Henry Kaufman: Treasury Needs to Stand Behind Freddie, Fannie

Henry Kaufman, aka Dr. Doom for his prominence and prescience in reading the bond markets during the painful early 1980s credit crunch, said not surprisingly that the Federal government needed to assist Fannie and Freddie.

Unfortunately, the more important part of Kaufman’s message is likely to be ignored. The former Salomon Brothers chief economist also urged Washington to step up the pace on regulatory reform, starting with the formation of a bi-partisan committee.

Unfortunately, this Administration doesn’t know the meaning of the word “bi-partisan.” And even though market participants know that an unmanaged crisis at the GSEs has the potential to End the World of Finance As We Know It, it probably will not focus the mind of legislators enough to get them to roll up their sleeves and take the problem seriously.

Readers like to pooh pooh the ability of Congress to contribute here. However, the securities law reforms on the 1930s came after a period of lax government and considerable corruption in the nation’s capital. But it took a collapse of the banking system to galvanize the needed response. Do we really need to repeat this history?

From MarketWatch:

The U.S. government needs to intervene to save Fannie Mae and Freddie Mac and then overhaul fragmented regulation of financial institutions and markets, according to comments Friday by economist Henry Kaufman, who rose to Wall Street prominence spotting previous credit crises.

The investment manager and former Salomon Brothers executive said that the U.S. Treasury Department should be ready to offer finance to the floundering mortgage giants and encourage the two agencies to draw on their contingency lines of credit with the government.

The Treasury “should also state that, if needed, it would be willing to supply new equity capital to these agencies through the issuance of preferred stocks,” said Kaufman, …

Kaufman, who once was known as “Dr. Doom” for his accurate forecast that the Federal Reserve would drive up interest rates to more than 20% in the 1980s, also called for the creation of a bipartisan commission to develop recommendations on an overhaul of “our fragmented supervisory and regulatory system.”

He added that current efforts to improve oversight of the country’s financial institutions lacks direction and is moving too slowly. “This commission should render a report by no later than October, and Congress should consider legislation even before a new president takes office. The urgency is too great and markets will not wait.”.

For skeptics, Dwight Cass at BreakingViews gives an idea of what a GSE doomsday scenario would look like:

The government-sponsored entities’ woes cause the value of their trillions of dollars of outstanding debt to plunge. Banks stuffed full of this paper face huge losses, which some can’t survive. They and other investors, such as foreign central banks, dump it.

Fannie and Freddie end up unable to lend, at least at their current pace, further punishing the reeling housing market. This causes more problems for banks and investors, making credit scarcer.

Of course, that all would take a truly incompetent response to a crisis that has been foreseeable for a year or more. But given US lawmakers’ belief that the GSEs are tools for their political ends, it’s not entirely out of the question.

That’s only the domestic part of the equation. A Fannie and Freddie crisis has the potential to trigger a dollar crisis, pushing already high commodity prices through the roof.

I have said repeatedly that the US is in the same position as Thailand and Indonesia circa 1997, except we have the reserve currency and nukes. It isn’t obvious how we avert a crisis. From a VoxEu summary of research on financial crises by Carmine Reinhart and Kenneth Rogofff:

Another regularity found in the literature on modern financial crises is that countries experiencing large capital inflows are at high risk of having a debt crisis. Default is likely to be accompanied by a currency crash and a spurt of inflation.

Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.

Note that China is also experiencing large capital inflows despite having large trade surpluses.

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  1. Scott Finch

    “Default is likely to be accompanied by a currency crash and a spurt of inflation.”

    There was an interesting paper that was published at nber.org about two months ago. The title of the paper was something like ‘the forgotton history of domestic debt’. The paper included various time series sets over different metrics.

  2. Lune

    2 points:

    1) I’m not sure how the govt can effectively intervene in the GSEs. We have finally reached the stage where even the coffers of the mighty U.S. Treasury are insufficient to bail out the current players.

    The GSEs have two problems. Firstly, they have been incredibly under-capitalized due to lack of regulatory oversight and an overly optimistic / sloppy view of the risks inherent in their assets, especially in light of the currently imploding housing bubble. To pay for this mistake, the treasury will be forced to cough up at least $500 billion, if not more, to adequately cushion GSE reserves against expected default rates.

    But that only deals with the GSE’s solvency as it stands today. The second problem is that Congress and the rest of the federal govt view the GSEs as the vehicle through which the govt will bail out the entire U.S. housing industry. Witness the raising of conforming limits, the relaxing of borrower standards, etc. that are being written into law. As you’ve posted before, Yves, GSEs are now not just the dominant lender in the mortgage market, they’ve essentially become the only lender. If Congress wishes to carry out this foolish fantasy (and it appears to have every intention of doing so, at least until the elections are over), the cost will easily be higher than the rest of the federal debt we’ve accumulated in the last 200 years.

    I’m sure there are some Senators who’d like to try, but is it even feasible to contemplate doubling the federal debt (I’m not talking the annual deficit…)? Without catastrophic global consequences?

    2) Perhaps I’m too sanguine about the effects of the GSEs failing. I don’t doubt that the effects would be severe. But in this situation, the effects will be severe regardless of what we do. The question is whether you want it all compressed within 6 months, or drawn out over 10 years. There is no option I see that avoids the pain. The only question is the speed at which the pain comes on and eventually goes away. Witness the sum effects of Japan’s govt interventions in the “lost decade”: dramatic loss of property and other asset (e.g. stocks) values. Rising unemployment. Destruction of the traditional social compact. Large fiscal deficits. If the Japan of the 1980s became the Japan of the 2000s within the span of only 1 or 2 years, it would have been viewed as the coming of the apocalypse. Yet did drawing out the ultimate consequences over 10-15 years ultimately mitigate any of the effects? I’d argue not really. Certainly not enough to compensate for an entire nation losing a generation of time.

    So in the end, Yves, I suspect that everything that you worry about happening should the GSEs default, will happen. The only question is how much time do we want to waste prolonging the inevitable rather than getting through it and starting the reconstruction process. Regardless, I believe this is merely an academic exercise because per point #1, the govt doesn’t have the money to really even try to delay the day of reckoning. We’ve finally hit the limits of our national balance sheet.

  3. Richard Kline

    The gubmint is going to intervene in the GSEs on a ‘failure is not an option’ basis. And rightly so. Why? Two reasons, both inescapable.

    First, GSE paper has been pushed by the Fed and the Treasury on a ‘good as Treasuries’ basis to foreign sovereign financial institutions and CBs.’ Our public authorities _must_ make good on this debt, or we will of a certainty see the complete collapse of our currency. That is the worst of all possible options, solving nothing while ruining everything; let’s not go there. Second, the mortgage market will continue to exist throught he next three-five years if and only if we have a market maker for conforming loans at least. If we let these institutions fail, we will have to charter another, but in a vastly worse capital environment where any belief in the viability of the market-maker model has been shattered.

    The question then is how to go about it, and what’s the best bang for the buck? While in general I favor nationalization, at least for banks, I’m less keen on it here. The liabilities for the GSEs far exceed those for the banking system, and as mentioned above will be harder to walk away from due to the structural consequences of doing so. Here, I think that Kaufman’s proposal is actually the best one I have seen, at least as a starting point. I don’t say this to favor existing equity holders in the GSEs, but they have very nearly been wiped out already if they are still long. Putting in equity keeps the GSEs intact, keeps them able to borrow on the capital markets to do business, and staves off a default cascade from their paper going sour en masse all at once. An equity stake can be sold off years or decades hence, potentially netting back something to the public till. The GSE staff are going to have to do extensive cramdowns on their wholly owned paper; it will be cheaper to keep them and let them do it, salvaging what they can on the loans’ underlying value. That’s a better outcome than junking these concerns and starting over.

    But here’s a twist I haven’t heard. Yes, the GSE’s should cover what they hold in mortgage bonds, with public equity providing the cushion. But their ‘guarantees’ on what they have put out there should be spilt off by Congress into a sepearate vehicle, with the explict understanding that the government will write down these guarantees as it sees fit, and that only after the mortgage holders do work-outs directly with the homeowners. The public simply should NOT stand behind guarantees made against bubble prices, at least at par. If necessary, the ~$70B of the GSEs present assets could be dedicated to this spinoff while the government keeps the remaining GSEs afloat and the guarantee buyers take what slice of the pie in the runoff spinoff. There will be much screaming about this, and the mortgages with trimmed guarantees will of course plunge in value—but less than if the GSEs simply default. The real exposure to vast loss in the GSEs in in these guarantees; the institutions can be salvaged absent that exposure.

    Going forward, the entire idea of ‘guaranteed values’ for mortgages needs to be sharply reconsidered. It might be appropriate for an issuer to guarantee to take a first loss position to a set level in the event of a decline in value of a mortgage, but that position should not be open ended. Buyers of mortgages need to see and assume more direct risk for price movements in the future, and this will need to be priced into the morgages themselves: it is the illusion of a _guarantee_ against loss which has helped to promote reckless _acquisition_ of mortgages by speculators.

    Will the present Congress do anything of the sort? Not a chance. The ‘housing bill’ and the ‘stimulus check’ boondogles we have seen to this point clearly state that most in Congress neither recognize their lack of competence in the issues, act at arms length from the Big Money constitutencies who put them in office, nor have any functioning organs lower than their pectorals. The Congress does have the encompassing legal authority to pass emergency intitiative legislation, and the staff competence to propose a comprehensive regulatory reform. The latter will take several election cycles, but that’s the norm. The former is desperately needed by the end of the year, really by October, but we just aren’t going to get it. The Democrats have no nerve, the Republicans have no shame, and together they are like matter and anti-matter, unable to produce a substantive reaction. And look, we elected these losers so We the People Need to look in the mirror and call out the mooks looking back at us there.

    . . . But yes, an equity intervention seems the best, thin end of the wedge for this gem-knapping operation, so let’s get on with it. By Monday, Hank and Bennie, by 0700 EST.

  4. Anonymous

    If the answer on Monday is that the Treasury provide an equity “cushion” (at some cost to existing equity holders) will not the market interpret this as an implied reluctance on behalf of the US Govt to explicitly honour that which the market had assumed (even if there is no legal obligation)?

    Will this not lead to an increase in the cost of borrowing not only for Fannie & Freddie but also for the US Govt?

    How else can the holders of Fannie & Freddie debt understand such an action other than that the US Govt will drip feed equity until the going gets too tough and then fail to honour its obligations.

    The legal/regulatory niceties of this are irrelevant. This is a question of FAITH.

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