The Unfortunate Parallels Between Dubai, Fannie and Freddie

Includes: FMCC, FNMA
by: Alpha Author

In the aftermath of Dubai World’s near default, The Economist magazine ran an interesting article that examines the so-called “Hybrid” organization (see The Rise of the Hybrid Company). According to the Economist:

The travails of Dubai Inc have left commentators struggling for the right phrase to describe Dubai World and its various siblings. They have come up with various formulations—state-controlled, state-supported, quasi-state, parastatal—without ever quite capturing what they are talking about. And Dubai is not the only place that is challenging the business vocabulary in this way.

Wherever you look you can see the proliferation of hybrid organisations that blur the line between the public and private sector. These are neither old-fashioned nationalised companies, designed to manage chunks of the economy, nor classic private-sector firms that sink or swim according to their own strength. Instead they are confusing entities that seem to flit between one world and another to suit their own purposes.

MY COMMENT: For examples from the U.S., see Freddie Mac (FRE) and Fannie Mae (FNM), pre-nationalization. France, in the form of its national champions, also engages in the practice. So do many emerging economies: China (and its SOE’s), Russia, Malaysia, Vietnam, Brazil, etc.

What should we make of these hybrid organizations? Their supporters have long argued that they enjoy the best of both worlds: the security of the public sector and the derring-do of the private sector. They can use their global reach to provide their home countries with the pick of the world’s resources. They can borrow money at a favourable rate thanks to “implicit” government guarantees. They can use their political muscle to outperform their less well-connected rivals.

MY COMMENT: I have never been a fan of Publicly-Backed Private Companies (PBPC’s). Although they may be able to borrow at lower rates because they are “implicitly” backed by their home governments, they often grow too large, become too bureaucratic, and eventually crater under their own inefficiency (thereby costing home-country taxpayers dearly in the process). In addition, their objective function is not always clear. Are they meant to profit-maximize for shareholders/bondholders, or are they meant to serve a larger social purpose?

The most interesting part of the Dubai World saga (in contrast with Fannie and Freddie) is that the government of Dubai has seemingly repudiated Dubai World’s debt. So much for that “implicit” guarantee. If this becomes the norm rather than the exception, you can soon say goodbye to the last remaining benefit of Public-Private hybrid companies – the ability to borrow at favorable rates.

I have nothing, in principle, against government-backed companies. Although they are generally inefficient and often do not make sense, there are instances in which they might be appropriate — e.g., in instances of severe market failure. However, if there is severe market failure such that the government must become involved to prevent perverse societal outcomes, my intuition is that private companies operating in a system of more stringent governmental oversight and regulation perform better than a system comprised of public-private hybrids.

In this sense then, I agree with the conclusion of the Economist:

The clearer the line between the state and the private sector, the better it is for those on both sides.

Disclosure: No positions