Steven Leavitt from Freakonomics fame recently joined fellow University of Chicago Economists Doug Diamond and Anil Kashyap to explain what the hell just happened. Obama should have these guys draft his next speech.
This episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8. Their combined assets are over $5 trillion. These firms help guarantee most of the mortgages in the United States. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed.
The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.
The continuing saga...
On Monday, the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.)
On Tuesday, the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world; perhaps best known to most of the world as the shirt sponsor of Manchester United soccer club, A.I.G. has assets of over $1 trillion and over 100,000 employees worldwide. The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.’s management, and is nearly wiping out A.I.G.’s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. (Don’t worry, Man U will be fine.)
So essentially the fed has engaged in a hostile takeover of a private corporation, and in doing so has bailed out numerous major investors, banks, foreign governments, etc. This kind of near socialistic action would never happen if conservatives were in charge of government... er, uhhh... anyway...
The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the "conforming" mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.
Oh... there's the conservative government. Completely ignoring the regulatory requirements for a contractor or company acting in the public interest and allowing outside speculators to gain obscene profit at taxpayer expense. Glad I wasn't losing my mind there...
Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages.
So... they overextended themselves in part through a special role guaranteed by the government and backed by taxpayer money, yet taxpayers are the ones who ended up getting fleeces/soaked by this scheme.
Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets.
And then we come to a truly private company who was irresponsibly using their private portfolio to manipulate finances for their own benefit.
Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.
Lehman’s costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman’s credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.
So we have Fannie/Freddie acting outside their mission to drive out mortgage lenders who do things the right way (i.e. no subprime), we have Lehman who irresponsibly invested and participated in this mess, essentially making money off of this other bad lending, and finally, insuring the whole mess, A.I.G...
A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.
So they made some bad decisions, insured the wrong people, and spread themselves too thin.
The problem..
We will never be able to find out what would have happened if A.I.G. had been allowed to fail. Furthermore, there are some reasons to believe that even if A.I.G. continues to operate, the fundamental stress in the financial system will remain. If the rescue does not mark a turning point, the bailout may be viewed quite differently down the road.
Should the government intervene if it merely postpones an inevitable adjustment? Creditor runs can make adjustment too fast; blanket bailouts can make adjustment too slow. Has the Fed found the speed that is just right?
Take the poll.