Friday, July 11, 2008

Are Fred and Fran too big to save?

The financial crisis symptom de jure: the struggles faced by Freddie Mac and Fannie Mae the giant mortgage loan repackaging companies chartered by the U.S. government, and (assumed to be) guaranteed by Congress. In fact the loan guarantees with the Treasury Department that are available to the companies amount to only a few billion dollars, so the US government's official obligation to help is miniscule. Bush administration suggestions that as part of a bailout, stockholders would loose almost everything hardly seem likely to improve the companies' capacity to sell stock in order to recapitalize after losses.

Which brings us to the question of whether the Fred and Fran can and should be helped. Everyone says that they will be saved if need be. But the costs? Quite possibly enormous. With price-to-market accounting, Freddie Mac is technically insolvent already.

The New York Times today has a story which suggests (without quite saying so) that the companies may be too big to save as well as too big to fail.

As government officials discuss various rescue plans — including taking over either or both companies in a conservatorship, others are pushing for more immediate action.

“We are potentially looking a crisis in the face, and we must not allow this to happen,” said William Poole, who retired in March as president of the St. Louis Federal Reserve. “The government must intervene.”

If a bailout were to occur, it would most likely make it more expensive for the United States government to borrow money in the future, since the government’s potential obligations, which currently stand at about $9 trillion, would rise by an additional $5 trillion. Moreover, such a bailout would potentially put taxpayers on the hook for billions to offset Fannie’s and Freddie’s losses.

“The major banks are taking write-downs of 20 percent to 50 percent of their assets,” said Sean Egan, managing director of Egan-Jones Ratings, an independent credit ratings firm. Just a 10 percent write-down in the value of Fannie Mae’s assets would be “a loss of $150 billion that taxpayers would need to offset. So you’re talking about the cost of another Iraq war.”

The most significant sentence is the one which asserts a bailout or takeover "would most likely make it more expensive for the United States government to borrow money in the future..."

Since the financial crisis began, many sectors of the U.S. financial system have lost much of their ability to borrow money. But money must be borrowed to sustain the trade deficits and prevent the dollar from collapsing. The US government itself has not seen the cost of borrowing increase markedly, with interest rates suppressed by central bank purchases.

If an when interest rates increase on U.S. government borrowing, the relatively managable 400 billion per year the U.S. currently pays in interest would also climb. This would set off a cycle of fiscal problems that might well trigger a free fall in the value of the dollar, and an economic collapse.

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