Arnold Kling  

Too Big to Bail?

Fairness Norms Breaking Down a... The Consensus Economic Platfor...

James Hamilton writes,

The overriding concern in dealing with the current mess is that the process of rapid and radical deleveraging would so impede the flow of new credit that the housing price declines, foreclosures, and bankruptcies significantly overshoot the values that we'd expect in a properly functioning credit market. In addition, I would worry about possible serious repercussions of a flight of foreign capital if there is a sudden perception that agency debt entails heavy risks.

...My recommendation would therefore be for a managed bailout in which the stockholders, creditors and taxpayers jointly share the bill.

For at least ten years, and perhaps twenty, the correct public policy objective has been to freeze or shrink Freddie and Fannie in terms of their share of the mortgage market. Instead, Congressional pressure has gone in the other direction, as recently as the currently-debated housing bill.

Indeed, there are a number of public servants in the executive branch who have held this view for a long time. See Greg Mankiw. It could be that some of these folks put out the story in the last few weeks that the government was worried about the health of Fannie and Freddie, in the hopes that this would weaken their stock prices and slow the momentum of the housing bill. If so, then these folks got a bit more than they bargained for in terms of results.

The growth of Fannie and Freddie has been such that they are beyond too big to fail. They are actually too big to bail. With an ordinary bank, regulators can facilitate a merger by buying some of the bad assets. With Freddie and Fannie, there is no merger partner big enough. Furthermore, the problem is not that they have some bad assets. The problem is that without investor confidence Freddie and Fannie's borrowing costs rise, and without low borrowing costs they cannot function.

In any case, the goal now should be to get more mortgage debt distributed to banks. My recommendation would be to lower the capital requirements for banks for holding mortgage-backed securities and for making investment-quality mortgages. The latter are mortgages with 20 percent down payments or 10 percent down payments with another 10 percent in mortgage insurance.

If banks are able to expand their holdings of mortgage securities, then Fannie Mae and Freddie Mac will be able to liquidate some of their assets without selling at a huge loss. That way, they will not have to borrow so much in the capital markets. If they are solvent, they can come back to the capital markets when they are able to demonstrate that they do have adequate earnings and equity.

UPDATE: For more background, see this New York Times piece.

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COMMENTS (3 to date)
stanfo writes:

This is something I haven't heard discussed about Basel II. Regulators should be given the power to adjust the capital requirements for specific asset classes as needed.

This would be great for smaller banks using the standard method for capital ratios. This is both a practical and brilliant solution to the problem of illiquidity.

Of course, other countries would need to adjust as well to stay competitive.

Dr. T writes:
James Hamilton writes, ...I would worry about possible serious repercussions of a flight of foreign capital if there is a sudden perception that agency debt entails heavy risks.
I find this confusing. We have been experiencing a big influx of foreign investment due to our high interest rates (and resultant low foreign exchange rates). Would additional loan failures at Freddie and Fannie Mae be devastating enough to overcome a prime rate that is 1% higher than most of Europe and over 3% higher than Japan?
Mike writes:


I have been away from the mortgage lending market too long to know the answer to this question but what happened to the old fashion notion that a prudent loan was one that required 20% down and if you wanted more leverage you had to pay a mortgage insurance company to insure the excess of the 80% loan to value.

I don't normally get into the blame and finger pointing game but it seems that some organization dropped the ball on this. Can you shed some light on what went down and what you think needs to be done differently in the future?

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