As Senator Everett Dirksen once said, “A billion here, a billion there, and pretty soon you’re talking real money.”
Although the powers that be have relied mainly on guarantees and loans rather than explicit payment to try to prop up financial institutions and the housing market, the same principle applies. Even though these commitments are contingent liabilities, the amounts are so large and the risks assumed are sufficiently dodgy that there is certain to be some payment to the piper.
An article in Bloomberg makes a first cut.
From Bloomberg:
Even as the Bush administration insists it won’t risk public funds in a bailout, American taxpayers may already be liable for billions of dollars stemming from Federal Reserve and Treasury efforts to quell a financial crisis.
History suggests the Fed may not recover some of the almost $30 billion investment in illiquid mortgage securities it received from Bear Stearns Cos., said Joe Mason, a Drexel University professor who has written on banking crises. Treasury’s push to have Fannie Mae and Freddie Mac buy more mortgage bonds reduces the capital the government-chartered companies hold in reserve at a time when foreclosures and defaults are surging.
Regulators “are playing with fire,” said Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh. “With good luck, none of these liabilities will come due. We can’t expect that good luck, and we haven’t had it.”
Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson were forced to respond after capital markets seized up and Bear Stearns faced a run by creditors. In an emergency action that jeopardizes the dividend it pays the Treasury, the Fed authorized a $29 billion loan against illiquid mortgage- and asset-backed securities from Bear Stearns that will be held in a Delaware corporation. JPMorgan contributed $1 billion.
Dividend Jeopardized
The Delaware company will liquidate the assets over 10 years, with JPMorgan absorbing the first $1 billion in losses, with the Fed bearing any that remain. Any such losses would hurt the Fed’s balance sheet, and ultimately the taxpayer, because they would reduce the stipend the Fed pays to the Treasury from earnings on its portfolio. The dividend was $29 billion in 2006.
“The fact that Treasury and Congress have been unwilling or unable to be proactive and provide a solution that involves putting taxpayer money at risk means that the Fed has had to take more measures itself, also putting taxpayer money at risk,” said Laurence Meyer, a former Fed governor, and now vice chairman of Macroeconomic Advisers LLC in Washington….
The average recovery on failed bank assets is 40 cents on the dollar over a six-year period, according to Drexel’s Mason, a former official at the Treasury’s Office of the Comptroller of the Currency. Nobody knows if that historical benchmark will hold for the Fed portfolio because the assets haven’t been disclosed, they have already been marked down and the Fed has 10 years to recover value.
“Over 10 years, you might eventually get your money back,” said Janet Tavakoli, president of Tavakoli Structured Finance Inc. in Chicago.’
Still, “that isn’t costless to the Fed, it isn’t the same as holding Treasuries,” she said. On some low-documentation loans, “you are going to be lucky to get 40 percent.”
Paulson reversed Treasury’s stand of the previous three years in approving the decision to direct Fannie Mae and Freddie Mac to expand their $1.5 trillion mortgage assets. Previously, Treasury and the Fed had called for cuts in the portfolios held by the government-chartered companies.
Fannie Mae and Freddie Mac will buffer against more risk by raising “significant” capital, Fannie Mae Chief Executive Officer Daniel Mudd and Freddie Mac Chief Executive Officer Richard Syron said at a press conference with James Lockhart, director of the Office of Federal Housing Enterprise Oversight that regulates the two companies.
The companies reported record fourth-quarter losses totaling $6 billion and warned days before announcing the additional purchases that credit losses will rise this year.
Lockhart dismissed the view that taxpayers could be liable for such losses. “Certainly not,” he said. The companies “have the capital, they support their own” mortgage-backed securities.
Yet the Treasury’s authority to buy $2.25 billion in each of the companies’ securities has created investor expectations that the firms hold an implicit federal guarantee against losses.
Lenders allow Fannie Mae and Freddie Mac to borrow more cheaply than rival companies because they expect Treasury would provide a bailout before letting them default.
Because Fannie Mae and Freddie Mac own or guarantee about 40 percent of the $11.5 trillion home loan market, the cost of a bailout would be “in the hundreds of billions of dollars,” said Andrew Laperriere, managing director at International Strategy & Investment Group in Washington. “Taxpayers should be increasingly concerned about the contingent liability.”
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I thought the lowering of capital requirements for (the already very troubled) FNM and FRE was a pretty clear signal that the ‘implicit’ guarantee behind them was being made explicit.
That might require Congressional action. But the Fed’s alphabet soup of facilities to prop up mortgage paper does, how shall we say it, considerably enhance the government’s commitment.
OT: The Depository Trust & Clearing Corporation (DTCC) announced today it cleared and settled more than $1.86 quadrillion in securities transactions in 2007.
>> At the end of 2007, J.P. Morgan’s exposure totaled $77.2 trillion in notional value, exceeding that of any other commercial bank, while Bear Stearns had $13.4 trillion in notional value.
Granted, the combined total exposure if the acquisition goes through could amount to less than that, since derivatives involving the two banks themselves would be cancelled. And with over-the-counter derivatives totalling a notional $516 trillion at the end of June 2007, according to the Bank for International Settlements.
In a research report it published last week, Bear said its more than 5,000 derivative counterparties and more than 1,000 futures counterparties were among the reasons the Federal Reserve and Treasury Secretary Henry Paulson felt compelled to find a buyer for the bank rather than see it go belly-up. Counterparties to these contracts are mostly banks, but also include hedge funds and insurance companies.
BEAR CHURNS
Bear Stearns deal boosts J.P. Morgan’s derivatives exposure
http://www.financialweek.com/app…92/1016/ ECONOMY
““The fact that Treasury and Congress have been unwilling or unable to be proactive and provide a solution that involves putting taxpayer money at risk means that the Fed has had to take more measures itself, also putting taxpayer money at risk,””
Why “has”? There’s no necessity in the Fed’s measures. It’s a choice, and IMHO the wrong choice.
“Yet the Treasury’s authority to buy $2.25 billion in each of the companies’ securities has created investor expectations that the firms hold an implicit federal guarantee against losses.”
So duh investors can be wrong. The U.S. government has been very clear there is no guarantee. If investors want to be wrong and think there is one, then they need to learn the hard way.
“I thought the lowering of capital requirements for (the already very troubled) FNM and FRE was a pretty clear signal that the ‘implicit’ guarantee behind them was being made explicit.”
Not at all. The lowering of requirements just rescinds higher requirements put in a few years back. Everyone’s looking for a guarantee; it’s just not there.
Yves…
If I’m not mistaken, in December 2007 OFHEO published in the Federal Register proposed regulations to increase the regulatory capital of FF because they had determined that the severity rate estimates in the FF models were incorrect, sometimes producing silly results to the extent of negative severity estimates.
I have the link if you need it.
The proposed regs estimated about a $10B increase in regulatory capital would be needed as of year-end 2006, but commented that this was slightly less than the 30% extra requirement which has just been reduced.
Why am I the only one sitting here wondering how this can be?
Doesn’t it matter that a regulatory body is on record as saying that never mind temporary increases due to accounting scandals, there need to be permanent increases, and this is ignored now?
By definition relative to these proposed regs, aren’t FF now undercapitalized?
Tell me I’m not insane…
I hate to say it, but what is going on with Fannie and Freddie is so appalling that I can’t stand thinking about it too deeply. There is a long piece by Doug Noland in the Asia Times (link in today’s Links page) that goes on at considerable length about regulatory backsliding.
They must have gotten the 5 x 7 glossies on Lockhart. He had stood up to the pressure to expand FF’s balance sheets, but lately has caved.
A key to minimizing moral hazard during The Great Unwinding is inducing American media conglomerates that own a broadcast television network to air entertainment programs in prime time that routinely militate against (the prospect of) offending policies (think next-gen Jed Bartlett (of NBC’s West Wing) channeling Jon Stewart and Vietnam-era Walter Cronkite).
Imho, this inducing is doable.
The full story is online at http://www.loveatmadisonandwall.com.
The short story:
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* The more meritocratic America is, the more profit these markets and associated media will generate for owners.
Why am I sharing the details at the aforesaid website, rather than launching a startup markets-maker?
Because I am a comedy writer, not an entrepreneur.
The business plan that is the basis of the site took shape because I want to develop a sitcom that showcases the best ways to leverage the Internet to expand educational and economic opportunity, and it turns out that producing this sitcom — now titled Love at Madison and Wall — is inseparable from launching the markets-maker described in the plan, not least because:
1. launching a markets-maker costs money
2. raising money from investors is easier if the marketing plan is good
3. a sitcom is an ideal centerpiece of a marketing plan (e.g., a plan for operating marketing as a profit center)
Please feel free to contact me with any questions, etc.
Beyond the above, I have been reading your blog for some time now. Great stuff.
Best,
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On the subject of bailouts, is anyone still looking at the the FHLB loans to CFC? That struck me as the first bailout, if only because they were given cheap money, which in my book, equals PV real money up front.
I have not heard anything about this bailout for a while, and I am curious if anyone is still watching it.
Bear Stearns deal boosts J.P. Morgan’s derivatives exposure
Yeah, and that can’t be a good thing (although it’s also not clear how bad it is). It’s usually said that what defuses some of the risk surrounding derivatives, e.g. CDS, is that there are so many players. But with the (apparent) demise of Bear, JPM has taken on another heaping helping. Even Bernanke would not be reckless enough to accept any of that exposure…would he?