Stiglitz; "Fannie’s and Freddie’s free lunch"

When commentators as diverse as Willem Buiter, Marc Faber, and Joseph Stiglitz (to name a few) agree on something, whatever their shared opinion is probably merits consideration.

In this case, it’s a cause near and dear to most readers’ hearts, namely, that the rescue efforts orchestrated by the officialdom are poorly designed. They treat taxpayers shabbily, let current shareholders and incumbents off too easily, and have moral hazard written all over them.

Stiglitz’s comment today in the Financial Times argues forcefully that the Federal rescues this year are fundamentally flawed. He believes that taxpayers should have the opportunity for upside from having put funds at risk. However, his solution is a defacto debt restructuring, since the new Federal funds would be senior. Some economists have called for nationalization of the GSEs without giving ideas for the mechanics; by contrast, Nouriel Roubini has contended that a debt restructuring is a viable solution and would not even require government assistance (although he acknowledges that his proposal is a non-starter).

From the Financial Times:

Much has been made in recent years of private/public partnerships. The US government is about to embark on another example of such a partnership, in which the private sector takes the profits and the public sector bears the risk. The proposed bail-out of Fannie Mae and Freddie Mac entails the socialisation of risk – with all the long-term adverse implications for moral hazard – from an administration supposedly committed to free-market principles.

Defenders of the bail-out argue that these institutions are too big to be allowed to fail. If that is the case, the government had a responsibility to regulate them so that they would not fail. No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to “self-regulation”. But that is what we have done with the financial system.

Even if they are too big to fail, they are not too big to be reorganised. In effect, the administration is indeed proposing a form of financial reorganisation, but one that does not meet the basic tenets of what should constitute such a publicly sponsored scheme.

First, it should be fully transparent, with taxpayers knowing the risks they have assumed and how much has been given to the shareholders and bondholders being bailed out.

Second, there should be full accountability. Those who are responsible for the mistakes – management, shareholders and bondholders – should all bear the consequences. Taxpayers should not be asked to pony up a penny while shareholders are being protected.

Finally, taxpayers should be compensated for the risks they face. The greater the risks, the greater the compensation.

All of these principles were violated in the Bear Stearns bail-out. Shareholders walked away with more than $1bn (€635m, £500m), while taxpayers still do not know the size of the risks they bear. From what can be seen, taxpayers are not receiving a cent for all this risk-bearing. Hidden in the Federal Reserve-collateralised loans to JPMorgan that enabled it to take over Bear Stearns were almost surely interest rate and credit options worth billions of dollars. It would have been easy to design a restructuring that was more transparent and protected taxpayers’ interests better, giving some compensation for their risk-bearing.

But the proposed bail-out of Fannie Mae and Freddie Mac makes that of Bear Stearns look like a model of good governance. It sets an example for other countries of what not to do. The same administration that failed to regulate, then seemed enthusiastic about the Bear Stearns bail-out, is now asking the American people to write a blank cheque. They say: “Trust us.” Yes, we can trust the administration – to give the taxpayers another raw deal.

Something has to be done; on that everyone is agreed. We should begin with the core of the problem, the fact that millions of Americans were made loans beyond their ability to pay. We need to help them stay in their homes, including by converting the home mortgage deduction into a cashable tax credit and creating a homeowners’ Chapter 11, an expedited way to restructure their liabilities. This will bring clarity to the capital markets – reducing uncertainty about the size of the hole in Fannie Mae’s and Freddie Mac’s balance sheets.

The government should set a limit to the size of the bail-out, at the same time making it clear that, while it will not allow Fannie Mae and Freddie Mac to fail, neither will it be extending a blank cheque. There may need to be a drastic reorganisation. There should be a charge for the “credit line” (any private firm would do as much) and, given the risk, it should be at a higher than normal rate.

The private sector knows how to protect its interests; the government should do no less. As long as the credit line is extended, no dividends should be paid. To ensure that the government is not simply bailing out creditors who failed in due diligence, at least, say, 25 per cent of any notes, loans or bonds coming due that are not lent again should be set aside in an escrow account, to be paid only after it is established that taxpayers are not at risk. Any government loans should be cumulative preferred debt: the taxpayers get paid before any other creditors receive a dime. To discourage moral hazard the interest rate should be at a penalty rate and, reflecting the rising risk, increase with the amount borrowed. Finally, the government should participate in the upside potential as well as the downside risk: for instance, by taking shares (which it might later sell) or, as it did in the Chrysler bail-out, warrants.

We should not be worried about shareholders losing their investments. In earlier years, they were amply rewarded. The management remuneration packages that they approved were designed to encourage excessive risk-taking. They got what they asked for. Nor should we be worried about creditors losing their money. Their lack of supervision fuelled the housing bubble and we are now all paying the price. We should worry about whether there is a supply of liquidity to the housing market, so that those who wish to buy a home can get a loan. This proposal provides the necessary liquidity.

A basic law of economics holds that there is no such thing as a free lunch. Those in the financial market have had a sumptuous feast and the administration is now asking the taxpayer to pick up a part of the tab. We should simply say No.

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  1. eh

    They treat taxpayers shabbily, let current shareholders and incumbents off too easily, and have moral hazard written all over them.

    In other words, businees as usual.

  2. Richard Kline

    So eh: amen.

    I agree with everything Stiglitz writes here to the extent that I could have written it myself, with exceptions near the end. Twenty per cent of those GSE bonds are held by our foreign sovereign _public_ creditors. I do not doubt for a second that they were expicitly encouraged to take stakes by Cabinet level officials and above over the last dozen years. This is not a minor issue. Regarding other creditors, they can go to the foot of the queue. The government, if it takes over the GSEs can indeed make a distinction between sovereign creditors and ‘other ranks,’ either directly, or in a side deal. This isn’t pretty but it’s important.

    The second distinction is that it might be a very viable option to offer those with stakes going into the proposed escrow the option of converting some of their claims into equity in the refurbished GSE; probably, that should be at a discount to face, but the exact terms are a detail. The point that Stiglitz makes, that revenues should be directed at paying down the public stake first, is the prime point, though, yes.

    A real government intervention would take a position of _real authority_ over these enterprises. But, but “Government manages badly; business manages well,” that’s been the phoney meme, right? Better because truer: “Government manages barely, but business makes out well.” That’s what we need to get away from.

  3. Anonymous

    He can write all he wants the US is a banana republic and the die has been cast, sale all US financial assets and get out while the getting is good.

  4. Timothy

    To default on the portion held by Sovereign lenders who were actively encouraged to believe in the Government guarantee would be a very dangerous road to go down, they must be treated differently, perhaps swapped into Treasuries. They problem comes with bonds held by third parties on behalf of Governments (usually Middle Eastern, generally out of London), proving they belong to Sovereign holders may be difficult, plus in the case of Saudi princes etc where is the line drawn between state & private holdings. It will be hard to persuade Americans to take a haircut if some pretty unsavoury regimes are made good.

    Assuming a solution can be reached to this problem I believe that the companies need to be split into many smaller entities no longer to big to fail & the government guarantee should be strictly and explicitly capped, with the companies paying a fee in return. Their activities should be limited to enabling the poor to become homeowners, not letting the middle class own bigger homes

  5. a

    “To default on the portion held by Sovereign lenders who were actively encouraged to believe in the Government guarantee would be a very dangerous road to go down…”

    What a bunch of poppycock. To the contrary the U.S. gov bent over backwards to say there was NO GUARANTEE. All this “implicit” guarantee talk comes from Wall Street and other buyers.

  6. rahuldeodhar

    Firstly, its terrible – I don’t think government has it easy.

    From a government’s perch, the reality is confusing. Institutions are taxpayers themselves and hence stakeholders. They are also income sources and service providers for citizens. A large number of institutions are foreign exchange earners for their country. Governments view certain sectors as drivers of competitive advantage. US views finance and money management as its competitive advantage. A government might opine that a running system is easier to coax into order than let the system falter.

    Yet whatever the reason, they must be elaborated and opened to public scrutiny. The best solution might emerge faster that way.

    The US financial system is quite robust – but it was created for different times. We have moved on and the system hasn’t. Its time to fix it. There will be a lot of pain globally if we make a mistake now.


  7. a

    I disagree with Stiglitz when he says that the taxpayers should be compensated for risk, as if that is all they are faced with. It’s not so much the risk that worries me as the out-and-out losses, because housing prices *will* go lower.

  8. winstongator

    No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to “self-regulation”.
    No private enterprise provides insurance without charging for it.

  9. Eric Prentis

    The United States is a plutocracy, run by the rich and powerful for the benefit of the rich and powerful; the US taxpayers’ no upside profit potential bailout of the as “good as bankrupt” Bear Stearns, Fannie Mae and Freddie Mac’s equity and bond holders is the latest example. To say the US is a corporate fascist state seems to have some merit in fact.

  10. Anonymous

    To default on the portion held by Sovereign lenders who were actively encouraged to believe in the Government guarantee

    You’re telling me that they bought hundreds of billions of dollars of those securities and didn’t even read the prospectus? And that they were pledged something, but didn’t get the pledge in writing?

  11. James

    Isn’t this the the face of class war in our “free markets” society. Par for the course in a world where entrepreneurship at the highest levels is capturing the government for the benefit of private gain and long term class interests. As long as we have the corporate propaganda establishment, ahem, “the free press” controlling the framing of the issues we will more of the same – to do otherwise is unpatriotic. The “Bush Apocalypse” =financial meldown + more war. Onward to Iran !

  12. Doc Holiday


    Some good stuff over here, which is slighty OT for this thread, but keep an eye there:

    and this: Alpert quotes hedge fund manager Rick Bookstaber who believes that financial engineers have accelerated crises and systemic risks via the complex dynamics of new futures contracts, exotic options and swaps. These new financial instruments create interlocking markets (capital, commodities, debt, equity, treasuries) which have the second-order effects of larger yield curve spreads and trading volatility. Alpert and Bookstaber’s views echo Susan Strange’s warnings a decade ago of ‘casino capitalism’ and ‘mad money’ as unconstrained forces in the international political economy.

  13. Anonymous

    “First, it should be fully transparent.”

    AMEN, bro! Hank Paulson’s presentation of the bailout to the Congressional committees was astoundingly, even insultingly, vague and ill-prepared.

    He said it might cost zero, or trillions. That he might buy debt, or equity, or lend money, or do nothing. Whenever the whim strikes him.

    He said that the taxpayers would be protected, but refused to divulge how.

    Had I been the chair of the committee, I would have summoned the Sergeant-at-Arms to escort Paulson out of the room, in response to his obvious contempt.

    That the Congressional gerbils and hamsters knuckled under and opened the public purse to this greasy Goldman Sachs crook makes me sick. Welcome to the world’s greatest plutocratic, nuclear-armed banana republic. Loot while the looting’s good, cuz when this clearance sale is over, we’re out of business.

  14. AnoninCA

    I think that you and Stiglitz underestimate the hole the government has backed itself into. In a world with reasonable regulations, no systemically important firm would be allowed to finance itself using repos or commercial paper.

    At this point we are where we are. If the government doesn’t support their debt, Fannie and Freddie collapse tomorrow with the obvious consequences for the mortgage market. (Remember the *safest* money market funds are in agencies. How do you say run on the bank?)

    The bill that passed Congress is grossly unspecific — but what would have been the financial consequences of publishing the details of a bailout before the bailout is ready? With financial firms the only good announcement is the announcement of a done deal — everything else is an arbitrage opportunity.

  15. Anonymous

    Remember the *safest* money market funds are in agencies

    No, they are not. For example, the Vanguard Treasury Money Market Fund (VMPXX):

    Investment strategy

    The fund invests solely in high-quality, short-term money market securities whose interest and principal payments are backed by the full faith and credit of the U.S. government. At least 80% of the fund’s assets will always be invested in U.S. Treasury securities; the remainder of the assets may be invested in securities issued by U.S. government agencies. The fund will maintain a dollar-weighted average maturity of 90 days or less.
    Investment policy

    The fund reserves the right to invest, to a limited extent, in floating-rate securities, which are traditional types of derivatives.

  16. AnoninCA

    Anon 4:21 pm

    Alright not the absolute safest money market funds. But agencies are the only paper the Fed has for decades treated as equivalent to Treasuries in Open Market Operations. This policy was designed to affect the way agencies were treated by money market fund managers — and it did. It’s simply not reasonable to compare agencies to SIV commercial paper and “asset”-backed commercial paper backed by credit default swaps.

    I’m not arguing that in some moral sense, investors in agency MMMFs shouldn’t lose their money, I’m just arguing that poor regulation let a situation develop where the government has no choice but to engineer a bailout. There are right ways and wrong ways to do this and I agree entirely with the third to last paragraph of Stiglitz’ article.

    Maybe the government should just have announced this morning that everyone with money in agency commercial paper will only have access to 90% of it, the rest is being held provisionally by the government to finance the nationalization of the firms. But would this be legal? Would this push a large percentage of the banking system over the edge? Whatever they do has to be already done, once the public finds out about it.

    I think it would be a disaster to have open debate over this in Congress.

  17. Realthink

    From a physical reality-based, Hubbert’s Peak-aware perspective, the critical consideration of any proposed solution is not about whether current Agency debt should be backed by the Treasury/Fed or not. It is about whether new Agency debt should be created or not. No new Agency debt would certainly mean very few new mortgages which would cause a sharp drop in new home construction. Which, from a Hubbert’s Peak-aware perspective, is exactly what the doctor orders.

    Because construction of more suburban and exurban McMansions is just digging further in the already deep hole most of the US population is in, as inevitably higher fuel prices will turn those homes into traps for their occupants. The US would be much better off if labor and (ever more scarce) resources were employed in a massive wind farm construction plan like Al Gore proposed recently.

    Related to this, the cars-on-natural-gas part of T. Boone Pickens plan is nonsense. Cars should go electric or at least Plug-in Hybrid (that’s why the US needs so much wind power). Natural gas should be reserved for cooking and heating.

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