GSE Losses As Shadow Bailout

I want to talk about this, from Megan McArdle:

It’s looking increasingly like Fannie Mae and Freddie Mac are going to cost the US government much more than AIG. In its latest long-term budget outlook released in late January, the CBO projected that the AIG bailout would ultimately cost the Treasury $9 billion dollars. Indeed, the entire private financial industry bailout is ultimately expected to cost less than $30 billion…By contrast, the nationalization of the Government Sponsored Entities is expected to cost the Federal government $64 billion between 2011 and 2020, on top of the $110 billion we’ve already spent.

Matt Yglesias has more. There will be more interesting stuff about an endgame for the GSEs here in the near future, but for now I want to talk about this argument.

You’ll probably see a lot of this going forward, that the banks losses weren’t really all that bad, especially compared to the GSEs Fannie Mae and Freddie Mac, as if these were two separate issues. However it is likely the GSEs took on some of the worst loans and mortgage-backed securities of the banks during 2007 and 2008, transferring losses from the private banking sector to the quasi-private-quasi-public GSEs.

Let’s look at The Reckoning articles from the New York Times on the collapse of the GSEs (my bolds), some particularly good reporting on the topic. Here’s Pressured to Take More Risk, Fannie Reached Tipping Point from Charles Duhigg, Oct 2008:

Had Fannie been a private entity, its comeuppance might have happened a year ago. But the White House, Wall Street and Capitol Hill were more concerned about the trillions of dollars in other loans that were poisoning financial institutions and banks.

Lawmakers, particularly Democrats, leaned on Fannie and Freddie to buy and hold those troubled debts, hoping that removing them from the system would help the economy recover. The companies, eager to regain market share and buy what they thought were undervalued loans, rushed to comply.

The White House also pitched in. James B. Lockhart, the chief regulator of Fannie and Freddie, adjusted the companies’ lending standards so they could purchase as much as $40 billion in new subprime loans. Some in Congress praised the move.

And also this article in the series, White House Philosophy Stoked Mortgage Bonfire by Becker, Stolberg and Labaton, from Dec 2008:

In an Oval Office meeting on March 17, however, Mr. Paulson barely mentioned the idea, according to several people present. He wanted to use the troubled companies to unlock the frozen credit market by allowing Fannie and Freddie to buy more mortgage-backed securities from overburdened banks. To that end, Mr. Lockhart’s office planned to lift restraints on the companies’ huge portfolios — a decision derided by former White House and Treasury officials who had worked so hard to limit them.

One doesn’t have to be an advanced game theorist to see the adverse selection in play – the loans sold to the GSEs from the major banks, under much political pressure, in this period were almost certainly of poorer quality and too expensive. Let’s get a little bit of data:

As the private sector started to dump housing and housing bonds quickly in 2007 and 2008, government officials made sure that the GSEs would be capable of absorbing these bad loans. See that relationship above? This constitutes one part of many “shadow bailouts” according to Roosevelt Institute senior fellows Rob Johnson and Tom Ferguson; this argument, and the graph above, is from their Too Big to Bail: The ‘Paulson Put,’ Presidential Politics, and the Global Financial Meltdown Part II paper. (In Part I, they argue that the Federal Home Loan Bank System was also used in a similar manner.)

Astute readers will notice that the action of government officials using public funding sources to provide makeshift backstops for losses of the banking sector to clear the balance sheets of toxic assets to “unlock the frozen credit market”, without having to go to Congress for funding, was also a central feature of Geithner’s PPIP plan, with FDIC stepping up to the plate once the GSEs went bust.

I sincerely hope a lot more of this information and analysis comes to light, especially the numbers and losses on the books. There are things that are good about the GSEs, and things that are bad, but the fact that it might have been ready to go as a garbage bag for the private sector’s bad bets, a bag taxpayers have to eat out of, has been the most surprising, and terrible, thing about it in this crisis.

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11 Responses to GSE Losses As Shadow Bailout

  1. With regard to this:

    Conservative, business, and libertarian sources have a long history of blaming failures that have followed the adoption of policies initially labeled as “free market” on the government. They are doing this with the housing bubble and associated financial crash heavily and aggressively.

    Currently, there are three major government scapegoats for the housing bubble and crash. These are:

    1. Alan Greenspan and the Federal Reserve for keeping interest rates low, usually the so-called Taylor Rule is cited.

    2. Fannie Mae and Freddie Mac

    3. The Community Reinvestment Act (CRA) for supposedly “ordering” banks to make loans to unqualified poor and minority borrowers who are portrayed as the bulk of the housing bubble and associated crash.

    In addition, there are many lesser government scapegoats that come and go briefly. For example, Elliot Spitzer is blamed for the AIG fiasco for his investigation of questionable accounting practices at AIG and forcing out Maurice Greenberg.

    In previous fiascoes, conservative, business, and libertarian sources followed essentially the same strategy. As soon as the bubble bursts they perform an about-face and aggressively blame the government for the fiasco. This occurred with the Savings and Loan fiasco in the 1980’s which included several regional housing bubbles (one in the New York City suburbs 1983-1988 for example). It happened with the Internet and Telecom bubble of the 1990’s where too tight monetary policy by (yes!) Alan Greenspan and the Federal Reserve was blamed, along with obscure clauses of the telecom “deregulation” acts of the period. It happened with the electricity market “deregulation” in California in 2000, where the huge price spikes and shortages were smoothly and aggressively blamed on environmentalists and environmental regulations. The late Milton Friedman made a career out of blaming (yes!) the Federal Reserve for the Great Depression. Numerous other government scapegoats for the Great Depression are regularly promoted as well.

    It is important to distinguish between policies labeled as “free market” or “deregulation” and “true deregulation”. For example, the Savings and Loan deregulation of the 1980’s involved large increases in Federal deposit guarantees through the Federal Savings and Loan Investment Corporation (FSLIC). Conservative, business, and libertarian sources said little about this until the bubble burst. Then, they performed the standard about-face and aggressively pointed to the fine print they had ignored to blame the “government” for the fiasco.

    As in the current situation with Fannie Mae and Freddie Mac, the policies labeled as “free market” or “deregulation” actually involve huge hidden subsidies to certain companies. However, aggressive “free market” and “anti-government” rhetoric is used to first promote the policies and then to blame their failure on the “government”. The actual policies frequently involve large government subsidies to businesses.

    To be successful, critics of the current policies must recognize this strategy, comprehensively rebut the blame the government excuses, and clearly demonstrate the long history of these excuses and the abrupt about-faces.



  2. sraffa says:

    Definitely Mike. The real bailouts are the Fed’s purchases of mortgage backed securities and the GSEs. This is where all the toxic assets went. But everybody’s freaking out about the TARP.

    I see very little complaining from the Fed-bashers on the bailout of toxic assets which has consitututed the lot of their purchases. Their treasury position has actually shrunk (!) since 2007. Traditionally, Treasury purchases were the main way monetary policy was loosened, but in this case, Treasuries have been sold, and a massive unelected, unpopular bailout of bank’s toxic assets has occurred.

    “On September 23, 2009, the FOMC announced that the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities”

    A trillion here and a trillion there, and pretty soon you’re talking about big money. But no, let’s whine about 787 billion to fix potholes, cut taxes,and prevent state tax increases and layoffs.

  3. This is not a new story. Maybe it’s just a sudden realization as to what took place.

    I mean seriously, how on earth do you think these banks made all that money last year? From making tons of high quality loans??

    There’s only one way banks go from the brink of disaster to one of the most profitable years they’ve ever had with an economy still in recession. You sell assets, because regular lending just ain’t makin’ it.

    It’s the same thing with AIG. That company paid out 100% on its obligations because the counterparties were banks. It AIG didn’t pay, then every money center bank would have been nailed … and your ATM and credit cards would have stopped working.

    I’ll sum it up in one sentence: The real bailout has been the transfer of assets (mortgage loans and their derivatives) of private financial institutions from their balance sheet to the balance sheet of the United States.

  4. John Thacker says:

    “but the fact that it might have been ready to go as a garbage bag for the private sector’s bad bets, a bag taxpayers have to eat out of, has been the most surprising, and terrible, thing about it in this crisis.”

    Really? Because it was predicted repeatedly by various Cassandras, including the Wall Street Journal page, for years. I completely expected it to work that way. Greg Mankiw warned about it in 2003. ( and )

    It’s true that the GSEs bought up (and later were made to buy up) the worst bets of the private banks. But it’s also true that if the GSEs weren’t willing to buy those loans, then the banks wouldn’t have made the loans in the first place.

    Both of those reasons are why some of the worst lenders, like Countrywide, fought against GSE reform. They wanted Fannie and Freddie to be around to take all their riskiest loans.

    That always was the biggest argument against the Fannie and Freddie implicit government guarantee and domination of the market (and willingness to buy mortgages in order to maintain market share.) It’s absurd to claim that this was “most surprising.”

  5. q says:

    well, why don’t you compare default and loan non-performance rates between the GSEs and the rest. you’ll clearly find that GSE loans perform much better than other loans. i’ll look for some data on this — but it’s widely available.

    there are two primary reasons that the GSEs are underwater right now. first, they were undercapitalized at the beginning of the crisis — their capital buffer was much smaller than the banks’. that’s bad, but it’s exclusive of the quality of their assets. secondly, their accountants are essentially working for the government now and so aren’t trying to hide losses the way that the large banks are. Here’s a rundown:

  6. Angela says:

    Nice post.

    I agree that more of this information and analysis need to come to light, especially the numbers and losses on the books.

    We won’t be able to discern fully the good and the bad about the GSEs totally without full information.

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  9. Jake Taylor says:

    The thesis of this blog post is false.

    Look through Fannie and Freddie’s financials. Their losses have come from loss provisions against loans purchased before 12.31.2008 and fair value losses on AAA private-label (subprime) ABS (85% of which have been downgraded) acquired in 2006 and 2007.

    They were never used to acquire banks’ ABS or structured financial products. And their holdings of private-label (subprime) ABS has declined each quarter over the past two years.

    • DF says:


      That’s the whole point: the shadow bailout began in 2007 as an attempt to shore up banks’ balance sheets before the public was aware there was a problem.


  10. Pingback: Some thoughts on Tyler Cowen’s Points on the GSEs | Rortybomb

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