Wednesday, September 10, 2008



As many of you might have guessed, I am reflexively opposed to the government seizure of Fannie and Freddie (“F&F”). However, having, like most of you, followed this story exhaustively, I came close to drinking the kool-aid and agreeing that, as regrettable as this particular bout of Republican style socialism was, it was necessary to avoid “systemic risks to the financial system.” On further consideration, though, I have concluded that my reflexes were as sharp as always—the nationalization of Fannie and Freddie were indeed wrong.

Let me start by saying that it is admirable that the federal government did not follow the baleful Bear Stearns precedent and use the public dime to provide financial succor to the equity investors in Fannie and Freddie. (I am told by an insightful and well placed source that there were contractual reasons that Bear common holders got their $10 smooch. I still am not convinced that those contractual reasons could not be circumvented with sufficient will on the part of the rescuers, but that is another conversation.) It is even more admirable that the government let the preferred holders go in the Fannie and Freddie 911 call. Given the widespread holding of F&F preferred among the nation’s banks, especially its smaller banks, I was willing to wager that the government would protect the preferred, but am delighted that it didn’t, especially since I didn’t consummate my bet.

However, as “toughly” structured as this bailout may have been, it still should not have been done. Fannie and Freddie should have been allowed to fail. The taxpayers are once again being put in the position of bailing out investors who should have known better than to conclude that F&F debt was riskless. In fact, the talk is that it was entreaties by foreign banks, especially by the Chinese central bank, that provided the final catalyst for the rescue operation. (So the American taxpayer is being put in a position of subsidizing highly paid, and supposedly highly skilled, investment managers throughout the world.) These central banks, like many domestic investors, had bought the paper with the notion that it was essentially the equivalent of U.S. treasuries in credit quality. But F&F paper traded at a spread for a reason that is (or was until the Free Market Hank and the Bushites rode to the rescue) made abundantly clear by recent events.

The argument that F&F should have been allowed to crash and burn is considered preposterous and naïve by most financial professionals, many of whom are talking their positions. We are told the financial system would freeze up if F&F were to fail. Lenders wouldn’t lend. Investors wouldn’t invest. Foreign investors and central bank would shy away from all American liabilities, including treasury liabilities, an especially scary prospect now that we are a “buddy, can you lend me a dime?” nation. But would investors and lenders take a long vacation? The people who make these investment decisions are very well paid and, despite abundant recent evidence to the contrary, pretty smart. They wouldn’t stop investing. Rather, they would stop investing in a careless and haphazard fashion. They would start earning their astronomical pay packages rather than merely saying “Yeah, it’s not full faith and credit, but it really is. Back up the truck” before going off to expensive broker paid “research conferences” financed by their investor’s “management fees”. Mirabile dictu, credit research would start coming back into vogue. Lending wouldn’t stop; careless lending would stop. If one is to argue that such a development amounts to the financial system’s seizing up, one must be prepared to argue that our financial system depends on careless lending. If that is indeed the case, we are in more trouble than even I think.

One more argument for the Fannie and Freddie bailout is that letting them go would provide a further “devastating blow” to the housing market. But, given that part of the bailout package is a very modest expansion in F&F’s balance sheets for the next year followed by a series of 10% contractions in those balance sheets, it’s hard to see how a shrinking F&F will provide lots of juice for the housing market. One could legitimately argue that, without F&F, housing lending would grind to a virtual halt. That is highly doubtful; given the much ballyhooed innovation in our financial system, good loans will get made, albeit at higher spreads. But is having credit spreads reflect a prudent assessment of the underlying risks, rather than a “what the hell, I’ll only hold it for a few weeks, if that long” attitude such a bad thing? A housing market propped up by insouciant lending standards needs further correction.

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