The Real Cost of the Agency Guarantee

Dan Gross says that if and when the federal government bails out Fannie (FNM) and Freddie (FRE), "the bailout will be a bargain for American taxpayers, because any cost of it will be overwhelmingly offset by the tangible and quantifiable economic benefits that taxpayers have collectively received over the years from the market's expectations that such a bailout would materialize if needed".

He's wrong, for two reasons.

Firstly, Gross quantifies the "benefits that taxpayers have collectively received" by looking at the interest rate they paid on their mortgages. He reckons that because of Fannie and Freddie's implicit government guarantee, those interest rates are 25bp lower than they would otherwise have been, and that the "present-day value of the historic implied guarantee" is on the order of $100 billion.

But if I'm a homebuyer, I don't put in an offer on a house and then go shopping for a mortgage: I put in an offer which is directly correlated to the amount of money that a bank is willing to lend me. Let's say I can afford $2,000 a month in mortgage payments: then if those mortgage payments will land me a $450,000 mortgage, then I'll bid $20,000 more than if those mortgage payments will get me only a $430,000 mortgage. A lower interest rate will increase the amount I have to pay for my house; it won't decrease the amount I pay on my mortgage each month.

In fact, Americans are paying more in mortgage payments today than they have at any point in history. Does that sound like they're saving money to you?

Now there is a group of people who have indeed realized "tangible and quantifiable economic benefits" from the GSEs' implicit government guarantee, and that's the shareholders of Fannie and Freddie. True, they're not feeling particularly well-off right now, but that's another story. If Fannie and Freddie had been government agencies rather than government-supported agencies, then the benefits of the government guarantee would have accrued to all taxpayers, rather than being dividended out to the GSEs' shareholders. But they weren't.

Here's Gross:

Until this week, the cost of this benefit has been effectively nothing--save for some foregone taxes and the cost of regulating the companies.

Effectively nothing? The cost of the implicit guarantee is not foregone taxes, it's foregone profits. The US government has essentially been insuring the debt of the GSEs against default, while neglecting to charge any insurance premiums.

And now that the guarantee is explicit rather than implicit, just look what's happened to US sovereign debt:

This is the first time in my career that I truly believe U.S. Treasury bonds sold off on credit concern. By this I mean, the credit of the U.S. Government. Long-time readers know I'm not an alarmist type, and I'm sure not saying the United States is going belly up, but credit default swaps on the United States of America moved 11bps wider today (from 9bps to 20bps). The 10-year Treasury moved 15bps higher. All on a day when people are scared shitless and there should have been strong demand for "risk-free" assets.

That's a real cost, Dan. It might not be a line item in any GSE bailout, but when the US has to pay more money to roll over its trillions of dollars in liabilities, every basis point counts.

Comments

[Ishortyou:]

well it doesnt seem that things are going to get better unless the housing market stabilizes, so the government better launch an aggressive plan to bump up the housing market to reduce inventories or all of us are going down.

2008 Jul 15 12:25 PM

[whidbey:]

Your analysis is too quick, too kind. The economic costs of the GSEs are A) the opportunities foregone for private investors who would have offered the mortgage money if the organizations were private. Such organizations would likely have been run better and would not have been subject to the miss deeds of Congress in such things as the Neighborhood Improvement Act (under priced loans). Under the GSE arrangements the costs of forced recapitalization are enormous since much of the debt held by the GSEs will not be recovered (no documents), and the loans they will make in the future will likely be substandard as the cost of restarting the housing market (bet on Congress will insist on more "deals"). C) The corruption of government by the GSEs has damaged Congress and the interests of the public in a responsive and honest government. The third point is sufficient grounds to try the executives of the GSE under the federal Corrupt practices Act, bribery, thief, and fraud. The costs are so shocking and the criminal behavior in Congress so open and intentional that we must do it respect ourselves. But, you will never hear a word. In Washington such crimes are rewarded with pensions.

2008 Jul 15 03:11 PM

[Mbuna:]

Excellent article Mr. Salmon! It appears to me that Dan Gross is advocating a point of view that I find all too rampant in the financial world currently. I would describe it as a sense of "entitlement" and more often than not "self entitlement". You see those GSE shareholders are "entitled" to their free insurance from the US government at the expense of the common taxpayers who are not "entitled" and who should be thankful for what (crumbs) they do get.
This is all pretty much taken for granted as how things are supposed to work. I do wonder however whether Mr. Gross is simply thick and unconscious about this or whether he is a slick devil consciously advocating his cause. Either way there are far more 'Socialism for the rich" advocates out there than you think.

2008 Jul 15 03:52 PM

[Mark Moran:]

The astonishing about this is how many people saw it coming and have been warning about it for years. Here's a recap of comments by Buffett, WSJ, NYT, et al.

www.findingdulcinea.co...

2008 Jul 15 04:54 PM

[domsam:]

<A lower interest rate will increase the amount I have to pay for my house; it won't decrease the amount I pay on my mortgage each month.>

Not so!

A smart buyer would go for a higher quality house if he has more money to put in the purchase(with the same monthly payment). Or he would very well go for the same house without increasing the offer price and save on the monthly payments(the subsidy will be saved).

2008 Jul 15 09:29 PM

[MichaelSchm...:]

Privatize gains and socialize losses -- that's American "free market" capitalism and the GSE's are perfect vehicles. Perhaps we can create similar vehicles to do that in the context of other purportedly vital or important public interests -- like education. That way the banks can make big bucks providing financing to support otherwise unsupportable price increases (and debt burdens) until . . . uhh, what, that's already happened??? Maybe then we need a new GSE to bail out the existing GSE's . . . .

2008 Jul 16 11:29 AM

[Jason Rines...:]

You got it Michael and we hear talks of health care and energy. Then the entitled can fleece those also and pass them to off to the tax payer. The damage is widespread here but the big trees of the forest will push there branches further which crushes everyeone looking for sunlight underneath. The forest will burn one way or the other with a lightning strike, they are just pushing the day of reckoning off for themselves a bit.

The political system is beyond broken in Washington, it is feeding on it's own citizenship. Such has occured with many governments in history which started out as benevolent Republics to there citizens, notably Greece and Rome. Rome ran the best when there Senate had two year term limits and ran the worst when the limits were removed. Such is the effect power has to corrupt where one corrupt politicians covers for another and does endless favors for it's personal friends.

To restore as close to a true free market from here, the socialists will push us toward economic collapse. It WILL happen and the damage has already been done. However, we will recover very quickly, the money cartel disrupted between the twin city empire of NY and D.C. and new leadership emerge as public servants.

2008 Jul 16 03:01 PM