The cost of mortgage agency bailouts

by on July 28, 2008 at 6:13 am in Economics | Permalink

I’ve read varying estimates of the cost of the mortgage bailout, including a sum of $1 trillion mentioned in The Wall Street Journal.  I have no idea what the number will be (and I’m not ruling out zero, or close to zero) but here is how to think about the costs:

1. Reimbursing agency debt holders is a transfer, not an economic cost.  No resources are destroyed by the reimbursement.

1b. The previous bad lending involves a cost — in this case too many homes — which already has been incurred.  This is not a cost of the bailout per se.

2. If government taxes the citizenry to raise money for the bailout, those taxes involve a deadweight loss.  Maybe 20 percent of revenue raised is a decent estimate of this cost.

3. Bailing out debt holders means that future lenders won’t be as careful as they should be.  This problem dates from LTCM, or even further back, and it gets worse each time.  The result is excess leverage and leverage of the wrong kind, namely to "too big to fail" institutions, which then become even bigger and more leveraged.  I haven’t seen a back of the envelope estimate of how much that really costs, much less a careful estimate, but this is a very important magnitude for calculating the net cost.

4. Often in these plans equity holders are (nearly) wiped out.  So beware all the talk of moral hazard.  The real moral hazard is on the side of future creditors, not the current, possibly-soon-to-be-extinguished equity holders.  They really are getting burned.

5. If the government dallies in executing the bailout, borrowing costs for the entire economy will rise.  A bailout has to be swift and decisive, assuming you want to do it.  Yet a swift and decisive bailout will likely involve errors of detail.

6. Doing a justified bailout this time makes it harder next time to avoid an unjustified bailout.  The bailout mentality is contagious in the political arena.

7. The transfer to the debt holders is generally regressive, at least under the likely assumption that the marginal taxpayers are less wealthy than the debt holders.  Of course some of the debt holders are foreign governments, which adds another element to the mix.

8. When it comes to the mortgage agencies, there is no real choice but to bail out the debt holders.  The alternative is a run on the dollar and collapse of faith in U.S. government securities and the end of the world.

Todd July 28, 2008 at 7:09 am

The end of the world? What probability would you assign to number 8? Because right now it sounds like you are presenting it as a certainty, which seems far too extreme to me.

Mark Harrison July 28, 2008 at 7:26 am

Run on the dollar caused by AVOIDING the bailouts?

From where I’m sitting (UK), the bigger risk seems to be that the US Government will carry on trying to bail out failed institutions until it has to default on its debt.

At that point, the Euro and the Yuan get to play a game of “who wants to be the new reserve currency?”

marmico July 28, 2008 at 9:33 am

(and I’m not ruling out zero, or close to zero)

That’s quite the panglossian view. About 15% of Fannie/Freddie’s retained and guaranteed book of business is
subprime (2.5%) and Alt-A (12.5%). Some $800 billion in total.

meter July 28, 2008 at 11:24 am

“Often in these plans equity holders are (nearly) wiped out. So beware all the talk of moral hazard. The real moral hazard is on the side of future creditors, not the current, possibly-soon-to-be-extinguished equity holders. They really are getting burned.”

The moral hazard is that we have rewarded upper management with huge bonuses for taking large, unchecked risks and that there are no mechanisms to clawback those ill-gotten gains (and yes, they were ill-gotten).

No matter what regulations are enacted, if we continue to place huge incentives on what is essentially gambling, we will continue to see this same phenomenon.

Leverage only magnified an existing problem.

Person July 28, 2008 at 1:38 pm

#1 & #2: I’m sorry, but the way economists treat transfers is just plain wrong.

When you yank resources away from one person, and give them to another, yes, there is a sense in which
wealth simply moved and was not destroyed. And yep, as wise economists, we can’t make a single moral judgment
about who is more deserving of that stuff, no. sir. ree. [sic]

Yet from the long-term perspective, you simply cannot ignore the question of who truly *deserves* those
resources. For example, if the transfer is away from the person who generated those resources, the long-term
impact is the clear message: “Hey, discount for the very real risk that your stuff will get yanked away
when you decide to actually be productive, so maybe ditch a few of these resource-creating activities here.”

So no, Tyler, you can’t look at anything as a “mere transfer”.

The OTHER problem is with the concept of a deadweight loss: I just don’t see how you can consider any cost,
to be one such that “someone lost, no one gained”. In *any* change in policy *someone* gains. Higher taxes?
Hey, that benefits me as an accountant in helping people look harder for ways to avoid the tax. So looking
for a true deadweight loss is rather pointless.

marmico July 28, 2008 at 2:34 pm

nelsonal: I don’t mean to hijack the thread but the 2007 OFHEO Report was released last week. The Bloomberg article you referenced links to the 2006 report.

From slide 24 of Fannie’s Q2.08 Investor Presentation, subprime exposure is $51.2 billion, Alt-A exposure is $344.6 billion of a total book of $2.7 trillion. Presumably, Freddie has similar exposure.

Isn’t it a distinction without difference to separate the retained book from the guaranty book to determine the credit loss exposure?

Weil at Bloomberg postulates that the agencies are insolvent and former Fedhead Poole (who knows more about the situation than you, Cowen or I combined), who got the ball rolling estimates the bailout at $200 billion.

Hence, my scepticism that Cowen assigns a probability that there will no or a de minimus cost.

Methinks July 28, 2008 at 9:02 pm

I have no idea what the number will be (and I’m not ruling out zero, or close to zero)

That’s not true – the cost will always be more than zero. The taxpayers are forced to take a risk for which they will not be adequately compensated or compensated at all. That is a very real cost. Why do people persistently forget to factor in risk?

Doing a justified bailout this time makes it harder next time to avoid an unjustified bailout. The bailout mentality is contagious in the political arena.

Fine, but we will be bailing out the same institutions in years to come. The need for the bailout comes from the fact that government created this monster of socialized risk and private profit and then took bribes from its lobbyists to ignore all constraints. Fannie and Freddie became casinos where all games were negative expectancy for the taxpayers. Of the government subsidy meant to reduce mortgage rates, 60-70% went to shareholders and reduced mortgage rates by only a few basis points. Hardly a great trade-off. The new bailout will give them a new regulator to put in their pocket. Either privatize them and set them free or nationalize them and be done with it. There is no justification for what’s going on now.

Roberteconomist July 29, 2008 at 3:38 am

Yep am sure the many PhD economists from places like Yale, MIT, and like Tyler from Harvard on staff at the two GSES also offered up all mannter of rationales and analysis that led to Freddie and Fannie being the great exemplars of capitalism
and insights of economics at their best…..Common Tyler–you are smarter than just repeating items from a microeconics text and using to explain or justify everything in the good ol U.S.A as being just hunky dorry. Hell, Fannie even ran a couple of Housing Econ Journal with all the usual BS of why these are the best of times and the wonder of markets!!! Tyler Pangloss Cowen over there…….

Person July 29, 2008 at 11:20 am

c8to: A moral hazard arizing from transfers is not the same thing as a deadweightloss. Inefficient use of resources is not necessarily a DWL either. For it to be a DWL, there must be a loss corresponding to no one’s gain, and certainly, some people do experience a gain, even from the broad perspective, from a bailout. Since someone gained, it’s not a DWL.

meter July 29, 2008 at 10:07 pm

Per my post above, there needs to be a way to clawback bonuses *and* to prosecute this kind of behavior in civil and in some cases criminal courts.

It mystifies me why white collar crime is so often shrugged off when the impacts are many orders of magnitude far-reaching than most other types of crimes.

meter July 30, 2008 at 12:31 pm

There is and was fraud involved, and if you think things have suddenly gotten better, read this at Calculated Risk:

http://calculatedrisk.blogspot.com/2008/07/fraud-in-2008-mortgage-vintage.html

Heads should be rolling…

傢俱 December 3, 2008 at 10:10 pm

I like this site, at the dawn of Christmas, like all the sites frequented by friends sent holiday wishes ahead of time, a happy holiday.

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