The Current Meltdown
- Why did the US gov’t create Fannie Mae and Freddie Mac?
o Originally created in 1930s to enable middle-class first-time homeowners to be able to buy their own homes as government agencies
o 1960s: Lyndon Johnson needed to find a way to finance the Vietnam War. One of the consequences of this was that Fannie and Freddie, whilst continuing with their public purpose, were allowed to sell shares; they became public-private hybrids
• In consequence, they reported to Congress but they operated very much like a private entity; could not be strong at either one
o Fannie and Freddie were buying mortage-backed securities from banks, which enabled banks to engage in lending. Throughout 2000s, people were borrowing who could not afford to pay back their loans (predatory lending); ergo Fannie and Freddie were put in a weakened financial situation
o Gov’t decided that Fannie and Freddie were too big to be allowed to fail; ergo, the Feds put them into “conservatorship,” whereby the Feds stepped in and temporarily nationalized them, in effect
• A decision will have to be made by the Administration and Congress on long-term issue
o One option is to sell them all; John McCain and Alan Greenspan want to sell them and that they should become much smaller; recapitalized through asset sales and federal funds, broken up into smaller units, sold off; would then become profit-driven and answer to the shareholders
o Another view: Eg Barney Frank, Sens. Schumer and Dodd: Want to see F&F’s public and private functions clearly delineated; downsized and publically traded; would be akin to a public utilities model; shareholder returns could be capped and lenders would be free to develop new financial instruments & investments in their own portfolio at F&F would be limited
o Third option: Nationalization; would go back to being gov’t agencies dedicated to public mission; would be accountable to gov’t, would not be allowed to go back to buying mortage-backed securities
BACKGROUND
HOW DID THE HOUSING BUBBLE GROW AND THEN BURST?
Keep in mind: Government provides money to various programs (med labs, etc) by directly billing Medicare and Medicaide; farmers, agricultural businesses get money from Farm Aid-Slash-Subsidy Programs
Sometimes this entails government backing loans in case they fail: This was the intent behind Freddie and Fannie; so long as they could attract business loans, money from taxpayers were not needed. But if loans were on verge of being defaulted, taxpayer money was guaranteed to take care of it.
Freddie and Fannie loans were guaranteed by the full faith and credit of the US government.
In present case, there is no possibility of having gov’t pay off debts and then letting F&F go on their merry way; we’ve taken them over. Those that own stock in F&F lost their money.
Bailout: A one-time gov’t step-in to provide money to a failing company
So we have gov’t intervention in many different forms: Can lend a failing business cash with expectation of payback with interest; in some interests, gov’t can also insist on options for equity share in the bailed out company (Congress currently asking for this); in some instances, gov’t provides a gift in the form of a grant and may or may not receive benefits – eg if gov’t interested in research it might give a grant to a researcher looking into that issue; gov’t might give a contract to a failing business, eg Bath & Ironworks, in order to prevent a failure
One of the most interesting bailouts in history was Chrysler Corporation bailout in 1979:
Chrysler in 1979 petition US gov’t for $1.5 billion in loan guarantees to avoid bankruptcy; at same time, former Ford exec Lee Iacoca was brought in as CEO, appeared in ads saying, “If you find a better car, buy it” – attempt to tout Chrysler as a top car and instill pride in American products; ergo, US gov’t reluctantly passed the Chrysler Corporation Loan Guarantee Act of 1979, signed by Pres Carter in 1980: Chrysler employees/ers in every district frightened of losing jobs, military bought many Chrysler products (jeeps, etc).
In early 1980s, the loans were being repaid and new models of cars were selling well. A significant aspect of its recovery was the revitalization of its manufacturing facilities: Became more efficient. Improvements in vehicle quality. In 1990s, Chrysler made first steps into Europe, set up factory in Austria.
In other words, they borrowed money to build cars and paid the loans back with revenue generated.
Bottom line: Bailouts are not common in US history; in Chrysler case, gov’t persuaded that too many people would be thrown out of work. Chrysler lived up to its loan, paid it all back. It also improved efficiency, reduced executive pay, laid off many management and execs and employees, reduced its fixed costs. Basically, the gov’t cosigned its loans and Chrysler lived up to it.
In past two weeks, the gov’t has become more responsible for major parts of the housing market through its seizure of F&F. It has entered the insurance business after taking control of AIG. In AIG’s case, Treasury is making a loan to them and the Treasury has announced plans for another intervention to allow financial institutions to be able to sell their bad assets (i.e., their subprime mortgages).
Last week: Leyman filed for bankrupty
Tuesday: Gov’t takes control of AIG, world’s largest insurance company
Note: Re the assets being sold: Many of those assets don’t have a market value; how those assets will be valued is one of the crucial questions being debated this week. “Who is being bailed out?”
We’ve had a problem with many investors who buy bonds because those who buy short term obligations of companies and financial institutions – that market provides the immediate needs for working capital to borrowers. IE, what companies do is, they borrow on a short-term basis to meet their payroll and other expenses. What has happened is, the market for those short-term loans has begun to dry up. One of the things that happened is, the regulatory agencies (SEC, Fed Reserve, etc) were becoming concerned, talking about what needed to be done, but initially the problem did not look like 1930s Depression-style big bad.
During Depression, what happened was Fed Reserve tightened monetary policy, which added to the depth of the economic problems of the Great Depression. The Stock Market Crash was in 1929, but Federal Reserve did not act until 1930s. Today, Fed Res and Treasury and SEC have been making changes so that we can avoid Depression-era tightened monetary policy. Nonetheless, investors still very concerned, and certain markets where people had investments in derivitives with Leyman Brothers for example wondered how gov’t’s actions were going to help them. People who sold credit default swaps – an insurance policy type that insures certain types of financial instruments….. The market was showing that the investment banking model was not working. Investment banks, unlike commercial banks, borrow money and then make investments that are high-risk but high-return, as compared to a commercial bank, and did not come under the same kind of regulatory system that commercial banks did, so they were really outside of the typical regulatory system for financial institutions.
Money market funds started experiencing problems, they were selling what they could, because people wanted to hoard cash, so they were either selling their money market funds or were instructing their finance handlers to sell their funds on their behalf.
So the Fed Reserve was discussing the plan to bail out AIG and what they could do for the broader systemic problems, but interest rate changes would not help. They met but left interest rate as it was because it wasn’t going to help the current crisis to change it. TreasSec, FedRes Chair, NY Fed Reserve Pres got together to try to fix it.
NY Fed Reserve Bank probably the most powerful in the Fed Reserve system, b/c it is where the action is.
Three discussed a systemic approach of buying distressed assets such as residential and commercial mortgages and mortgage-backed securities. At the same time, the Fed Res put billions of additional cash into the system but it did not calm the market, and short term interest rates were gyrating. What was happening was, banks were holding reserves b/c they were afraid they were going to have to meet many diff kinds of obligations, and banks didn’t trust each other to lend to each other. SO, we had this major crisis where we had 144.5 billion dollars pulled out of money market funds, and without those funds, the commercial paper which finances auto lending, money cards, etc – they were facing outrageously high costs, means factories shut down, people lose their jobs, etc., major consequences for Main Street and not just Wall Street – the problem has a cascading effect
Last week, the market for mortgage backed securities disappeared; the yield on mortgage backed bonds were rising and the trading on those went away even though gov’t nationalized F&F.
TresSec Paulson wants US Congress to approve a plan to allow Tres to create a new facility to hold auctions and buy up distressed assets. Without Congressional approval, Tres could expand programs to buy mortgage backed securities through F&F, but that wouldn’t be enough to address underlying problem of subprime mortgage meltdown and mortgage backed securities. Fed Res not equipted to handle the problem; part of problem in banking system, part in economy, part in the mortgage-backed securities outside of responsibility of the Fed Res.
Bernanke asked Congress for the authority to buy billions of dollars in assets. This will actually be a reserve auction where these various financial institutions will go to the Fed with their financial instruments, and there will be a bid where they will say, “ My mortgage backed securities are worth X,” leading to a back and forth – the question is how those assets will be valued, b/c how they will be valued speaks to who will be the “winner”
If you step back and think about it, if there was a market for those assets, then the banks and the investment houses would have sold them. There is no market for them, because housing prices have declined, many people took out mortgages that couldn’t afford them, etc. So what’s the value of those assets? Many had become illiquid, ie untradeable. If they lack value and cannot be traded, there will now be an auction. How much will the Tres’s new agency going to pay for those assets?
The Federal Reserve as an independent regulatory agency:
The FedRes is stepping into a very different role, a much more “political” role, than it has in some time. Some people are questioning the FedRes’s independence at this point b/c one of the things we need to keep in mind – remember we talked last week about the fact that Independent Regulatory Agencies are independent, with Pres appointing chair with advise and consent of Senate, meaning that they operate independently and apolitically; this independence is supposed to keep those agencies from being politically maneuvered, b/c there can be problems with, say, Congress setting interest rates; we had such problems in 1970s, eg Nixon persuaded Paul Vulger to keep interest rates low for political reasons and this created larger problems in the financial system. So some are questioning whether elected officials should be able to decide without Congressional vote which companies should and should not get assistance.
Fed Res Chair Ben Bernanke: Meeting with Congressional committees this week.
The Federal Reserve is independent, has a Board of Governors, and most of the time it stays out of political debates so that it can be independent. Politicians often want lower interest rates in order to give the perception that they’re working for the people, but in most cases they defer to the Reserve. (Not now, though – much anger about financial probs)
In past year, Federal Reserve has extended its lending programs and its purview: It has lent money (Bear Sterns), gotten involved in Treasury decisions, etc.
The government has now gotten involved in industry outcomes.
We are in a storm, and though we can hypothesize how things will turn out, we do not know for sure until it is over.
Most favor intervention by gov’t because of the magnitude of the problem. But some people are saying that the problem and the way it’s being presented – they’re making the analogy between what’s going on now and the Bush Administration’s presenting to Congress and US public what happened just before Iraq War. They say it’s the equivalent because it’s saying, “We have no choice, this is what we have to do, and we’re gonna do it.” If you can convince people that there is an immediate problem and you have the answer, then you can usually coalesce certain groups – eg when they met with Congressional leaders on Saturday, they presented a very dire picture. Often only way to get people on left and right to come together: Idea of not having too much choice.
AIG
American International Group does business with just about every financial institution in the world. It is a central player in the unregulated credit default swap market, which is about $60 Trillion. There is no central clearing house or regulator for credit default swaps.
Credit Default Swaps (CDSs): One company pays another company to protect it from the risk of default on a debt instrument (loan, etc): The insurer compensates the insuree for the lost. The insurer is usually an investment bank or a hedge fund. The insurer is required to post collatoral to support its payment obligation, but the collatoral deposit in most cases was too small. This was one of the real problems AIG faced; ergo AIG was undercapitalized.
AIG was given a loan because it had hundreds of billions of dollars of mortgage related assets. Those would be added to those being sold by other financial institutions, further depressing housing values. The counterparties to CDSes would not be able to collect their trades. Regulators knew that if Leyman went down, world would not be impacted in large way, but world not prepared for AIG to go down. There is no precedent for fed gov’t lending to an insurer, but they had little choice.
Enter the SEC.
One of the things going on is, SEC looking at potential market manipulation. SEC will require hedge fund managers to submit under oath their trading activities in financial company shares and related instruments such as CDSes. What happened with CDSes is, there are some people who are ethical, but others who were unethical. What happens with a CDS is, you bet that a company’s stock is going to go down so you want to sell before it goes down: Enter the CDS, which is an insurance bond that guarantees a certain amount. What can happen is, certain people because CDSes are not regulated would spread rumors that a company’s value was going down and then they would be able to manipulate the market. Sellers charge buyers’ fees to insure the bonds and loans from default. Buyers can benefit if the cost of protection rises. We’ve had large price declines in stocks accompanied by moves in CDses – that’s what led to people being concerned about market manipulation. CDSes became a gamble on what was going on.
CDS-related manipulations are the main problem. Added on to the CDSes has been what’s called “short selling.” Short selling is where certain investors believe that a stock price is going down so they will sell short – sell before the price goes down. There were rumors by those who wanted to manipulate the market and sell short. Short selling has been banned.
CDSses trade off the Exchange and are outside the scope of regulation. There’s a great increase and prices have swung sharply before news of major company news. SEC has not brought any cases because there is debate about whether CDSes are securities, thus within SEC jurisdiction, or another instrument outside their purview.
New York State Insurance Department is now looking at CDSes as insurance, will require them to register. This is a new development. State, not federal.
The SEC has taken the position that swaps that reference to securities such as bonds are subject to oversight, but right now the SEC is issuing subpeonas to gather info, want to look at hedge funds to see if there were any rumors that led to the downfall of Bear Sterns or Leyman Brothers. SEC is halting short sellers of financial companies, requiring hedge funds and other asset managers to submit their decisions/records.
Sunday night: SEC modified that order. They have a list of companies where traders are not allowed to sell short. They are saying that there is an exception to the requirement for something that is already in the pipeline as part of a futures contract. They clarify that the exception applies to all market makers including over the counter market makers and applies to all market making and hedging activity. They want to enable market makers to be able to continue to supply liquidity.
Goldman Sachs, Morgan-Stanely:
As mentioned last week, investment banks get their money from taking on debt and then investing and then paying that debt with high rates of return because they have a high level of risk in the types of instruments they are involved in.
The independent investment banks were not regulated by the Federal Reserve as commercial banks were. GS and MS transformed themselves into bank holding companies. That will reshape the way that we see finance take place in the US, around the world. Their model of investment banking where they don’t have the cushion of bank deposits like commercial banks was a problem.. By becoming Bank Holding Companies, they will have tigheter regulation from several gov’t agencies rather than just the SEC (which only looked at certain aspects of what they were doing). These holding companies will now have access to Fed Res lending facilties, will be able to borrow from other banks, will be fully regulated banks in much the same way commercial banks are.
We are seeing much movement to more regulation, to be expected given the enormity of the problem, and much more government involvement in the market.
Subprime Mortgage Market: A market where people who don’t have good credit could access to get a mortgage when they wouldn’t otherwise qualify. That basically came from our philosophy stemming from the 1990s saying we wanted to open home ownership up to a greater number of people. Many were qualified who really couldn’t afford to take out the mortgage.
By contrast, a prime mortgage is for someone who has good credit. A subprime mortgage had higher interest.
The Dr. argues that under an administration more bent towards regulation, we wouldn’t have the same problems we have now. However, the prob wasn’t only in the exec branch: Congress often had constitutions complaining about tighter regs on mortgages etc. Lack of enforcement, a regulatory framework with many reg agencies were both problems. Also: If a financial institution did not fall very cleanly under a regulatory body, they could shop around and choose the reg agency that gave them oversight. Leyman eg had office of Thift Supervision as their oversight body, even though there was no real relationship between their activities and TS’s purview.
