Fannie and Freddie’s Bust and Deeply Flawed Government Bailout

Source: Nouriel Roubini's Global EconoMonitor

Fannie and Freddie’s Bust and Deeply Flawed Government Bailout

Nouriel Roubini | Sep 7, 2008

The government takeover of the two insolvent GSE’s – Fannie and Freddie – is no surprise to the author of this blog. Two years ago – in August of 2006 – this forum argued that the biggest bust in housing since the Great Depression would lead to a systemic banking crisis, a financial crisis, a severe credit crunch, as serious recession and the bust of Fannie and Freddie . 

As we wrote then:

The scariest thing is that the gambling-for-redemption behavior…are not the exception in the mortgage industry; they are instead the norm. There are good reasons to believe that this is indeed the norm as lending practices have become increasingly reckless in the go-go years of the housing bubble and credit boom.

If this kind of behavior is – as likely – the norm, the coming housing bust may lead to a more severe financial and banking crisis than the S&L crisis of the 1980s. 

The recent increased financial problems of … sub-prime lending institutions may thus be the proverbial canary in the mine – or tip of the iceberg - and signal the more severe financial distress that many housing lenders will face when the current housing slump turns into a broader and uglier housing bust that will be associated with a broader economic recession. 

You can then have millions of households with falling wealth, reduced real incomes and lost jobs being unable to service their mortgages and defaulting on them; mortgage delinquencies and foreclosures sharply rising; the beginning of a credit crunch as lending standards are suddenly and sharply tightened with the increased probability of defaults; and finally mortgage lending institutions - with increased losses and saddled with foreclosed properties whose value is falling and that are worth much less than the initial mortgages – that increasingly experience financial distress and risk going bust.

One cannot even exclude systemic risk consequences if the housing bust combined with a recession leads to a bust of the mortgage backed securities (MBS) market and triggers severe losses for the two huge GSEs, Fannie Mae and Freddie Mac. Then, the ugly scenario that Greenspan worried about may come true: the implicit moral hazard coming from the activities of GSEs - that are formally private but that act as if they were large too-big-to-fail public institutions given the market perception that the US Treasury would bail them out in case of a systemic housing and financial distress – becomes explicit. 

Then, the implicit liabilities from implicit GSEs bailout-expectations lead to a financial and fiscal crisis. If this systemic risk scenario were to occur, the $200 billion fiscal cost to the US tax-payer of bailing-out and cleaning-up the S&Ls may look like spare change compared to the trillions of dollars of implicit liabilities that a more severe home lending industry financial crisis and a GSEs crisis would lead to.

The main, still unexplored issue, is where the risk from mortgages is concentrated: among the sub-prime lenders …or among commercial banks or among hedge funds and other financial intermediaries that purchased mortgage backed securities (MBSs) or among the GSEs (Fannie and Freddie)? 

Commercial banks claims that they have transferred a lot of their mortgage risk to other financial intermediaries – such as asset managers, hedge funds or insurance companies – who purchased large amounts of MBSs. But banks have still lots of mortgages on their books and, on top of it they have tons of consumer debt exposure (credit cards, auto loans, consumer credit) that may go really bad in a recession. If part of the housing risk has been off-loaded to hedge funds, the risk is not just of some of these hedge funds going bust but also their prime brokers (i.e. large investment banks) getting into trouble; counterparty risk will become serious once the hot potato of mortgage risk is pushed from one counterparty to the other. 

And finally, a large part of the housing risk is also in the hands of Fannie and Freddie. How much are the GSEs at risk is a complex issue…Either way, a serious housing bust followed by an economy-wide recession implies serious financial risks for the entire financial system, not just risks for the real side of the economy. A systemic risk episode triggered by a housing bust cannot be ruled out...

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