A New York Times article tonight, “U.S. Likely to Keep the Reins on Fannie and Freddie“, raises the specter that the mortgage giants may never return to private form. Frankly, we think that is not entirely a bad thing. Fannie and Freddie were originally agencies of the US government and were (sort of) spun out in the late 1960s, when their borrowings on top of Vietnam war funding made the Federal balance sheet look ugly. And in typical plus ca change, plus c’est la meme chose fashion, the reason the GSEs have not been fully taken over is to avoid consolidating their debt onto the Federal balance sheet.
The article takes the tack that Fannie and Freddie may never be reprivatized, and then suggests that the big banks that are increasingly coming into the government orbit may suffer the same fate:
Despite assurances that the takeover of Fannie Mae and Freddie Mac would be temporary, the giant mortgage companies will most likely never fully return to private hands, lawmakers and company executives are beginning to quietly acknowledge.
The possibility that these companies — which together touch over half of all mortgages in the United States — could remain under tight government control is shaping the broader debate over the future of the financial industry. The worry is that if the government cannot or will not extricate itself from Fannie and Freddie, it will face similar problems should it eventually nationalize some large banks.
Now the conclusion could prove correct, but the analogy is false. Freddie and Fannie are very different cases than the big banks. They were never truly private; that was a big part of the reason they were put into conservatorship. They came to depend on both very high levels of leverage (that is, they held paltry amounts of equity) AND funding at virtually the same rate as the US government. Even then, both Fannie and Freddie engaged in accounting fraud to burnish their numbers and justify more handsome pay to top brass.
In other words, this was a business model that barely worked even in the good days.
Now to the fate of the big banks. At first I had thought the stress test process was deeply cynical, that banks would be given phony marks to bolster public confidence (a dangerous game if they come apart anyhow in less than a year) or that the process would be used to show that the government was reluctantly forced into taking them over. The stress tests can lead to the government requiring banks to raise more equity, and if they cannot raise it from private sources, they will need to resort to Uncle Sam. Given the already depressed levels of big bank shares, any fundraising would be massively dilutive, and still carries the risk that the government injections at a later date will still largely take out recent capital contributions.
An even more sobering possibility is that Bernanke and Geithner believe that the current lousy state of financial markets is the result of irrational pessmimism. If the government throws enough liquidity at the market, animal spirits will return and all will be well.
Nationalism arrived at this way, call it reluctant nationalism, could well make reprivatization more difficult than the more traditional kind (think the FDIC receivership, except the government can’t dispose of the assets by Monday, so it has to keep them for a while, perhaps as long as a few years, to figure out what the highest and best exit strategy is for the various components). Why would that be so?
First, as a Wall Street Journal story last week on Citigroup illustrated, in the creeping takeover scenario, neither bank management nor the various agencies involved are clear on who has authority to do what. Now admittedly, if this process continues, that ambiguity may be reduced, but it seems intrinsic to the arrangement. Nationalization as takeout, by contrast, puts the government officialdom in charge and ought to involve changes in top management and the board.
Similarly, reluctant nationalization keeps the behemoth financial firms intact, while the “nationalization as takeout” version assumes stripping out of bad assets, and a possible breakup of the firms. One or both would reduce the size of the remaning entities, which would make it easier to find new management candidates (frankly, no one has demonstrated themselves to be capable of managing such large concerns, while there are more candidates to run smaller operations).