The bear cometh. Where be the bullets?

I teach finance at the university level, and as much as I would hate to see the US Government effectively bail out Fannie and Freddie, if that is what is came to there would be no choice. These government-sponsored enterprises are truly too big to fail. We simply couldn't stand by and let the channel for as many as half of the mortgages in this country go belly up.

I heard an excerpt of the interview during my commute (yesterday, I think). The telling aspect missing from the transcript is the tone in Rogers' voice: essentially, "how can they be so stupid?"

Rogers is correct, at least in his opinion of the decisions, because of some simple reality:

1) An economy is a system, not a collection of isolated parts. Every system has a balance point or area, and our economy has been rather far from it for a very long time.

2) Belief trumps facts. The fact is that some sectors will lose while other sectors will gain; the belief that all, or nearly all, sectors can gain is asinine fantasy at best. The government has long used artificial props in losing sectors, a negative feedback loop that only hurts gaining sectors sooner (usually) or later.

I don't know how widely read you are, Rod, but my POV is that I'm no more of an economist than you are. Your "shinola" remark is undeserved self-deprecation. Trust your common sense, as I trust mine, and rip the veil of fantasy beliefs from the facts of the system. This blog post is an excellent start.

I'm not that expert in economics, but I would make a couple of points.

1. [I]f investors come to believe that the government won't let something fail, then there's no reason for that something to take risks responsibly. There's some merit to this, but as we saw from the tech bubble in 2000, the Enron fracas, and many other cases (heck, you can go all the way back to the 20's, when nothing was regulated or insured by the government), there often seems to be a perverse tendency for investing, business, &c. to take large-scale irresponsible risks even if there is no expectation of a bail-out. Moreover, the very regulations that Republicans have been gutting for the last decade or more are some of the things that are supposed to motivate responsible risk-taking (review, e.g. the Mother Jones article about Phil Gramm you linked to awhile back). Regulation can't solve everything, but the laissez-faire attitude that if they know there's no bail-out, they'll get in line, certainly won't solve everything, either.

2. I forget where I read this, but a few days ago I saw the approximate GDP (Gross Domestic Product, that is, the total of all goods and services produced in the country per year) of the US given as about $15 trillion. For the world, it's about $50 trillion. The Fannie Mae/Freddie Mac cumulative debt (about $5 trillion) is about one third of our whole GDP, and a tenth that of the whole world! That puts in perspective the repercussions that could occur if the whole thing went down. You're talking (potentially) instant 30's-type depression or much worse.

Thus, while I favor any executives at these companies getting any fines, penalties, or even jail time for the grossly irresponsible investments and policies they pursued, I think it's a bit glib to say, "let 'em go down, and maybe they'll learn something".

I teach finance at the university level and as much as it chaps my hide, we simply couldn't afford to let Fannie and Freddie fail. Those government-sponsored enterprises are the channel for roughly one-half of all of the outstanding residential mortgages in the country. If it comes to that, they are truly (in my opinion) to big to fail.

It is the age-old question regarding "moral hazard." Do we let the "guilty" (those who knowingly took risks) off the hook? However, we can't forget the flip-side of the moral hazard issue. A great many who did not take risks and played by the rules could get hurt if Fannie and Freddie went down. That "great many" would likely include people like you and me. Indeed it might be better to let the guilty off of the hook in order to avoid exacting massive punishment upon the innocent.

Don't forget that if it came down to a federal bailout of Fannie and Freddie (and I am not sure that we will get there), the stockholders would lose most if not all of their equity investment. Remember that in the Bear Stearns situation the Bear equity holders lost the majority of their investment. The so-called "bailout" was of the counter-parties, those who were on the other end of various financial contracts. Bernanke and company did what they had to do (I believe) given the fear of what sort of contagion might spread if all of those other parties were hurt. Multiply that by many times when it comes to Fannie and Freddie.

One reason the Feds require such agencies (and commercial banks as well, of course) to have a certain level of stock ownership is so that you have private investors who have some control of the company and have "skin in the game." Fannie and Freddie are as much a failure of corporate governance as anything. Goodness knows the stockholders (owners) of these enterprises have taken a bath. However, still, that did not provide enough guardrails to keep "F&F" out of potentially serious trouble.

It's as if we are all in a car with a somewhat inebriated driver going around sharp curves on the highway. Let's just hope we get home relatively safe and sound and remember to use a designated driver next time!

There you go. Many nuanced questions and not many answers. Yes, I am a true academic :)

We'll never get to the source of this because too many are invested in the system. The heart of the problem is the Federal Reserve, and neither party has anything bad to say about it.

Since Freddie and Fannie are government sponsored, it's the Democrats who fought tighter regulation and oversight. Republicans have been attacking Fannie and Freddie since the 1980s, if not earlier. The $5 trillion mess that is Fannie & Freddie outweighs everything Bush & the Republicans have done. More debt than even Reagan racked up. Ironic.

Adam, they don't even have to sell their holdings. Just stopping buying will knock down the dollar. Who wants to bet that China is just waiting until the Olympics are over to announce they will no longer increase their U.S. reserve holdings? Could be a very interesting autumn this year.

Could be a very interesting autumn this year.

"Interesting" may be the understatement of the century!

[I]I feel obliged to point out that the John E who posted the above referenced post is not me, John E. - your friendly agnostic stoic. I would not anyone to have the impression that I claim to be qualified to teach anything at the university level, much less finance.[/I]

Well, maybe I am qualified to teach finance. But The Good Lord forbid that I ever have to run one of these enterprises :)

Tip o'the hat from one "John E." to another.

Tip o'the hat from one "John E." to another.
Posted by: John E. | July 16, 2008 5:49 PM

Hat tip right back at you - I've modified my nom de post to avoid future confusion.

That's funny, John E. Must say, for seven seconds I was mighty impressed.
Posted by: mm | July 16, 2008 5:50 PM

Yikes! Well I'm certainly glad that I cleared that up, then! ;-)

Don F, I think the key words in the article are "...at least at the margin...". With 1.6 trillion in holdings they really can't reduce their exposure much without rattling the currency markets. And it looks like they seriously want to reduce their dollar risk exposure. Après nous le déluge.

"I think it's a bit glib to say, "let 'em go down, and maybe they'll learn something"." Or "too big to fail."

It's not just those guys that caused this. It is a whole set of dominoes. But how many of us have taken a look at our own 401Ks or IRAs to see how big a part of them is Fannie Mae or Freddie Mac? How much of a hit can _we_ afford to take? Everything is connected.

John Hussman (tinyurl.com/6bne8k)

"[I]t is important to understand that the risk to Freddie and Fannie isn't that their entire mortgage portfolio, or even a significant percentage of it, will go bust. The problem is that these companies operate on about 40 times leverage, so their shareholder capital can't provide adequate buffer for the losses."

Regarding Fannie Mae and Freddie Mac, here are the sources for the GDP of the world and of the U.S., respectively:
http://www.salon.com/tech/htww/2008/07/14/fannie_mae_and_freddie_mac/index.html

and http://bubblemeter.blogspot.com/2008/07/investors-run-scared-from-fannie-mae.html.

Just so y'all know I'm not making it up. ;)

I'm in general agreement with the posters who argue that Freddie and Fannie deserve to go down, but along with (economist) John E. and AML, I do think that they are indeed "too big to go down", to put it crudely.

I really wonder how productive it is to screw with Iran considering our reliance on the Chinese and the Chinese dependence on Iranian oil.

Bingo. As the UK and France learned that they had a new boss during the Suez Crisis, so might we in the near future. Some here might enjoy seeing us getting our comeuppance.

Jim has been RIGHT 90% of the time so you can figure out the odds for yourself.