GSE and Moral Hazard

Author: David Kotok, Post Date: September 6, 2008
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GSE stands for Government Sponsored Enterprises and is now the common reference for the federal government’s housing mortgage lenders Fannie Mae and Freddie Mac (FF).  Other GSEs like the Federal Farm Credit Banks or the Federal Home Loan Banks are not public shareholder-owned and have not encountered the problems of FF.

“Moral hazard” is a term with several definitions.  It is frequently used to describe how the action of a governmental entity like the US Treasury or the Federal Reserve can encourage speculative risk taking.  When players in the financial marketplace believe that the government will bail them out and/or cushion their losses, those players change their risk-taking profiles from what they otherwise would do.  They begin to gamble, based on the belief that the government will make them whole if they lose and allow them to keep their winnings if they succeed.

As the weekend news unfolds we are witnessing the tug of war between the US government’s instruments of policy and the forces of moral hazard.  Here is the scorecard in the ongoing saga of FF.

The roller coaster ride in the common share price of FF reveals the ultimate play of a moral hazard.  If Treasury Secretary Paulson’s plan preserves any value for these shareholders, it will ratchet up the level of moral hazard to a new high for the United States.  That scenario would take a probably valueless security and use the government’s credit (read: taxpayer money) to make gambling stock market investors whole or cushion their losses.  Paulson knows this.  So does the other federal power broker, Fed Chairman Bernanke, which is why this outcome is unlikely.  Anyone who is playing in the stock of FF is purely gambling.

FF preferred stock is considered equity by most investors.  It is senior to the common but is not in the category of debt incurred to finance mortgages, derivative guarantees, or mortgage pool guarantees.  Some shares of preferred are held by US commercial banks and some are held by foreign institutions.  They purchased it knowing it had equity status.  In addition, many speculators have bought FF preferreds on the open market during the last year on the hope that the government would keep them whole.  They are an example of a financial market player who is acting out the moral hazard definition.

The Paulson plan for preferreds status is unknown as this is written.  An hour ago, Chris Whalen of Institutional Risk Analytics sent me a news reference quoting a “person briefed on the plan” that says the preferreds will be kept whole. 

If the Paulson plan makes the preferred whole it will provide a windfall profit in the billions to those who recently speculated on the government’s bailout structure.  If the plan collapses all the equity, the preferred will be nearly worthless, just like the common.  Saving the preferred is also an action within the moral hazard definition.  In this case, making the preferred whole will increase moral hazard by an order of magnitude.  It will include a form of equity in the federal bailout arsenal.

FF derivatives and counter-party contracts are an entirely different matter.  Here the financial system is threatened with unknown and possibly serious consequences, just like it was when Bear Stearns was forced into a merger with JPMorgan Chase.  The federal authorities cannot risk a systemic failure.  That is why the FF restructure will preserve the derivative contractual obligations of FF.  There may be some moral hazard issues, but they are overwhelmed by the factors of systemic risk.

FF mortgage pool guaranteed securities and debt obligations are likely to be honored in full.  Billions are held by state and local governments in the United States.  Similar large holdings are found among the central banks and foreign institutions of the world.  They purchased and held this paper based on the fact that the United States would honor the guarantee of the federal agency, even though the guarantee was not explicit.  These buyers had history on their side.  The US has not permitted any agency to default.  In the end and after all the political wrangling, it is not about to start now.  Does keeping the debt holder whole amount to some form of moral hazard issue?  The answer is yes.  Is it necessary?  The answer is also yes.

If the government wishes to stop this enlargement of moral hazard in the future it must get out of the implied guarantee business.  It must stop seeding and fertilizing moral hazard as it did when it permitted the federal housing finance agencies to become stock market plays and then allowed the management of those agencies to make fortunes with stock options on those shares.

Governmental explicit action is the best way to reduce moral hazard.  Transparent and consistent behavior works well.

Will the government end this FF saga in a way that ratchets down the moral hazard created by previous administrations?  That is the most fundamental of issues.  As of this writing the answer is unknown.

A decision to allow the common and preferred shareholders to lose and to nationalize FF and remove their publicly traded shareholder status will reduce moral hazard risk and promote better-functioning financial markets.  That will return risk to more symmetry with regard to the outcome of risk taking. 

Any plan by Secretary Paulson that preserves equity will raise moral hazard.  It will plant the seeds of the next crisis even as it attempts to cure this one. 

At Cumberland we have tried to avoid fixed-income instruments which are dependent on some form of moral hazard for their payments.  When we identify one after purchase, we are not afraid to sell it and take a loss.  We also understand that the market doesn’t always do the homework necessary to distinguish between good value in fixed income and appearances of value.  The unfolding saga in the municipal bonds insurers is a good example.  Here too, investors ignored the hazard that was developing as Muni insurers went outside their traditional business lines.

In the case of Muni bond insurers the government did not bail them out.  It is letting a $2.6 trillion dollar asset class work through its problems.  That is encouraging investors to do the work required in order to make good investment decisions.  This lack of action by government has lowered moral hazard exposure in Muni-land.  In the end that will serve the public well and facilitate the successful financing of state and local government for many years to come.

Treasury Secretary Paulson can look to this example in Munis when he advances his plans for FF.  He must remember that he represents the taxpayer and holds a seat of trust.  As trustee of the federal purse Paulson must remember that he is spending the money of those who make their mortgage payments on time, NOT those who gambled on moral hazard prevailing.  That is the ultimate trade-off in the FF restructuring plan.

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