The Risk Disclosure Problem, Revisited

Ricardo Caballero writes

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

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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