What if we didn’t bail out the creditors?

"Could you clarify just how far on the hook I should be for someone else’s frauds?"

That’s MR commentator CK and the answer is "lots."  Here’s more detail on the bail out, by the way.  Not good.

But let’s say that the Treasury did not support the debt of the mortgage agencies.  The Chinese bought over $300 billion of that stuff and they were told that it is essentially riskless.  The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly.  The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value.  Most of the U.S. banking system would be insolvent.  Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot.  The rate of unemployment would climb into double digits and stay there.  Many Americans would not have access to their savings.  The future supply of foreign investment would be noticeably lower.  The Federal government would lose its AAA rating and we would pay much more in borrowing costs.  The deficit would skyrocket.

And I haven’t even mentioned the credit default swaps market.  Well, I have now.

But for another point of view, try Jeff Rogers Hummel.


Hummel and I have our differences (although my opinion here hardly matters - no qualifications to have one besides being a citizen).

While I oppose government guarantees, I think the ones that were made (even against my will) should be honored.

But then, Hummel supported abolition of slavery without compensation to the slaveowners (posthumously), and I don't really think THAT worked all that well either. The English abolition, where there WAS compensation, seems to me to have had a better result than the USA method.

Fire and brimstone coming down from the skies! Rivers and seas boiling! Forty years of darkness, earthquakes, volcanoes... the dead rising from the grave!

Human sacrifice, dogs and cats living together... mass hysteria!

Perhaps the Rubicon was crossed in July, but until that time every statement ever made on the subject by anyone with official status was "these are not obligations of the U.S. government and we do not back them". If this line had been maintained and the GSEs had defaulted, there would be a clear distinction between GSE debt and government obligations and if the Chinese central bank complained the appropriate response would be, "We kept our word." I think enough foreign investors would respond to that reasonably that any drop in the government's access to capital markets would have been very slight.

That's way over-stated.

Keep in mind that the US government has always explicitly denied that it backed the housing giants. So letting them fail would be maintaining its credability. There is no reason that the US government's bond rating should be affected. "Keeping our word" would mean not backing this debt.

Yes, the Chinese would take a bath and borrowing costs for the US government would increase, perhaps substantially. Perhaps, then, the US government would borrow less! Unfortunately, that happy situation would likely not persist for long: when Brazil's government really did default on debt it really had guaranteed, they were back to being normal players in the bond market, with only a small risk premium, within 3-4 years.

The stock market would undoubtedly take a tumble, but would not loose anywhere near half its value. The stock market has been predicting the failure of the housing giants for a week now; it's down ~6% in that time, and there is other news contributing to that.

Most in trouble would be the financial firms who count bonds issued by the housing giants as tier 1 capital. Probably some of them would fail, and there would be a lot of mistrust among financial players about who is solvent, which would impede trading. We worked through that previously by opening the Fed's borrowing window to these players, and that worked out reasonably well.

Borowing costs for homeowners would increase, as they should. Homebuyers have enjoyed an implicit subsidy because the housing giants have promised those loaning them the money to buy their houses that they don't face the risk that the homebuyers won't pay. Here's hoping that, eventually, we shut down the housing giants and people pay the real cost of their risk. Banks know how to package mortgages into MBS that carry default risk, and in future they can finance their mortgage operations that way.

And the dollar? Short-term currency fluxuations are hard to predict. Long-term they depend on PPP, which is to say inflation. As long as the fed does it's job, there is no reason that inflation, and the dollar, need to be affected by any of this.

I understand that things could get really bad if the mortgage agencies were not bailed. But I am not sure how bailing the agencies helps anything.

As you seem acknowledge, we need Chinese capital to fund our nations trade deficit. Without that money, interest rates are going to go up sharply and the interest portion of the federal budget will skyrocket. This one, two, punch would be am economic catastrophic for this nation.

But if you buy this argument, you also have to accept that the money we borrow to bail the agencies is also going to come from China (or other foreign sources of capital. In other words, we are borrowing more from China in order to insure that China will be payed back. So how is this helping us out of the hole we are in?

The Treasuries currently pay out a lower interest rate then agency bonds thus the arguments that it makes sense to borrow with treasuries and buy agency bonds. But since the majority of treasuries are relatively short term, the Federal interest bill could still go up in a hurry down the road. And then where would we be?

At very least, I don't think that it is right for agency bonds to get a federal guarantee and yet pay out higher interest rates than treasuries.

In other words, I think it would have been better for the Chinese to take an orderly haircut now instead of taking a disorderly haircut latter when the US has to resort to inflation to balance the books.

And don't forget, the Medicare debt is coming up.

Lady Liberty is such a tease. She flirted outrageously with Mister China, and he took her to a fancy restaurant she could never afford on her own. Trouble is, he thinks she implicitly promised to sleep with him. Of course, she could legitimately claim she did no such thing. But then Mister China wouldn't take her out any more, and she'd have a hard time getting used to macaroni and cheese every day.

The NYT article says that they will continue lending after being placed in "conservatorship." Can someone please explain why this is necessary, or even a good idea? Why won't they be wound up like any other bankrupt company? Are they expected to CONTINUE injecting artificially cheap capital into the housing market, and thereby increase the taxpayer's risk?

Mr. Cowen,

What value are you presuming for an Agency paper in the absence of a bail out. Surly not zero?

Tyler, I think we can agree that the most dangerous chanel for an effect is through mistrust in the banking system. That was the relevant chanel during the Great Depression. Fortunately: (1) your link says that agency debt is a substantial part of the capitalization of only a few small institutions and (2)knowing what we now know, the fed can respond appropriately. On the other hand, I admit that my own suggestion to open the fed's lending window wider is problematic. When the fed opened its window to investment banks a few months ago, I believe it accepted agency debt as collateral; if it were to continue to do so, that would obviously constitute an implicit guarantee.

What I hope we can also agree on is this: that given Paulson's choice between having a GSE system that guarantees mortgage debt and moving to a fully private MBS system in which lenders bear default (and prepayment) risk, we want the latter. For borrowers, in the worst case, that means that they pay jumbo-level rates on all mortgages, i.e. 1-2% higher. I believe there are several cross-country comparison studies showing that GSE systems do not have much effect on rates of home ownership.

Yeah, I guess we're stuck with the guarantees even if everyone theoretically opposed them. Could we at least get a few Fannie and Freddie people prosecuted to reduce the moral hazard element slightly? I mean, seriously, the tens or hundreds of billions this fiasco will suck up could have been spent on health care, better equipment in Iraq, cancer research, you name it. I know that's a bit hyperbolic, but at some point financial crimes become almost as egregious as physical ones, in my opinion.

As for steps going forward, I can only hope that the agencies will be wound down over time. How is it rational to pay the bill for all this moral hazard and keep the problematic mechanism in place? I understand that a quick halt would be problematic, but why can't we say that in ten years, Freddie and Fannie will be no more? Slightly more expensive mortgages are a small price to pay to avoid situations like this, in my opinion.

"Could we at least get a few Fannie and Freddie people prosecuted to reduce the moral hazard element slightly?"

Do you mean politicians, people who bought FNM&FRE paper, or both?

"I think that means we need tighter regulation to prevent fraud"

Why? First of all, that's closing the barn door after the horse is gone. Secondly, 9% arears isn't fraud. And why not just smaller companies that can go bankrupt and we yawn, not this constant economic doomsday terrorism. Small enough to actually check into what they are buying. Small enough not to issue stock to all the banks in the known universe and threaten serious consequences from our only rival nation.

But no, we are likely to make the system even more monolithic.

Also, separating out just the lenders, why would "borrowing costs" rise? What are they going to do with the money? Why wouldn't they buy other stuff, like corporate bonds or T-Bills?

So, people buy stuff *thinking* it's safe and has a good return, sounds kind of like housing. Aren't the Chinese part of the problem here? Didn't their buying bonds and copying our software rather than paying for it (and other means of not buying our real stuff with our dollars) sort of artificially lower interest rates contributing to the funds available to mis-allocate to houses?

So, is this still a market goof or a government goof? I know the market is going to pay for it, but who *should* get the blame? I kind of like the fire and brimstone approach, but I'd be open to a more moderate dismantling of this system.

Well then, it should come down. If it's a capitalistic system, as it purports itself to be, then bad management must be met with stern consequences.
That the empire would collapse and hundreds of millions of people would lose their savings and the economy would be ruined would be a good thing.

Not immediately. Not right away. But it would teach posterity a really harsh lesson. It would be a historic message. DO-NOT-DO-THIS-EVER-AGAIN.

Maybe people would even heed the lesson. They haven't historically. They insist on making the same mistakes over and over.

But maybe this time would be harsh enough...

Fannie and Freddy are dead meat. What if the Chinese return all those now worthless bonds, what is that going to do?

Whether it will be total or partial collapse is not clear now. But there will be consequences. No government has ever been strong enough to keep spending beyond its means forever. It always ends. It is never pretty.

Mr. Taylor, I am amazed that you can predict the future so well.
How long ago did you predict the collapse of Fannie and Freddie?

And what might be your prediction for what happens now that the Feds have taken
it over?

We need to force the democracy issue on China so we could finance and install Chinese leaders that will work for the American people for a change.

Hi I am from the Netherlands and have little knowledge about financial markets and how they operate but is it not like this when I run a small business and I go down, the risk is all mine.

No taxpayers money will come to help me, so why should American tax payers have to put their hard earned money to financial institutes who seem to have been to big that control was lost and managers incapable to foresee what was coming.

Or did they just wait until Gods water would flow over Gods own land and those who couldn't swim (tax payers without a say/vote)would pay the ultimate price anyway.

What a shame, I have to 2 grand children in CA I suppose they will need to work hard, to cover for all the debts the American goverment has accumulated in many years now, which is also theirs now and they don't even know it.....yet

Thank you for the links. None of them explain how far "onto the hook" a citizen must be placed to make amends for some other fool's idiocy. Nor do any of them explain why a citizen should be forced onto that hook.
I will admit that some of the items you suggest might result do not strike me as "bad things". Losing a central bank is not a bad thing. Removing inflation would be a benefit to those of us who are not bankers or government employees. Most of the banks are already Shiavoed, draining more taxpayers wealth into their lifeless husks is not going to bring them back. If any commodity is 40% overpriced, why is it a bad thing if it falls in price? Not sure why you think unemployment would rise from its current 16% level ... breadlines but no bakeries, soup kitchens but no american made pots and no imported Ramen? As for access to your savings, would that be the savings represented by the lines of credit on the plastic cards? It was neat to watch the town's rich family run around trying to stave of bankruptcy a few years ago, it is even neater watching a bankrupt nation run around trying ...

A number of the questions on the Registered Investment Adviser exam, which I took - sure, it isn't a brilliant grad degree in economics, like the ones possessed by all the folks who got us into trouble - specifically ask one to differentiate among the various kinds of public, quasi-public, and private debt. The correct answer is that GSE debt is NOT guaranteed by the government. If a lowly RIA has to know this, why don't the Chinese and everyone else who bought the stuff? The difference is probably because the government can jail brokers and advisers, but it can't jail China.

Amen. It's all coming. This is the road we are on and it cannot be stopped it's much bigger than anything we can percieve. It's like a force of nature but it's called greed.

For those of you just joining the discussion, a summary of the comments so far...
phase 1> shock....
phase 2> denial...

we are entering anger...more parks to come

Why wouldn't all these companies simply go into foreclosure, where the government seizes them and sells off their assets, like Washington Mutual. After all, there is value in these firms. No bailout. No golden parachutes. Whoever wants to buy the debt, can buy it, and try to manage it, pennies on the dollar. Let the chips fall, because there's always someone with money who will buy them at the clearing house. I don't believe all the gloom and doom. How is it that WaMu's demise demonstrated to us how easy it could be done, but no one wants to talk about it? Take the politicians out of the picture, and live goes on. No bail out. Things will be unsettled for a year or two, but in a free market, it will all come back. It always has, it always will.


Very grateful to a bunch of much better skills. I look forward to reading more of the future of the subject. Keep the good work。thanks!

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