Monday, September 15, 2008
Today, speculation will abound regarding the government’s role in shoring up the financial system. The question is: When does it stop? Many will say that Lehman Brothers is not deemed “too big to fail”, while Fannie Mae and Freddie Mac were. Therefore, Lehman fails and Fannie and Freddie do not. In some sense this is true, but yesterday I heard the term “flawed economic model” in reference to both types of firms: the investment broker/dealers (Lehman Brothers) and the Government Sponsored Entities (GSE), Fannie Mae and Freddie Mac. If the model is “flawed,” then it should be pushed out of the market. Just like the theory of evolution – only the fittest will survive.
Nouriel Roubini, the quintessential dismal economist, calls the broker/dealer investment bank model flawed. The banks are not insured by the Federal Deposit and Insurance Program (FDIC), but highly leveraged and extremely susceptible to a bank run, which can only end in failure. This is what happened to Bear Stearns. Roubini predicts that the end to the broker/dealer system is near. Now, since Merrill Lynch will be bought by Bank of America, only Goldman Sachs and Morgan Stanley remain. So stay tuned.
Alan Greenspan spoke on CNBC’s last night and called the GSE model a “flawed economic model. It essentially socializes losses while privatizing gains.” Since Fannie Mae and Freddie Mac were implicitly backed by the U.S. Treasury, the American taxpayer was always responsible for the liabilities of Fannie Mae and Freddie Mac, while the shareholders reap the rewards (profits) and hold the assets (mortgages).
Although they are too big to fail (that is if one wants the U.S. housing market to survive), the timing of the takeover of Fannie Mae and Freddie Mac is suspect. Secretary Paulson said it best last night, the U.S. Treasury did what they had to do….they needed to restore faith in the financial system and restore faith in the U.S. economy (a.k.a., financial system first, U.S. economy second). I understand that the two are intertwined, but isn’t one the subset of the other? The failure of Fannie Mae and Freddie Mac would most certainly wreak havoc on the U.S. housing market, essentially bringing the secondary mortgage market to its knees, but it sounds to me like the U.S. Treasury succumbed to the demands foreign official investors.
The chart illustrates the trend in foreign official holdings of U.S. agency debt and foreign private holdings of U.S. agency debt. Foreign official institutions (foreign central banks, like the People’s Bank of China) were acquiring GSE (agency) debt like it was candy well-after signs of struggle emerged. Private foreign investors reduced their holdings of GSE debt when U.S. housing prices started to fall, but foreign institutions did not. Between Jun. 2007 and Jan. 2008, foreign official institutions added over 23% of new agency (GSE) debt to their portfolios, while at the same time, U.S. home values lost 9%.
Like Lehman Brothers, who will file for bankruptcy this morning, foreign central banks failed to diversify their portfolios. When the U.S. market blew up, they were holding too much GSE debt. It seems to me that the U.S. Treasury was concerned with foreign central banks and their trillions in U.S. debt holdings – they did what the Chinese wanted them to.
Yes, Fannie and Freddie were too big to fall, and as Greenspan suggests in his interview, the two firms should eventually be broken apart and sold off at market. However, the timing of the takeover suggests that the top priority of the U.S. government was to shore up the financial system and then to stabilize the U.S. economy. I just think that the U.S. financial system has a lot of kinks to work out and question the merits of recent government actions.
Please leave comments. Best, Rebecca Wilder