Optimality of Government Sponsored Entities, Fannie Mae and Freddie Mac

First Written on October 24, 2008 and Updated On December 10, 2008

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

Updated on December 10, 2008

The U.S. Congress held a hearing on December 9, 2008 with experts and ex-GSE executives. Those who advocated elimination of the existing government-sponsor charter of GSEs stated that the government guarantee causes moral hazard due to excessive risk taking. But this logic should also lead to a conclusion that to preclude moral hazard risk the existing charter of commercial banks and investment banks - that hold federally insured deposits and are considered too big to fail - should be eliminated. This would mean that the government should give no explicit or implicit guarantee to any financial institution because such guarantees lead to moral hazard risk and excessive risk taking. This argument is consistent with the current paradigm of maximization of utility of a representative agent, not the new paradigm of prosperity amid stability for democratic capitalism.

That some federal guarantee (of deposits, debts or too big to fail) is needed for stability of the system was felt by the government regulators during to the 2008 financial meltdown as well as during the Great Depression when deposit guarantee was instituted or when GSEs were formed. But such guarantees have caused immense losses to taxpayers due to moral hazard.

Safe Banking avoids moral hazard risk while ensuring financial stability. It does not lead to elimination of GSEs.

Written to Congress on October 24, 2008

Indeed, the Congressional hearing on October 23, 2008 revealed a profound truth that the prevailing wisdom or paradigm cannot determine whether it is optimal for taxpayers to privatize the GSEs, Fannie and Freddie.  This paradigm maximizes the utility of net-worth of a representative agent of the economy.  The prescription based on this paradigm will obviously depend on who the representative agent is. The representative agent was different behind the differing prescriptions made during the October 13 hearing on whether to privatize the GSEs or not to. 

The hearing confirms resoundingly that the prevailing paradigm–that has guided the academia, regulatory agencies and the Congress over centuries–is incapable of answering unambiguously whether the vast majority of taxpayers in a democratic U.S.A will optimally privatize the GSEs.   

A New Paradigm of Stability amid Prosperity

My rumination over two decades[1] has led me to a new paradigm which may be agreeable to the vast majority in a democracy, “Prosperity amid Stability: A New Economic Paradigm for Democratic Capitalism.”[2] All my previous memos are based on the new paradigm which trades off (balances) prosperity with stability.  This seems to be a new paradigm ever analyzed.  Even the Federal Reserve Board has conceded in a testimony on October 15, 2008 that it would hereafter consider stability in economic decision making on interest rates.

The current economic paradigm of maximizing the utility of net-worth of a representative agent does not consider stability.  This unfortunate lacuna is responsible for the global meltdown and warming. 

A famous economist has said that in the long-run we are all dead, implying that there is no necessity to incorporate long-run stability in formulating public policy that affects the posterity.  The current global disasters show that his philosophy is inappropriate for government decision making.   

The new paradigm of “Prosperity amid Stability” led me to see in 2003 an impending disaster brewing within the U.S. banking industry.  I felt impelled then to communicate the same directly to the U.S. Senate. The Senate must have heeded to the missive to call for testimonies and conferences on safety and soundness of the banking system. But a few individuals (not the vast majority of voters) could present themselves as the representative agents.  Their dharma was to maximize the utilities of their wealth.  They recommended policies that resulted in government guaranteed systemic moral hazard for self-aggrandizement.  But such policies have hurt the best interests of the vast majority by causing instability that we are facing today.

Over the last decade, I have actively pursued for an adoption of the new economic paradigm to promote optimal rules of governance by which individuals could maximize utilities of their net worth (prosperity), but not cause instability like global depression or warming.  My self-interest is to foster democratic capitalism that has been lacking in democracies. 

Communism denudes social strength because it enforces equal pay with no incentive for individual perseverance.  Maximum prosperity is possible under capitalism. But without optimal rules of governance, capitalism even under democracy can financially bondage the vast majority, cause instability and ultimately erode individual prosperity. 

Optimality of GSEs

The new paradigm of prosperity amid stability can guide in setting an optimal course for the GSEs.  Privatization of all banks including the GSEs will enhance prosperity (wealth) of a few managers and controllers of the banks.  But such privatization will perpetuate, if not accelerate, usurious credit growth through usuriously high interest rate that has begot the current instability.[3] A tradeoff between individual prosperity and stability will lead to private banks and government sponsored banks like GSEs. In reality, the GSEs have a much lower rate of default than the private banks. 

Most private banks and bank holding companies have destroyed their capitals.  It is not because of the GSEs.  BHCs formed off-balance sheet “firewalled” subsidiaries, sometimes with less than one-tenth of minimum regulatory capital on a consolidated basis, after the repeal of the Glass-Steagall Act.  This was to gamble in the capital markets to enhance their own fortunes just like in the pre-Great Depression era. Banks could gamble because of government guarantees, offered directly on deposits and indirectly due to the expectation that they are too big to fail. 

Optimality of GSEs is subsumed within a Safe Banking policy.[4]

With profound regards,

Sankarshan Acharya

[1]I was drawn to public policy during the Savings and Loans crisis that led to research on optimal bank reorganization and pricing of federal deposit insurance, published in Journal of Finance.

[2]This is a paper on the economic wisdom needed to preserve democratic capitalism, written in simple English without diluting standard economic arguments.  It is freely available on the internet at a site devoted to prosperity amid stability, http://www.pro-prosperity.com/Research/Prosperity%20Amid%20Stability%20-%20A%20New%20Economic%20Paradigm.pdf

[3]How to measure usurious nature of interest rate is presented in the paper, available here: http://www.pro-prosperity.com/Research/Prosperity%20Amid%20Stability%20-%20A%20New%20Economic%20Paradigm.pdf

[4] http://www.pro-prosperity.com/Research/moralhazard-safebanking.pdf

Bernanke Urges `Backstop' for Mortgage-Bond Market (Update1)


By Craig Torres

Oct. 31 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said the market for mortgage-backed bonds will require some form of government support through either guarantees or insurance programs to weather times of heightened stress.

The Fed chief also said Fannie Mae and Freddie Mac, the largest sources of money for U.S. home loans, should retain some form of government support and oversight even if the companies are transformed from their current federal conservatorship to become private companies.

Bernanke's recommendations for a government role contrast with those of such free-market advocates as Alan Greenspan, who has urged an end to official support for Fannie and Freddie. Bernanke said the current crisis shows there wouldn't be a mortgage securities market without some government backing.

``The U.S. government's strong and effective guarantee of the obligations issued under the current government-sponsored enterprise structure must be maintained,'' Bernanke said today in remarks to a conference in Berkeley, California. ``If the GSEs were privatized, it would seem advisable to retain some means of providing government support to the mortgage securitization process during times of turmoil.''

Government Takeover

Treasury Secretary Henry Paulson engineered the seizure of Fannie Mae and Freddie Mac on the weekend of Sept. 7 after the biggest surge in mortgage defaults in at least three decades threatened to topple the companies. Bernanke raised a number of scenarios for the future of the companies, without stating which option he prefers.

Securitization, the process where home loans are packaged together into a bond and sold to investors, is important because it allows banks to distribute risk and provides a wider pool of capital to finance mortgages, Bernanke said.

One approach would be to create a government bond insurer which would allow issuers to obtain a government guarantee for their bonds for a fee, the Fed chief said.

``This new agency would offer, for a premium, government- backed insurance for any form of bond financing used to provide funding to mortgage markets,'' Bernanke said. Mortgage securities ``issued by the privatized GSEs as well as mortgage- backed bonds issued by banks would be eligible.''

Covered Bonds

Bernanke also discussed the option of covered bonds, while noting that they might be less competitive with existing finance options. Covered bonds offer banks a way to raise money for new mortgages without either selling the loans or packaging them into securities. Instead, a bank issues bonds that are backed by a dedicated and regularly updated pool of loans, which stay on the bank's balance sheet.

Another alternative for Fannie Mae and Freddie Mac would be a public-utility model, where the two remain as shareholder- owned corporations and are overseen by public boards, Bernanke said.

``Beyond simply monitoring safety and soundness, the regulator would also establish pricing and other rules consistent with a promised rate of return to shareholders,'' he said.

The Fed chairman didn't discuss interest rates or the economy in the text of his remarks.

The Fed cut the main interest rate this week to a half- century low of 1 percent to limit damage from the collapse of the U.S. mortgage market and avert what may be the worst recession in a quarter century.

Lacker, Greenspan

Richmond Fed President Jeffrey Lacker has endorsed the view of former Fed Chairman Greenspan that the government should nationalize Fannie Mae and Freddie Mac before splitting them up and selling them off.

``I would prefer to see them credibly and demonstrably privatized,'' Lacker said in an Aug. 20 interview with Bloomberg Television.

Bernanke said it's an ``open question'' whether the GSE model ``is viable without at least implicit government support.''

``Private-label securitization has largely stopped,'' Bernanke said. The fact that GSE issuance continued suggests ``at least under the most stressed conditions, some form of government backstop may be necessary to ensure continued securitization of mortgages,'' he said.

Paulson hasn't taken a position on the future of the two mortgage finance companies beyond their current status under federal conservatorship, where they are overseen by the government while remaining shareholder-owned.

Record Foreclosures

U.S. foreclosure filings rose to a record in the third quarter, and will probably increase as the economy worsens and the availability of financing shrinks, RealtyTrac Inc., a seller of default data, reported on Oct. 22.

Almost 20 percent of U.S. mortgage borrowers owed more on their loans during the third quarter than their house was worth as foreclosures depressed prices and the economy weakened, according to First American CoreLogic, a Santa Ana, California- based seller of economic and real estate data.

Borrowing costs have remained high. U.S. 30-year mortgage rates tracked by Freddie Mac rose to 6.46 percent this week, up from 6.04 percent the previous week and 6.07 percent on Jan. 3. Banks are unlikely to compete for new loans and offer lower rates so long as the outlook for the economy remains dim, economists said.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net

Last Updated: October 31, 2008 14:40 EDT