Thursday, July 24, 2008

Weighing in on Fannie & Freddie

WAIT, don't go! I promise this won't be boring! Okay, maybe it will be a little boring, but you also might learn a thing or two, so stick around and edumacate yourself, dammit!
First of all, let me start by saying that the most important lesson to take home from the Fannie Mae / Freddie Mac problems, is that in England 'fanny' is a slang term for the front bits of a woman, not the back bits. Did you know that? I didn't either! It gives me a whole new understanding of why the stupid Brits laughed so much when I said I was going to store stuff in my fanny pack. They laughed and laughed even though, according to them, I don't even have a fanny.
See? I told you... NOT boring!
Anyway, moving on... Congress is currently working toward passing legislation enabling emergency funds for Fannie and Freddie as well as control over both mortgage giants' executive salaries. Seems like a good move to some, a bad move to others. You wanna know why there's a divide on the issue? Well, if you'll be patient, shut up and listen, I'll tell you.
Economists have a favorite expression and that expression is: "We're not ineffectual nerds! We helped explain that when a lot of people want a product, it will cost more. That's useful right? RIGHT?"
Okay, so maybe that's not their favorite expression, but it's close. But their second favorite expression is "Moral Hazard" and that's the expression that's relevant to this post.
What's a Moral Hazard, you ask? Well it's a term for the risky behavior that results from having insurance. Personally I feel the term Moral Hazard should be renamed "Jerkwad Hazard", or if you want to be a little more politically correct, perhaps "Risk Hazard". But anyway, what Moral Hazard means, in a nutshell, is that if you were somehow insured against losing your money at a Blackjack table, you'd bet higher amounts, play riskier and not really care about the outcome. You would lose your risk aversion. This is what Moral Hazard means. Seems logical right?
Side Note: I've sometimes seen people try to apply Moral Hazard to Health Insurance which is patently ridiculous. Giving everyone free (or affordable) health coverage doesn't mean everyone's going to start going to the doctor. Moral Hazards only apply to things people ENJOY doing. And sitting around a hospital room or doctor's office with a bunch of other sickies and whining rugrats is something most people AVOID doing even when they have broken legs and ruptured spleens. Nobody likes going to the doctor, so Moral Hazard doesn't apply to health coverage. But people (and businesses) do rather enjoy making money, so Moral Hazard is a useful term to describe what happens when the Federal Government insures that a company or bank can't fail.
Now then, lest you think the government is completely and totally filled with morons (it is), let me tell you that The Fed DOES understand the Moral Hazard problem and tries to avoid creating it. They do this even though Wall Street itself is very "failure friendly"... most collapsed hedge funds and bankers end up working elsewhere or getting golden parachutes for their fantastic failures.
For example, the Fed stepped in when Bear Stearns collapsed with a plan that avoided the Moral Hazard issue. Bear was a huge bank with $300 billion in assets that would have caused a big ripple in the marketplace had it totally collapsed. So when The Fed encouraged JP Morgan to buy the beleaguered Investment Bank they also wanted to make sure Bear (and its shareholders) were virtually wiped out. JPMorgan initially wanted to offer $8 to $12 per share for Bear Stearns but The Fed lowered the offer to $2 to ensure Bear was significantly punished.
As you can see, even though The Fed stepped in to staunch the bleeding from Bear they also did what they could to avert the Moral Hazard problem. Now let's look at Fannie and Freddie: Bear might have been huge ($300 billion in assets is nothing to sneeze at), but Fannie and Freddie are super-mega-hyper-global-death-ray HUGE. The two of them control $5 TRILLION in mortgages! Almost half of all the mortgages in this country are backed by the two institutions. So if Bear's collapse was a big problem, then Fannie and Freddie's potential collapse is a fantastically craptastic problem!
Hoping to avert their collapses, Congress will finalize the legislation of emergency funds next week in the amount of $300 billion to help the companies, but in doing so it seems the Moral Hazard problem has risen its ugly head, right? The government is propping up Fannie and Freddie and guaranteeing they won't fail... which is the very definition of a Moral Hazard, the same situation The Fed wanted to avoid with Bear.
But waitaminute, not so fast! There's a twist. Let's first examine why Bear Stearns collapsed:
As a bank, Bear had a bunch of principal and interest payments it needed to make it each month on outstanding debt. For argument's sake let's assume you had a mortgage with Bear and back in 2007, you missed a payment. No big deal for Bear right? They just dipped into the cash lying around from their other depositors and shareholders and paid off whoever they needed to pay off that month and then came after you with nasty letters and phone calls and damage to your credit. Now fast forward to March 2008. Depositors and shareholders at Bear start getting scared. They think the bank has a TON of risky mortgage securities on the books (they might have, but those securities might also have turned around if Bear could "stay at the table" long enough).
So the rumors about Bear's lack of liquidity start, everyone panics and fearing Bear's collapse, people start pulling their money out. If Bear didn't have a liquidity problem before the run, the panic definitely caused one. With depositors and investors pulling money out at an incredible rate Bear sits there facing a liquidity problem caused specifically by people afraid of Bear having a liquidity problem. With a lack of cash sitting around, what happens when you miss your mortgage payment to Bear then? Suddenly they have no cash to meet their own payment obligations and the result is a downward spiral of money caused by marketplace panic and little else.
Back to Fannie and Freddie... if the government nationalized both companies, investors and shareholders would be wiped out. Completely. So any rumors of nationalization would drive away investors and CAUSE the very same downward spiral of money that would lead to Fannie and Freddie's eventual collapse. Though the panic about "liquidity" would not be the same, the fact that shares would be worthless would cause everyone to sell -- which is pretty much exactly what happened when Fannie & Freddie's stock prices declined so badly a few weeks ago.
As Government Sponsored Entities, Fannie and Freddie actually have rules and regulations that forbid them from getting involved in the subprime mess, so most of the loans on their books are solid and not at risk for default. But some panicky Wall Streeter looked around, saw Bear and IndyMac failing and said, "Hey, waitaminute, Fannie and Freddie have to meet TRILLIONS of dollars in loan obligations. Bear and IndyMac had only a fraction of that and they both collapsed. I'm getting out!"
Those fears triggered a sell-off and left both institutions looking weak, but what else is there for Congress to do at this point? The issue is complex because rumors of nationalizing Fannie and Freddie would lead to their collapse, but propping them up would lead to the Moral Hazard problem.
Well let me be the first to say (in all my genius) that the main problem here is legislating "after the fact". A common theme running through this young and mostly pointless blog is that financial institutions are growing too large and many of the newer ones (hedge funds / private equity) are seriously under-regulated.
The government regulates the market share of everything else, so why not financial institutions? As banks, lenders and funds continue to grow, we're more and more likely to see problems like Fannie/Freddie with fewer and fewer answers. Thanks to derivatives, modern financial institutions are so interdependent on one another that when a big one collapses it sends ripples through the whole system. And ripples hurt. Even when banks and lenders are doing the right things (as the Bear and Fannie/Freddie cases illustrate), sometimes their failures become inevitable. Storing free cash underneath the mattress (or in a fanny bag... cue Brit laughter) for a rainy day doesn't help when you own every other house in the country and all the mattresses in the world can't store the reserves you need.


Parr said...

Great post. Intelligent and you did what you set out to do, I think. Make a boring topic into something easy to understand with just enough entertainment value.

One comment about Moral Hazard and health care. There are people that like to go to the doctor and other medical places. The homeless and those with mental health issues. A homeless person would love to get put up in a hospital room for days at a time. And those with mental issues can't help themselves.

Of course, these are minor things that could be figured out through the legislation of 'free' healthcare.

Sprizouse said...

Thanks man... I hope I made an arcane subject interesting. I'm actually working on a MASSIVE (and likely REALLY boring) post about the whole financial system right now. I bet you can't wait.

But more importantly... let me ask you this: What do you know about the Romantic Poets??? They've been around A LOT longer than Fannie and Freddie.

Parr said...

hahaha good call.
Its kinda weird. When I was younger, I used to save my halloween candy till late spring so I wouldnt run out of a good thing and always have something around. Its like, after I read that, then what? Then what will I have left? I got issues....