Colin Powell on the End of George W. Bush's Term and the Beginning of Barack Obama's
Hoisted from the Archives: Where Oh Where Are the Smart Conservatives?

The Mortgage Finance Sector: Not the Swedish Model

Chris Carroll writes:

Banks and turtles: [I]t has become clear that the... Federal Reserve really does stand ready to provide unlimited sums of money at the prevailing interest rate of zero. The fundamental difficulty is that the Fed cannot fulfil such a “lender of last resort” role without implicitly or explicitly guaranteeing some of the dodgy loans that have been made in recent years....

However, at least in the case of mortgage-backed securities, a real physical asset (not just a turtle) stands behind the piece of paper, and smart people (who should know) tell me that the market is placing absurdly low valuations (such as, 10 or 20 cents on the dollar) on these securities. The question that has engaged the great financial brains of our day, from Hank Paulson to Larry Summers to Ben Bernanke, is why markets won’t place a proper price on these assets. Everyone seems to have reached the same conclusion: Any particular asset that a bank offers for sale is sure to be the one thing that the bank secretly knows is the worst piece of toxic waste on its balance sheet. Potential buyers know this, so banks do not even bother to try to put lipstick on a pig by offering to sell such items on a piecemeal basis (economists call this the “adverse selection” problem)....

[A] wholesale nationalisation of the banking industry causes a raft of political and economic problems; in particular, lending in a politicised system.... So, we are left with the example of Sweden; in 1992, in a similar situation to our own, the Swedish government took a shareholder stake in the entire financial system.... But perhaps they have a point: There may be a better way.... The particular part that might be addressed differently consists of mortgage-backed securities that would be easy to price if one knew for sure what will happen to housing prices over the next few years.... The Fed (or the Treasury) could offer insurance policies against the risk that, say, the Case-Shiller house price index will end the year 2010 at a level that is lower than its current value by 20 per cent. If the Fed is serious about preventing deflation, then such insurance will not ever be paid off. The government could therefore collect the insurance premiums (in exchange for taking away some risk), and both markets and government would be better off....

There are countless practical difficulties in implementing such a plan, starting with the question of how to guarantee participation by a large enough fraction of the troubled assets. But the offer of insurance might be enough to bring in some of the investors who have so far been hoarding all their cash in the form of Treasury securities, in which case the plan will have worked, even if the government ends up having to pay out some money on the insurance policies...

When was it... was it really nine months ago?... Yes, that was when I began telling the great and good that it was time to act more aggressively, and that my preferred policy was:

  1. explicitly nationalize Freddie and Fannie so that their debt is a full-faith-and-credit obligation of the federal government.

  2. have Fannie and Freddie then buy up every single mortgage and mortgage-backed security at market prices.

  3. Profit!

  4. The economy recovers.

The "profit" part comes because once Fannie and Freddie are part of the government they (a) borrow at the Treasury rate, (b) buy up mortgages at distressed values, and (c) collect interest and principal payments. Private banks cannot reliably profit by doing the same because if they do so and if prices of mortgage-backed securities fall even further--never mind that they are already below "fundamentals"--then the private banks are shut down for good. No bank is going to follow a strategy that further increases its chances of vanishing forever.

The "economy recovers" part comes about because as mortgage security risk is taken up by Fannie and Freddie, it vanishes from the pool of risk and uncertainty that has to be carried by the private sector. The risk to be carried thus comes back into balance with the private banking sector's diminished risk tolerance, and asset prices rise, and firms can borrow again.

We have monetary policy. We have fiscal policy. We need a risky-assets support policy as well. Chris Carroll has a proposal that could work. But I would prefer simply the temporary nationalization of mortgage finance--it is more certain to work, and promises to be more profitable for the government.