Tuesday, July 15, 2008

Moral Hazards and Corporatism

This WSJ piece on Freddie and Fannie is a must read. The current debacle is a classic example of the problem created by state interventionism into the economy; and now "we" have created a situation with no good outcome.
Tom Smith's commentary seems pretty much right on:

There is so much wrong with the setup now it's hard to know where to start. Because F and F have their special status as GSE's, they have crowded out the private market players and grown to monstrous size. This means you have poor institutional diversification. Instead of many banks financing our houses, you have two gigantic ones. They get cheap, subsidized money because they are GSEs and use it to buy risky assets, and so have a money printing machine. What a deal! Except the risky assets were mispriced because the risk was poorly understood, but why should F and F care since they are not really spending their own money anyway. They are not subject to SEC rules and generally nobody knows what the heck their portfolio is worth anyway, and nobody's too worried anyway. Everybody is willing to play along because we all know the US Treasury stands behind them, except that it is a $5 trillion (or more?) off balance sheet debt for the federal government, probably the biggest off balance sheet liability in the history of the universe, barring profligate ET's we don't know about. They're probably up there in their flying saucers, throwing down Antarian roobles on when the shit is going to hit the fan.

As a first approximation, you could do something like give all the equity holders of FF (that's Fannie and Freddie) debt junior to the outstanding debt, and make the US government the 100% shareholder. Then set up a board under a special charter subject to the supervision of the Fed, the SEC and the Treasury, so nobody gets too powerful, especially not the Fed, which is a scary bunch. Perhaps establish by statute some status for the debt such as "Not guaranteed by the United States, but in fact, actually, fully guaranteed by the United States," and let the market sort it out. Just kidding on that. I really think it has to be fully guaranteed, at least for now, until some privatization scheme can be worked out, in the post-Obama era, around 2017 or so. But how to move to a full guarantee without making T-bills look like the fully subordinated notes of Rub-A-Dub Car Wash, I don't know.

So just to sum up, what we have here is a gigantic federal program nobody authorized to lend mind-boggling amounts of money we don't have for people to buy houses they could not afford.