Most Radical Part of the Bailout

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The most radical part of the Treasury’s plan for Fannie Mae and Freddie Mac is not investing in the equity of Fannie and Freddie, in order to bail out the holders of their bonds and mortgage-backed securities. It has always been clear that the “implicit government guaranty” of Fannie and Freddie’s obligations was a real guaranty, although various government officials occasionally tried to deny it, and that the government has always been on the hook for the real equity risk.

Instead, the most extreme part of the weekend’s announcements is that the Treasury will become a direct investor in mortgage assets: it will simply issue Treasury debt and use the proceeds to buy MBS for its own portfolio. No need for a GSE balance sheet or a government housing bank, let alone any market resource allocation — the government will fund and hold mortgages in its own portfolio. The goal apparently is to increase demand for them and tighten their spreads.

This part of the plan has gotten remarkably little discussion. It will of course be quite popular with anyone who is already long MBS, but should be less popular with anyone who wants a market-based financial system.

Of course the undeniable lesson of history is that there is a 100% probability that there will be government intervention in every severe housing bust, and this one, as is now obvious, is no exception to the rule. We can understand the underlying financial dynamic by thinking about the private financial system as if it were one big, aggregate balance sheet.

In a bubble, this balance sheet rapidly expands. The expanding loans it grants cause the price of the underlying assets — in this case, residential real estate — to rise in price. As the collateral rises in price, the loans seem safer and more successful, and the expansion continues. The balance sheet expansion causes cash flows, increased wealth, profits, and bonuses to a great many people — home builders, mortgage brokers, banks, bond salesmen, successful house or condo flippers, ordinary home buyers, mortgage investors, financial engineers, realtors, mortgage insurers, appraisers, rating agencies, financial managers, GSEs. The fact that so many people are making profits from them makes bubbles notoriously hard to control, once inflated. But all of these profits depend upon the continued expansion of the balance sheet — in other words, of the bubble getting constantly bigger.

Of course, at some point it becomes clear that the cash flows necessary to repay all the loans are not going to appear — so the size of the balance sheet and the prices of the assets supporting it as collateral are realized to have been a mistake. The bubble deflates: this is known as a “liquidity crisis.” Everyone grows more conservative at once — everyone tries to shrink the balance sheet at once. This is the bust, which we might also call the “shrivel.”

You can see how any one balance sheet can shrink, but how is it possible for the aggregate balance sheet to shrivel? If everybody is trying to de-lever at once, how can this happen?

The answer is that there is another aggregate balance sheet: that of all the elements of the government. So think of the interaction of two great balance sheets: the private balance sheet is able to contract, because the government balance sheet expands.

This is what we have been observing for much of the last year, and see in dramatic fashion making Fannie and Freddie direct government operations. The government balance sheet also includes in addition the FHA, Ginnie Mae, the FDIC, the Fed’s special lending facilities and its Bear Stearns bailout portfolio, and now, it appears, a Treasury direct mortgage investment portfolio.

In general terms, this is what happens in every threatening housing bust. No one in authority wants to be in the history books as the one who stood there and did nothing while the financial system collapsed. So let us grant that first you have to survive the crisis.

But it is not too soon to start thinking about how we are planning to put the great government balance sheet expansion into reverse one day.

Mr. Pollock is a resident fellow at the American Enterprise Institute in Washington, D.C.

The New York Sun

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