Tuesday, July 15, 2008

Were the GSEs Out-of-Control?

I must admit, I've been a little puzzled by some of the reactions to the GSE bailout. Yes, the taxpayers will have to pay for the GSE bailout. No, it's not fair. But some people seem to think that the GSEs were out-of-control, mortgage-slinging cowboys whose gross excesses we're now picking up the tab for. For example, Megan McArdle writes:

Because they are government sponsored, the government let them get away with practices that would never fly in the private market.
And Professor Stephen Bainbridge also writes:
The implicit government guarantee—which now has become explicit—thus has had serious adverse consequences. It has encouraged Fannie and Freddie management to take risks that firms subject to market competition and lacking a government safety net would never take. In particular, Freddie and Fannie have increasingly held on to mortgages rather than reselling them as asset backed securities, which exposes them to much higher repayment and other risks.
Professor Bainbridge seems to think that "firms subject to market competition" would never do something as risky as keeping mortgage-backed securities on their balance sheets. This is, of course, profoundly stupid (though not at all surprising, as law professors tend to be the worst breed of market-worshipping amateur economists). All the financial houses kept MBS on their balance sheets. Bear Stearns, anyone? The idea that "market discipline" would have kept the GSEs in line is truly laughable. The market provided absolutely no discipline during the housing boom—why do you think we're in this mess to begin with? Both McArdle and Professor Bainbridge seem to think that the GSEs were out-of-control, and taking wild risks. The GSEs weren't buying or securitizing subprime mortgages though. In fact, the only thing that kept the GSEs from running full speed into the subprime market was government regulation—specifically, the conforming loan limits in their charters. I think the confusion stems from a misunderstanding of the externality that the GSEs' implicit government guarantee creates. The implicit government guarantee creates an externality because the public bears some of the cost of the GSEs' exposure to interest rate risk. Any mortgage portfolio is subject to interest rate risk. Investors use derivatives such as interest rate swaps to hedge their interest rate risk. If an investor has too much unhedged interest rate risk, creditors will demand that the investor pay a higher interest rate to compensate the creditors for their interest rate exposure. Like the big financial houses, the GSEs use an imperfect dynamic hedging stategy, which essentially hedges short-term interest rate risk but leaves long-term interest unhedged (it's a lot more complicated in reality, but that's the idea). Creditors should demand a higher interest rate as compensation for their exposure to the unhedged long-term interest rate risk, but because the government implicitly guarantees the GSEs' debt, creditors lend money to the GSEs at artificially low rates. Of course, someone has to bear the cost of the GSEs' exposure to unhedged interest rate risk, and that someone is the U.S. taxpayer. That's (more or less) how the GSEs' implicit government guarantee creates an externality, not by inducing the GSEs to take wild risks and act like cowboys. The GSEs only take on "excessive risk" in the sense that they take on more risk than is justified by their low borrowing costs. Before the collapse of the mortgage market, the GSEs were actually taking on less risk than other banks—it was still too much risk relative to their capital base and the low borrowing costs, but it was low risk nonetheless.


Jane said...

No private investment company, as far as I'm aware, would allow almost all of their capital to be concentrated for a long period of time in a single market for which they held a quarter of the securities. Fannie and Freddie's allegations that they could get around this massive overexposure by hedging have turned out to be ridiculous, as indeed many people have been saying all along.

To put it another way: without the implicit government guarantee, their costs of capital would have shot up long ago, as lenders ran screaming from the catastrophic unhedged risks on their balance sheet. There is no way they would have gotten into their current condition without the GSE status.

Obviously, you did not need to be a GSE to get into this type of trouble in the housing market, but Fannie and Freddie could not have gotten into this size of trouble without help. Moreover, places like Bear Stearns were taken down by collapsing asset values; Fannie and Freddie's problems, AFAICT, stem from cash flow, which makes the triumphant declarations that they didn't actually issue subprime mortgages rather silly. There's nothing inherently wrong with subprime mortgages as long as the risk is correctly priced; FM/FM seem to have mispriced at least as thoroughly as Bear did.

Economics of Contempt said...

I agree with some of this. My objection is to notion that the GSEs were taking on some special level of risk (in absolute terms).

It's important to distinguish between the pre-credit crisis GSEs and the GSEs during the credit crisis. Ever since the financial markets froze up, the government basically directed the GSEs to start buying mortgage-related securities to take them off iBanks' balance sheets and get the markets moving again. They were deputized by the government, sent into the jumbo market (via the stimulus package), and told to start soaking up subprime mortgages. Yes, that led to an overexposure to the mortgage sector, but that overexposure certainly wasn't caused by their implicit government guarantee. These are extraordinary times, and the GSEs can't be blamed for absorbing the private sector's outrageous risk. They didn't do it because they're out-of-control, risk-loving cowboys. They did it because that's what they were directed to do, as a response to the credit crisis.

In other words, if there had never been a credit crisis, the GSEs would never have taken on so much risk. And it was the excessive risk-taking in the private sector, not by the GSEs, that led to the credit crisis. So how, pray tell, does this make the GSEs wild cowboys?

The pre-credit crisis GSEs weren't taking on some special level of risk. Quite the contrary. The problem was that they didn't fully hedge ordinary levels of risk, and weren't paying for their incomplete hedges through higher borrowing costs.

Also, Bear Stearns may have been taken down by collapsing asset values (kind of), but they were in such a precarious position precisely because of their huge exposure to subprime.

Jane said...

Eh, it's still not clear to me that Bear Stearns was taken down by its balance sheet, rather than a liquidity crisis brought on by rumors. Moreover, we fundamentally disagree that the GSEs got into this trouble two months ago. The GSEs have had repeated problems with their balance sheets--they're still not completely out from under their last problems.

Fergus O'Rourke said...

Is Jane's surname "Galt" by any chance ?


Everything seems out of control.

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