The Financial Services Bailout: Reprivatizing Credit Risk

In his great book, Crisis and Leviathan, Robert Higgs discusses the "one way ratchet" of the expansion of government power in crisis. It is hard to push back the flood of government and bureaucratic power rolled out to address the crisis. It does recede some, but never back to where it was before. If you haven't read it, I commend Higgs' book to you as particularly relevant to the current situation.

Needless to say, in credit and financial markets we have had a truly vast expansion of government intervention and control, with many proposals for even more expansion being put forward. In part, this is the political response to the universal cry of the panic: "Give me a government guaranty!"

A good example of the ratchet effect with government guarantees is provided by the history of deposit insurance. Here is what the two main sponsors of the Banking Act of 1933, also known as the Glass-Steagall Act, which created federal deposit insurance, said about their creation:

Senator Carter Glass: "This is not a government guaranty of deposits." He continued, "The Government is only involved in an initial subscription to the capital of a corporation that we think will pay a dividend to the Government on its investment. It is not a Government guaranty."

Congressman Henry Steagall: "I do not mean to be understood as favoring the Government guaranty of bank deposits. I do not. I have never favored such a plan."

But go into any bank or thrift today and read the FDIC sticker by the teller windows. It says, "Backed by the full faith and credit of the United States government." It is a government guaranty, pure and simple, and the government is busy expanding it greatly.

I will discuss three ideas for reprivatizing credit risk:

  • The creation of new banks
  • Much bigger loan loss reserves in good times
  • The ultimate restructuring of Fannie Mae and Freddie Mac.

New Banks

We should have a national program to encourage the creation and capitalization of new banks to provide new sources of private credit.

It is virtually impossible to push back the flood of government and bureaucratic power rolled out to address a crisis.

Now is in fact a great time to start new banks, when so many old ones are constrained by the deadweight burden of bad loans and unfortunate investments. Which would you rather invest in: a new bank with a fresh opportunity to make loans and investments when credit standards are high and interest rate spreads are wide; or an old bank sinking in bad loans and losses, ever more entangled with the government as partner and "helper"? And with a new bank, nobody has to try to define the value of troubled assets, let alone set a price at which to sell them to the taxpayers.

Creating new banks deserves to be a top priority. But financial regulators are doing the opposite: making it slow and difficult. From their narrow perspective, they would prefer to force all new banking capital into their problem situations. Move up to the broad perspective of having well functioning credit markets, and it is easy to see that new, unemcumbered banks are what we want.

This has happened before in periods of financial stress. In 1933, America was faced with frozen mortgage markets. Part of the response was to define a new financial charter, the federal savings and loan association, and the government promoted the creation of these new credit institutions across the country.

The Lincoln administration, in addition to fighting the Civil War, had to figure out how to finance it. Part of its response was the creation of a new financial charter, the national bank, and new national banks were promoted by the government and set up across the northern states.

I don't think we need a new charter today, just new banks, although reducing the burdens of being a bank holding company could help widen the field of possible investors. Some of these new banks could be quite sizeable when capitalized by institutional investors, and would be very useful for expanding credit on a private basis.

Much Bigger Loan Loss Reserves in Good Times

To have successful private credit risk bearing, we need much bigger loss reserves created in good times. If you lever up during the boom and don't build reserves, you will undoubtedly end up in the government's clutches when the bust comes.

This was forcefully stated by George Champion, the Chairman of the Chase Manhattan Bank in the 1960s, when he recommended that banks "increase the reserve for bad debts to a point of having at least 5% of total loans. This would not be out of line with the enormous losses that had to be written off in the last few years," he observed, speaking in 1978. His peroration:

"Don't apply for privileges in Washington. You lose your strength. You lose your independence. Don't get in a position where you are going to have to rely on the government to bail you out."

To put the whole issue in perspective, just imagine the crusty old chief credit officer pronouncing to the aspiring young banker (me): "Bad loans are made in good times."

This eternal financial truth is all you need to know in order to understand that the accounting theoreticians of the SEC and the FASB are wrong yet again when they oppose building reserves in the aforementioned good times. They claim this would mean "cookie jar accounting during periods of bumper profits." But the "bumper profits" of a credit expansion, let alone of a credit bubble, are not real--they are an illusion created by the credit expansion itself.

This illusion then turns into real cash outflows from the banks: big bonuses, dividends, and outsized stock repurchases, to be later much regretted, since they made equity disappear and vulnerability increase.

With bigger, more old-fashioned loss reserves, we can do better in the next cycle.

The Ultimate Restructuring of Fannie Mae and Freddie Mac

A key point is that the ongoing bailout of Fannie and Freddie is a government intervention to save a failed previous intervention.

In the last year, Fannie and Freddie have gone from being a government-sponsored duopoly to being a government-owned duopoly. They have changed from being GSEs to being government housing banks. They are therefore available to be directed by the government to participate in mortgage financing based on political policy, not profit. The director of their regulator, the FHFA, is in fact the CEO of both Fannie and Freddie. Quite a job!

This government housing bank status should have a firm sunset. Then a long-term restructuring should divide Fannie and Freddie into three parts:

  1. Prime mortgage securitization
  2. Mortgage portfolio investing
  3. Government activities

The prime loan securitization business, which is a business, should be fully privatized into private companies to compete like anybody else, sink or swim, flourish or fail.

The business of owning a leveraged portfolio of mortgage loans and MBS should be moved into a banking charter or real estate investment trust with a fresh start as part of the private market, again, sink or swim.

The final element of the former Fannie and Freddie consists of those activities which belong in the government, such as providing subsidies in one form or another and providing non-market financing of risky loans. These should stay in the government, being merged into the structures of the Department of Housing and Urban Development-FHA-Ginnie Mae. Their funding would and should then have to be appropriated by the Congress in a transparent way, instead of escaping the appropriations discipline by being hidden in the GSEs.

The total result would be that no GSEs could reemerge: a consummation devoutly to be wished.

In summary, these three projects--new banks, bigger loan loss reserves in good times, and restructuring the former GSEs--would move us in the right direction toward reprivatization of credit.

Alex J. Pollock is a resident fellow at AEI.

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