Monday, September 08, 2008

Buying a Pig In a Poke

Congratulations. As an American taxpayer, you are now the proud owner of two failed mortgage companies whose losses will soon exceed their capital reserves. But don’t worry, because your tax dollars will now prop up the failed institutions and quietly compensate for those losses. Hey, what’s a little more taxpayer debt when you’re already in the hole a few trillion?

Treasury Secretary Hank Paulson waited until the Sunday calm in the weekly news cycle to break the news that he has just nationalized Freddie Mac and Fannie Mae, the two (heretofore) quasi-public/private mortgage lenders. Per this NY Post article, the Bush administration took this action “to avert the potential for major financial turmoil;” a bogeyman that may never have materialized.

Actually, you and your fellow taxpayers only own about 80% of Fred and Fan. The other 20% is retained by investors that made big money for years from the shoddy lending practices of the two mortgage giants. And guess what! These same investors are now preparing to reap market gains from the takeover.

Usually when the government takes over a failing banking institution, common and preferred equity holders lose their investment. That’s how risk functions in the market. While Paulson has stopped these investors from getting dividends, they still retain their equity shares, meaning that they own those shares with minimal risk while still getting paid like they’re higher risk instruments. This is incentive for them to behave in a riskier manner.

Another problem is that debt holders have been fully secured, meaning that they also lose no money. In effect, they get the payoff benefit from high risk without bearing any of the cost. (You’re bearing the cost for them.) This will encourage debt investors to engage in risky behavior. But more importantly, it will also encourage debt holders in other shaky institutions to look to the government to prevent their losses.

The Wall Street Journal calls this model a “perverse mix of private profit and public risk, which [gives Freddy Mac and Fannie Mae] an incentive to make irresponsible mortgage bets with a taxpayer guarantee.” The takeover won’t do much to help current homeowners that have been hurt by years of mismanagement. It will harm future prospective homeowners by making it more difficult to buy a home.

The takeover is not all bad. The WSJ notes that the two firms have been ordered to “stop to their political lobbying.” Most people are unaware of how extensively Fred and Fan lobbied our politicians to look the other way and to give them sweet deals over the past half decade while the looming crisis has been visible for all to see.

It didn’t have to be this way. Reform would have been far less painful at an earlier stage. But the political will to deal with the obvious problems didn’t exist. Someone would have needed to stand up to the powerful politicians as well as industry groups that depend on Fred and Fan for an advantage in the marketplace. This is reminiscent of some other government programs.

Again we see how government meddling distorts the market and ends up hurting those it purports to be helping, while enriching the pockets of a few — all in the name of doing good, and doing so in the name of “the people.”

One observer said that presidents often tend to do things that fly in the face of their party’s positions. No one thought that a Republican would strengthen diplomatic ties with Communist China, but Nixon did. And no one thought that a Democrat would reform welfare along conservative lines, but Clinton did.

Now we have a Republican administration that has nationalized a fair chunk of the mortgage lending market. Both major parties seem bent on moving as much of the private sector into the public sector as possible. I can feel my cynicism rising.


y-intercept said...

I don't know if one should call this takeover as nationalization as the taxpayers already owned the risk.

IMHO, these two dinosaurs from the New Deal did their real damange to our country as the quasi-government insured loans were a prime factor in driving housing out of the price range of so many people.

The fact that pretty much every one of FDR's New Deal creations has created a crisis for people down the road has yet to phase any of the New Deal worshippers.

The really funny thing is that Obama is loudly proclaiming that he would have had the government take over of Fannie and Freddie earlier ... as if politicians haven't been mucking with these programs since their inception.

Scott Hinrichs said...

What you are saying is that we actually nationalized this segment of the mortgage industry years ago. We just disguised it by having corrupt front organizations that traded public shares. Now that the gig is up, we are simply being honest about who really owned these mortgage companies all along.

This makes the Enron debacle look rather minor by comparison. It also seems like something out of the Sopranos, only on a much grander scale.