One of the widely criticized features of Japan’s approach to its post-bubble crisis was that its regulators tried for some time to avoid the recognition of bank losses. In a deflationary environment, it was not clear how this would lead to a better ending, since with a flagging economy and no inflation to reduce the real (as opposed to nominal) value of the debt, there was no reason to expect the borrowers’ ability to pay to improve. Thus, these dud assets would remain dud assets until some banks (occasionally) made large writeoffs, forcing others to at least whittle away at their dud loans, and a worsening of the downturn in the late 1990s and some financial firm failures finally forced the government to recapitalize banks.
The latest proposal from Bernanke has Japan written all over it. Rather than let the housing market fall to its sustainable price level (in the long run, housing cannot trade far out of line to incomes) and address the damage to bank balance sheets directly, through consolidation and recapitalization, the Fed chair is instead suggesting to not merely continue to support the de facto guarantees to Freddie and Fannie debt, but to continue to provide some sort of prop to the MBS market.
Note that this runs counter (philosophically, at least) to what Paulson said in the conservatorship announcement. that Freddie and Fannie would expand their balance sheets in 2009 but start shrinking them in 2010. We said at the time we doubted that would happen and indeed, the script is already being revised.
The US over time needs to reduce its subsidies to the housing market. It may be quite a while until that can be done, and for political and practical reasons probably has to wait until we are past the downturn we are entering. But it is appalling that the authorities are already renouncing the few commitments to that goal that they have made.
And this of course misses another issue. The Fed, and ultimately the US taxpayer, cannot serve as the guarantor of the entire financial system, which appears to be the posture it is taking. The Fed has already moved to take on considerable risk not only through its alphabet soup of domestic programs, but now has considerable foreign exposure through dollar swap lines.
Federal Reserve Chairman Ben S. Bernanke said the market for mortgage-backed bonds will require some form of government support through either guarantees or insurance programs to weather times of heightened stress.
The Fed chief also said Fannie Mae and Freddie Mac, the largest sources of money for U.S. home loans, should retain some form of government support and oversight even if the companies are transformed from their current federal conservatorship to become private companies…. Bernanke said the current crisis shows there wouldn’t be a mortgage securities market without some government backing.
“The U.S. government’s strong and effective guarantee of the obligations issued under the current government-sponsored enterprise structure must be maintained,” Bernanke said today in remarks to a conference in Berkeley, California. “If the GSEs were privatized, it would seem advisable to retain some means of providing government support to the mortgage securitization process during times of turmoil.”
The vagueness in this statement is deeply troubling. Bernanke wants the GSEs privatized, yet still wants government support to the MBS market. How is that supposed to work, exactly? A new Federal guarantee program, the son of Freddie and Fannie, to compete with the privatized Freddie and Fannie?
In fact, he considers that to be a completely reasonable idea:
One approach would be to create a government bond insurer which would allow issuers to obtain a government guarantee for their bonds for a fee, the Fed chief said.
“This new agency would offer, for a premium, government- backed insurance for any form of bond financing used to provide funding to mortgage markets,” Bernanke said. Mortgage securities “issued by the privatized GSEs as well as mortgage- backed bonds issued by banks would be eligible.”…
Bernanke also discussed the option of covered bonds, while noting that they might be less competitive with existing finance options. Covered bonds offer banks a way to raise money for new mortgages without either selling the loans or packaging them into securities. Instead, a bank issues bonds that are backed by a dedicated and regularly updated pool of loans, which stay on the bank’s balance sheet.
Another alternative for Fannie Mae and Freddie Mac would be a public-utility model, where the two remain as shareholder- owned corporations and are overseen by public boards, Bernanke said.
“Beyond simply monitoring safety and soundness, the regulator would also establish pricing and other rules consistent with a promised rate of return to shareholders,” he said.
The reason Freddie and Fannie were privatized, and were NOT fully taken over by the government (roughly 20% of the shares remain outstanding) is that the powers that be do NOT want to consolidate Freddie and Fannie debt on the Federal balance sheet. The same problem would occur with any new entity once it had been in operation a few years.
The efforts to get a covered bond market started here have produced underwhelming results. And the “utility model” sounds like largely reverting to status quo ante. We tried that before and it didn’t work, remember? If the GSEs are properly capitalized as private companies without Federal support, they would have to have balance sheets a great deal smaller than what they are now. Bernanke simply refused to acknowledge the elephant in the room.
But more troubling than the particulars is the philosophy:
….it would seem advisable to retain some means of providing government support to the mortgage securitization process during times of turmoil.
That goes WAY beyond merely continuing government support for mortgages already issued or guarnateed by the GSEs. This implies an ongoing commitment. How do you provide support during times of turmoil and not other times? This is either appallingly naive or patently dishonest. Take your pick.