To Escape From The Old Ideas

Just think of the following situation. I have $1 with me, and you give me $39. With this $40 I buy bank-originated pools of mortgages that cannot be sold elsewhere and have long term risks. I will use some risk techniques that can fail and also invest some 15 per cent of the funds in low-quality assets that will not be able to pay.

Risky? No. As I have become big with purchases of mortgages of $1.7 trillion, I cannot fail. Further, I will offer insurance on another $3.5-trillion worth mortgages and charge 20 cents for $100. I hold capital of 45 cents for $100 and give you a return higher than a government bond. You will not believe my story, but if I tell you that Uncle Sam is backing me, then you will change your mind. For sure.

The authors of Guaranteed To fail start off by telling you the how government-sponsored enterprises (GSEs), Freddie Mac and Fannie Mae, worked to take the US into a deep financial crisis. This model was backed by the government, which could not allow them to fail as 50 per cent of their debt was held by financial institutions and another 20 per cent by foreign investors. More importantly, it went well with the political aspiration of providing housing to millions. As they were GSEs, their accounts did not spill into the Budget, and the model was one of a hedge fund. This one had to fail.

The book is a jolting reminder of the financial crisis that rocked us to an extent that we are not yet out of it even now. Even as another collapse looms large over the US and Europe, the authors present the darker side of the US financial system in stunning detail. This one is special as it explains how the government's own model was designed to create problems for itself.

While we all talk of stringent capital conditions, GSEs went around this issue quite intelligently. Banks had to hold 4 per cent of core capital for mortgages, but only 40 per cent of this for mortgage-backed securities (MBS). So, banks could originate $100 of mortgages, and sell them to GSEs who would repackage them as MBS and sell it back to them. In this set-up, they got back these assets, albeit in a different form, and held only 1.6 per cent capital, while GSEs held 0.45 per cent, which gave a total of 2.05 per cent — which is 50 per cent of what would have otherwise been required. Intuitively, one could generate more assets with the same capital. But once the crash came, the government had to step in to bail out the system.

The authors reiterate that while all other suspects such as American International Group, investment banks and commercial banks came under the scanner during and after crises, GSEs somehow managed to avoid scrutiny. Even the Dodd–Frank Wall Street Reform and Consumer Protection Act does not mention their case with any seriousness. Clearly, there is need to reform the system, which stems from the moral hazard that lurks in every corner — GSEs cannot fail because the state supports them till the end.

So what are the solutions? The book suggests that the investment function of these GSEs should be dispensed with as soon as possible. The original idea was to create liquidity in the market, but this is an obsolete idea. As they have $1.7-trillion assets, they should be dispensed with by creating a resolution trust corporation (RTC) that takes on the role of a bad bank and systematically lowers this number. Next, the guarantee function should be done in a more judicious manner to bring in market discipline. The authors also suggest nationalisation of the GSEs so that their accounts become a part of the budget rather than an off-balance-sheet item. The government then has to pay more attention to these numbers. They also speak of options such as privatisation or hybrid forms as public-private partnerships to make Freddie Mac and Fannie Mae more tenable in the long run.

The book is an easy read and well-written as examples or analogies drawn are simple to understand given the complexity of the subject. The authors strongly feel that the US really does not want to change too many things here, and prefers to do a Fred Astaire around the issue bringing to mind what (John Maynard) Keynes had to say — the difficulty lies, not in the new ideas, but in escaping from the old ones.
 
Authors' Details:
Viral V. Acharya, Matthew Richardson, Stijn Van Nieuwerburgh and Lawrence J. White are professors at the Leonard N. Stern School of Business at New York University, and are experts in applied financial economics. Acharya and Richardson are co-editors of Restoring Financial Stability And Regulating Wall Street (2010). Van Nieuwerburgh is an expert on household finance and mortgage markets, while White has served on the board of Freddie Mac during 1986-89.

Sabnavis is chief economist at CARE Ratings

(This story was published in Businessworld Issue Dated 29-08-2011)