FNM, FRE, and AIG Bailed Out?! WTF?!

Fannie Mae and Freddie Mac were Government Sponsored Entities (GSEs) but they were no different from any bank that profits by borrowing money at one interest rate and loaning it at a higher one.

In the case of the consumer banks we are accustomed to, the money we deposit in our checking and savings account is money borrowed by the bank. On this, the bank pays a low (or, in the case of many checking accounts, 0%) interest rate. When we take out a mortgage from a bank, it is money loaned (a “loan purchased”) by the bank. On this, the bank earns a relatively high (5% or more) interest rate. The difference is profit, and that simple principle makes the (financial) world go ‘round.

Now Fannie Mae and Freddie Mac made mortgage loans, but they did not take consumer deposits. They got the money for these mortgage loans by selling the loans at a premium to (primarily foreign) investors. This meant the borrowers owed money to these investors, not Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac further profited from fees for this service. Investment banks have similar money-making operations going. The profit margin on each such transaction would have been quite small, so to maximize profit, the GSEs became adept at making and then selling large numbers of loans.

Like so many banks, these GSEs ran into two problems:

  • On the supply side, it became increasingly difficult to find good-quality borrowers
  • As people began defaulting on their loans, it created a problem in the middle, on the books of these GSEs. The loans in their inventory were worth less than what the GSEs purchased them for (and in some cases, worthless)
  • On the demand side, investors began to question the value of the assets they were purchasing, thereby further depressing the value of the GSE's inventory.

Of course, the dynamic process of buying and selling large numbers of loans did not stop suddenly. As the GSEs discovered they had bought loans for more than they were worth, and had to sell loans at a loss, they began to burn cash and head to bankruptcy.

My question is: so what? Terry Gross’s guest, Michael Greenberger, described the market for these loans as “shadow” and unregulated. Well, you know what? When you take stupid financial risks, you lose money. When you buy something you don’t fully understand, you don’t realize until later how stupid your risk was. Any personally responsible individual investor knows this, and has felt it in his or her brokerage account. Why should the fat cats invested in GSE stocks and bonds, the people running enormous sovereign wealth funds, have any protection from the losses of big risks, when individual investors don’t?

By bailing out these GSEs (and who knows what else) the government has accomplished two things:

  • artificially inflating the value of bad loans by promising to pay them off and
  • allowing bad loans to continue being made, with the promise to pay them off

I could be missing something, but it seems to me any one with half a brain would see how transparently stupid this is. Well, the market has more than half a brain, and that is why this action served only to confirm the degraded value of assets across the financial industry. As Joe Nocera of the NY Times put it, “the Treasury Department has actually contributed to the biggest problem in the market right now: an utter lack of confidence” The result was the failure of even more banks.

It reminds me of scenes from holocaust movies where a group of oppressed refugees hide somewhere in utter silence from their pursuers. As long as everyone is quiet, there is a chance they will escape, but one of them coughs, so they all fall into the hands of their captors.

Our government coughed. Merril Lynch, Lehman Brothers, and AIG have all fallen.

One credible rationalization for this action is that future economic growth will compensate for the recent overspend by the population (measured by mortgage defaults) and the current enormous expenditure by the government (measured by the price tag on bailouts). But, the government doesn’t generate revenue directly from economic growth—its money comes from two places: taxes or the mint’s printing presses. Printing more money will cause inflation and dilute the value of prospective buyers’ current holdings. So taxes it shall be.

Even my favorite ten-year-old understands that while these bailouts may allow (foolish or fooled) borrowers to remain in their homes, the tax burden and inflation may drive many non-borrowers out of their homes in years to come.

You know all those cheap Chinese goods on the shelves at Wal-Mart? Buy them now on your credit card! Interest rates are artificially low! Soon, with higher taxes and higher interest rates, you won’t be able to afford them!

In other words, our children will pay for our folly. Unfortunately, there is no way to put lipstick on that pig. This is why the bailouts have been presented to us as preventing a global financial catastrophe. Personally, I can’t see how it could be any worse.

The other rationalization is more insidious, but was brought to my attention by conservative personal finance advisor Dave Ramsey: the Republican administration is goosing the stock market in the short term to ensure McCain’s election in November. Even the possibility of such an abuse of power argues for smaller, less powerful government. Isn’t that what the Republican Party used to stand for?

George Will said on This Week With George Stephanapoulos,

You [Stephanapoulos] asked the Treasury Secretary, "Is this socialism?" He answered, "No, it's not socialism; it's necessary."...When the British Labor Party was socialist, it defined socialism as government control of the commanding heights of the economy---which in Britain at that time was coal, steel, and railroads. The commanding heights of the American economy are financial services and they are now controlled by the government."

Tags: Economics, Politics

Updated at: 21 September 2008 12:09 AM