The "imminent collapse" of
America's largest home loan banks?
"Should we worry?" asks Paul Krugman
By Jon Fernquest |
Paul Krugman is an eminent economist , professor at Princeton University, winner of the prestigious John Bates Clark Medal, a liberal public intellectual, a regular columnist for the New York Times, and a prolific blogger.
Today he discusses the latest disturbing development in America's Subprime Crisis, the possibility that America's gigantic government-backed home loan banks Fannie Mae and Freddie Mac might fail.
On Sunday, the so-called 2008 GSE support plan was presented by US Treasury Secretary Henry Paulson to prevent the failure of these two banks.
Blogs devoted to economics in the United States have been covering this issue closely, such as Economist's View and Brad De Long. Also see Business Week. (Photo of Paul Krugman on right.)
Here is the article in full:
Commentary
New chapter in America's financial crisis
Paul KrugmanNew York Times Op-ed Piece
featured in the Bangkok Post
15-07-2008
And now we Americans have reached the next stage of our seemingly never-ending financial crisis. This time Fannie Mae and Freddie Mac are in the headlines, with dire warnings of imminent collapse. How worried should we be?
Well, I'm going to take a contrarian position: the storm over these particular lenders is overblown. Fannie and Freddie probably will need a government rescue. But since it's already clear that that rescue will take place, their problems won't take down the economy.
Furthermore, while Fannie and Freddie are problematic institutions, they aren't responsible for the mess we're in.
Here's the background: Fannie Mae - the Federal National Mortgage Association - was created in the 1930s to facilitate homeownership by buying mortgages from banks, freeing up cash that could be used to make new loans. Fannie and Freddie Mac, which does pretty much the same thing, now finance most home loans being made in America.
The case against Fannie and Freddie begins with their peculiar status: although they're private companies with stockholders and profits, they're "government-sponsored enterprises" established by federal law, which means that they receive special privileges.
The most important of these privileges is implicit: it's the belief of investors that if Fannie and Freddie are threatened with failure, the federal government will come to their rescue.
This implicit guarantee means that profits are privatised but losses are socialised. If Fannie and Freddie do well, their stockholders reap the benefits, but if things go badly, Washington picks up the tab. Heads they win, tails we lose.
Such one-way bets can encourage the taking of bad risks, because the downside is someone else's problem. The classic example of how this can happen is the savings-and-loan crisis of the 1980s: S&L owners offered high interest rates to attract lots of federally insured deposits, then gambled with the money. When many of their bets went bad, the feds ended up holding the bag. The cleanup cost taxpayers more than $100 billion.
But here's the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago.
Partly that's because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn't do any subprime lending, because they can't: the definition of a subprime loan is precisely a loan that doesn't meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.
So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.
In that case, however, how did they end up in trouble?
Part of the answer is the sheer scale of the housing bubble, and the size of the price declines taking place now that the bubble has burst. In Los Angeles, Miami and other places, anyone who borrowed to buy a house at the peak of the market probably has negative equity at this point, even if he or she originally put 20% down. The result is a rising rate of delinquency even on loans that meet Fannie-Freddie guidelines.
Also, Fannie and Freddie, while tightly regulated in terms of their lending, haven't been required to put up enough capital - that is, money raised by selling stock rather than borrowing. This means that even a small decline in the value of their assets can leave them underwater, owing more than they own.
And yes, there is a real political scandal here: there have been repeated warnings that Fannie's and Freddie's thin capitalisation posed risks to taxpayers, but the companies' management bought off the political process, systematically hiring influential figures from both parties. While they were ugly, however, Fannie's and Freddie's political machinations didn't play a significant role in causing our current problems.
Still, isn't it shocking that taxpayers may end up having to rescue these institutions? Not really. We're going through a major financial crisis - and such crises almost always end with some kind of taxpayer bailout for the banking system.
And let's be clear: Fannie and Freddie can't be allowed to fail. With the collapse of subprime lending, they're now more central than ever to the housing market, and the economy as a whole.
Paul Krugman is a regular columnist with the New York Times.
Vocabulary:
2008 GSE support plan - [Breaking News] "...the 2008 GSE support plan was announced by United States Treasury Secretary Henry Paulson on July 13, 2008, after a week in which the shares of government sponsored enterprises Fannie Mae and Freddie Mac fell almost by half. The plan contained three measures: an increase in the line of credit available to the GSEs from Treasury, so as to provide liquidity; the right for Treasury to purchase equity in the GSEs, so as to provide capital; and a consultative role for the Federal Reserve in a reformed GSE regulatory system. On the same day, the Federal Reserve announced that the Federal Reserve Bank of New York would have the right to lend to the GSEs as necessary." (See Wikipedia)
a GSE - a Government Sponsored Enterprise, banks created and supported by the US government, "a group of financial services corporations created by the United States Congress. Their function is to enhance the flow of credit to targeted sectors of the economy and to make those segments of the capital market more efficient and transparent. The desired effect of the GSEs is to enhance the availability and reduce the cost of credit to the targeted borrowing sectors: agriculture, home finance and education.[citation needed] Congress created the first GSE in 1916 with the creation of the Farm Credit System; it initiated GSEs in the home finance segment of the economy with the creation of the Federal Home Loan Banks in 1932; and it targeted education when it chartered Sallie Mae in 1972 (although Congress allowed Sallie Mae to relinquish its government sponsorship and become a fully private institution via legislation in 1995). The residential mortgage borrowing segment is by far the largest of the borrowing segments in which the GSEs operate. Together, the three mortgage finance GSEs (Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks) have several trillion dollars of on-balance sheet assets." (See Wikipedia)
Fannie Mae - Federal National Mortgage Association, a GSE, a US government created bank which helps to replenish money for home purchases and loans, the leading market-maker in the U.S. secondary mortgage (home loan) market (See Wikipedia
)
Freddie Mac - Federal Home Loan Mortgage Corporation, a GSE similar to Fannie Mae specialising in home loans, "Freddie Mac buys mortgages on the secondary market, pools them, and sells them as mortgage-backed securities to investors on the open market. This secondary mortgage market increases the supply of money available for mortgages lending, and increases the money available for new home purchases" (See Wikipedia)
the Subprime Crisis - an ongoing global financial crisis that started in 2007 caused by risky loan practices during the US housing bubble (See Wikipedia)
eminent - a well-known and respected person (usually because they are good at their chosen profession, for example, an eminent statesman, an eminent diplomat)
an intellectual - a person who spends a lot of time studying and thinking about complicated ideas
a public intellectual - an intellectual who publishes analysis of current events (See Wikipedia on the 2005 global intellectuals pollin which Krugman places fifth worldwide)
prolific - producing a lot
dire warnings - warnings that something very serious and terrible is about to happen
imminent X - event X just about to happen, to happen shortly
imminent collapse - just about to collapse, will collapse soon, will collapse in the near future
X contrary to Y - X is the opposite of Y
contrarian - a person with the opposite opinion or view
a position (on a matter) - an opinion or view (on a matter)
take a contrarian position - have the opposite opinion
overblown - exaggerated
facilitate - help (See glossary)
pretty much the same thing - similar, but not exactly the same
peculiar - strange
status - position, ranking, category, state
a peculiar status - a strange position or state (that something is in)
privileges - a right, advantage, or power that few people have (See glossary)
receive special privileges - given special rights and advantages
a guarantee - a promise that something will happen (See glossary)
implicit - indirect, not said directly, not explicit
an implicit guarantee - a promise to do something that is not stated directly
reap the benefits of Y - gain from Y
picks up the tab - pay the bill for, pay to fix the problem
heads they win, tails we lose - meaning: we always lose, they always win (like cheating in gambling)
one-way bets - a bet which one side always wins
taking of bad risks - taking where you are likely to lose
the downside - what happens if you fail
savings-and-loan crisis of the 1980s - a banking crisis in the US during the the 1980s and 1990s, 747 savings and loan associations (S&L's) failed, the cost of the crisis was around USD$160.1 billion, about $124.6 billion paid for by the U.S. government, which contributed to the large budget deficits of the early 1990s (See Wikipedia)
federally insured deposits - the US government provides insurance for deposits in US commercial banks for up to $100,000 per depositor, this means that if the bank fails most depositors get their money back, the large number of bank failures in the Great Depression spurred the United States Congress into creating this insurance (See Wikipedia on Federal Deposit Insurance Corporation)
the feds ended up holding the bag - the US government has to pay to solve the problem
a scandal - a shocking and immoral thing that someone does
accounting scandals - when accounting records are falsified in an immoral way for personal gain (and people find out about it)
curtailed their lending - reduced or stopped lending money
housing prices were really taking off - the price of houses was increasing very quickly
a subprime loan - A loan offered to applicants with less than top-quality credit ratings (See Wikipedia on Subprime Crisis and Subprime lending)
incentives - rewards for acting in a certain way
bad incentives - rewards for acting in a bad way
X offset by the fact that Y - Y compensates for X, Y balances and reduces the effect of X
the sheer Y - emphasizes the quality Y (for example, "the sheer delight of listening to the music," the sheer drop off that cliff, the sheer desperation of not having any money)
the sheer scale - the very large size
a bubble - when asset prices rise to unreasonably high levels given true asset values, investors make a lot of money, and are very enthusiastic about the market, then one day asset prices suddenly drop (the crash), investors lose a lot of money as well as their enthusiasm for the market, besides causing market instability, bubbles also have a negative effect on economies because they temporarily misallocate funds into non-optimal uses" and then quickly pull them out (See glossary)
the sheer scale of the housing bubble
negative equity (in a house) - the total of your future payments is less than the value of the house (so if you sold the house now, you would lose money)
put 20% down (in a house purchase) - pay 20% of the cost of the house to begin with, then pay the rest of the cost in monthly payments
delinquency - failure to pay a debt or tax
rising rate of delinquency - more and more people are failing to pay their debts or taxes
capitalisation - the sum of a corporation's long-term debt, stock and retained earnings. also called invested capital
capitalisation (of a bank) - the capitilisation of a bank is highly regulated with regulatory capital requirements set by the Basel Accord (See Wikipedia on reserve requirement and capital requirement)
thin capitalisation (of a bank) - bank has very little capital, does not have enough capital
put up enough capital - have enough capitalisation
X posed risks - X had risks (associated with it)
machinations, political machinations - secret and complicated plans to gain power
a bailout - helping someone get out of a difficult situation by giving them money
a taxpayer bailout for the banking system - teh government uses money that the taxpayers paid to the government to solve a problem in banking system (the implication here is that some people did not pay for their mistakes, instead the taxpayers paid for their mistakes)
