevitable to me.

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