Nouriel Roubini has consistently been accurate in predicting the course of our snowballing credit crisis, and has also made some important intellectual contributions to the discussion. such as how the breakdown of the Bretton Woods system has lessons for the future of our Bretton Woods 2 currency program.
But in my view, Roubini’s post today is his most important contribution to date. Sadly, I anticipate, just like his early warnings of coming financial trouble, that it will be ignored.
Roubini argues that restructuring Fannie’s and Freddie’s debts is not an awful prospect. They have large books of, by housing standards, pretty decent assets. He estimates that the haircut required would be only 5%, which could either be handled via principal restructurings or payment reductions.
FreedomWorks would like to point out that a bailout is a transfer of possibly hundreds of billions of U.S. tax dollars to sophisticated investors and governments overseas.
The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds…
FreedomWorks President Matt Kibbe commented, “The prospectus for every GSE bond clearly states that it is not backed by the United States government. That’s why investors holding agency bonds already receive a significant risk premium over Treasuries.”
“A bailout at this stage would be the worst possible outcome for American taxpayers and mortgage holders, who have been paying a risk premium to these foreign investors. It would change the rules of the game retroactively and would directly subsidize the risks taken by sophisticated foreign investors.”
“A bailout of GSE bondholders would be perhaps the greatest taxpayer rip-off in American history. It is bad economics and you can be sure it is terrible politics.”
But the flaw in Kibbe’s reasoning is the notion that the Federal government would handle a rescue in an up-an-up fashion, in which the expense would be explicit. It’s a given, as discussed in a related post, that the salvage operation will seek to hide the costs and, if the past is any guide, be successful at it too.
Roubini’s entire post, “Insolvency of the Fannie and Freddie Predicted Here Two Years Ago. What Happens Next? Or How to Avoid the ‘Mother of All Bailouts’,” is worthwhile. Here is the meat of his proposal:
The issue now is: what happens next to Fannie and Freddie?….
The conventional answer is that their shareholders get fully wiped out but that their creditors (those holding the $5 trillion of these agencies’ debt and their other liabilities) are made whole…
First notice that….. investors always expected that the liabilities of the two GSEs would be eventually backed by the U.S. government. And in spite of the decade long rhetoric….that Fannie and Freddie were private firms…. the reality was different: these were effectively public institutions – not private ones – used by the government (especially this administration) to pursue public policy goals. The hawkish rhetoric about the “moral hazard”….was thrown out of the window the moment the housing and mortgage bust started. Instead, for the last few months the GSEs – that were already bleeding and becoming insolvent on their own portfolio – have been used by the government to back stop the mortgage markets….
To minimize the financial cost of this farce the administration should stop pretending that these are private institutions and go ahead and take them over and nationalize them ….The financial costs of this farce include the $50 billion of subsidy that the GSEs bondholders/creditors are receiving every year as the spread of the agency debt over Treasury is now close to 100bps (100bps on $5 trillion of liabilities is equal to $50 billion)….. But if the government is going to bail them out – because the consequences of a capital levy on their bondholder will destroy the mortgage and housing markets – the government should at least make this implicit liability (the guarantee of the $5 trillion debt of the GSEs) explicit and thus save the U.S. taxpayer that $50 billion subsidy…
….let us consider …what should be done in an ideal world? The simple answer is that we need to limit as much as possible the moral hazard of a bailout of Fannie and Freddie….And such a bailout is neither necessary, appropriate nor desirable.
Of course most of Wall Street, domestic and foreign investors and Congress are already screaming and begging “Bail us out, bail us out!” …. But these screams of “the sky will fall” if we don’t rescue Fannie and Freddie are vastly exaggerated and incorrect for a number of reasons.
First, notice that the hit that bondholders will take will be limited in the absence of their bailout. With a debt/liabilities of about $5 trillion and expected insolvency – as of now and in the worst scenario of $200 to $300 billion – the necessary haircut is relatively modest: either a reduction in the face value of the claims of the order of 5% (if the mid-point hole is $250 billion) or – for unchanged face value – a very modest reduction in the interest rate on their debt after it has been forcibly restructured.
Second, a 5% haircut is much smaller than the 75% haircut that the holders of Argentine sovereign bonds suffered in 2001-2005, much smaller than the haircuts that holders or Russian and Ecuadorean debt suffered after those sovereign defaults, and much smaller than the 30% haircut that holders of corporate bonds suffer on average when a corporation goes into Chapter 11 and its debt is restructured. So why should Uncle Sam – i.e. eventually the U.S. taxpayer – pay that $250 billion bill when investors in the U.S. and around the world can afford it? The same investors are getting a fat subsidy of $50 billion a year (whose NPV is much bigger than $250 billion) for holding claims that now provide a 100bps spread above Treasuries and are under the implicit guarantee of a full bailout.
Third, of the two options we need to pick one: either we formally guarantee those claims and start paying the Treasury yield on that debt saving the tax payer that $50 billion subsidy; or if we maintain the subsidy a credit event in the form of a small haircut because of insolvency would be the fair cost that such investors pay for earning the extra spread over Treasuries.
Fourth, while the haircut would reduce the market value of such agency debt and inflict mark to market losses to investors such losses are already priced by the fact that the widening of the agency debt spread relative to Treasuries – from 10bps to about 100bps – has reduced the mark to market value of such agency debt. So, in the current legal limbo of insolvent GSEs whose debt is however not formally guaranteed the persistence of the spread would lead to those $250 billion mark-to-market losses regardless of a formal default, restructuring and haircut on that debt. We may as well resolve that insolvency and restore the positive net worth of the GSEs by doing the haircut.
Fifth, a haircut on the debt of the GSEs does not need to destroy their business, the mortgage market or the housing market. The best debtor is a solvent debtor that has restructured and reduced its unsustainable debt burden: that is why firms coming out of a Chapter 11 process that reduces their debt burdens are viable businesses ready again to produce goods and services in a viable and profitable way. The worst thing that can happen to the GSEs is to remain as zombie comatose insolvent institutions whose debt burden is not restructured and who are barely propped by an implicit government lifeline. Do we really believe that GSEs with unrestructured debt kept alive in a zombie government “conservatorship” (the solution now most likely preferred by the U.S. administration) could function properly and continue their service of supporting the mortgage and housing market? Lets instead clean them up first and make them financially viable – after an out-of-court Chapter 11 style debt reduction – so as to ensure that they keep on providing the public goods that they are alleged to give.
Sixth, the existence of GSEs….is a major part of the overall U.S. subsidization of housing capital that will eventually lead to the bankruptcy of the U.S. economy. For the last 70 years investment in housing – the most unproductive form of accumulation of capital – has been heavily subsidized in 100 different ways in the U.S.: tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures.
The reality is that the U.S. has invested too much – especially in the last eight years – in building its stock of wasteful housing capital (whose effect on the productivity of labor is zero) and has not invested enough in the accumulation of productive physical capital (equipment, machinery, etc.) that leads to an increase in the productivity of labor and increases long run economic growth. This financial crisis is a crisis of accumulation of too much debt – by the household sector, the government and the country – to finance the accumulation of the most useless and unproductive form of capital, housing, that provides only housing services to consumers and has zippo effect on the productivity of labor. So enough of subsidizing the accumulation of even bigger MacMansions through the tax system and the GSEs.
And these MacMansions and the broader sprawl of suburbian/exurban housing are now worth much less – in NPV terms – not only because of the housing bust and the fall in home prices but also because: a) the high oil and energy prices makes it outrageously expensive to heat those excessively big homes; b) households living in suburbian and exurban homes that are far from centers of work, business and production that are not served by public transportation are burdened with transportation costs that are becoming unsustainable given the high price of gasoline. So on top of the housing bust that will reduce home values by an average of 30% relative to peak high oil/energy prices make the same large homes in the far boonies of suburbia/exurbia worth even less – probably another 10% down – because of the cost of heating palatial MacMansions and because of the cost of traveling dozens of miles to get to work in gas guzzling SUVs. Thus, it is time to stop this destruction of national income and wealth that a cockamamie decades long policy of subsidizing the accumulation of wasteful and unproductive housing capital has caused….
Will this optimal policy solution – an haircut for bondholders – be undertaken? Most likely not as the political economy of housing, mortgages and of “privatizing profits and socializing” losses may dominate the policy outcome. Financial institutions love a system where they gamble recklessly, pocket the profits in good times and let the fisc (taxpayer) pay the bill when their reckless behavior triggers a financial crisis; this is socialism for the rich. That is why you already hear the whole Wall Street Greek chorus moaning for a bailout of the GSEs. But the financial costs of this financial crisis – the worst since the Great Depression – are mounting so fast that any bailout will become fiscally extremely expensive.
Indeed, my initial estimates of $1 to $2 trillion dollars of losses from this financial crisis did not include the bailout of Bear Stearns’ creditors, the bailout of the GSEs bondholders, the fiscal costs of the Frank-Dodd bill, the fiscal costs a severe U.S. recession that is mushrooming an already large fiscal deficit, the fiscal cost of bailing out – a’ la Bear Stearns – the last four remaining major independent broker dealers (as the time for such independent broker dealers is now gone as – given their wholesale overnite funding – they are subject to bank-like runs much more severe than for banks), the cost of bailing out the Federal Home Loan Bank system (another GSE system that pretends to be private and that has been happily propping up or bailing out – to the tune of hundreds of billions of liquidity support – illiquid and insolvent mortgage lenders). Switching the informal guarantee of GSEs debt to a formal government guarantee would by itself increase the US gross public debt by $5 trillion and effectively double it.
Thus, soon enough, if we fiscalize all of these losses the U.S. may fast lose its AAA sovereign debt rating and eventually end up like an insolvent banana republic. It is thus time to put a stop to the coming “mother of all bailouts” starting with a firm stop to the fiscal rescue of Fannie and Freddie, institutions that have behaved for the last few years like the “mother of all leveraged hedge funds” with their reckless leverage and reckless financial activities.