When Hell Freezes Over

March 16, 2008

The big financial news this week is that the Iron Curtain that was supposed to separate the well disciplined Masters of the Universe in private market investment banks from the girly-men of finance at Freddie Mac and Fannie Mae has turned out to be nothing more substantial than tissue paper.  The Fed joined in a shotgun marriage with JP Morgan Chase to staunch a run on Bear Stearns.   

Can you spell "too big to fail?"

For years now, the members of FM Policy Focus, which includes JP Morgan Chase, and other financial sages, have been beating their breasts over the "moral hazard" created by Fannie and Freddie's special charters and implicit federal guarantee.  As late as last year, Fed officials and OFHEO, the safety and soundness regulator of the two companies, were calling Fannie and Freddie a systemic risk to the financial system.  Investors, they argued, lulled into a stupid trance by the charters, would buy their debt without regard to its risks.  The firms could thereby borrow money recklessly and expand to such a degree that their leveraged positions would threaten the system's stability.

The corollary to this argument was that private sector firms could not rely on such back up and therefore were more soundly capitalized and their debt more carefully scrutinized.

Ooops.  It seems that hell has indeed frozen over.

Fannie and Freddie may pose greater risks to the system than we yet realize.  God knows their economic and accounting losses have been a surprise. 

But while the Fed was sleeping, Wall Street and money center banks went on a credit binge that actually is threatening the financial system.  When one of them got to the brink of insolvency as nervous investors called for their cash, who but the Fed stepped in to save them?

There can be no doubt that Fannie and Freddie's special charters put them in a special position with the government.  Their debt typically trades above Treasuries, but below comparable commercial paper, reflecting the market's higher degree of confidence in its provenance.  They have their own two special regulators and currently are operating under a 30 percent surcharge against their mandatory minimum capital.  They are suffering unprecedented accounting and economic losses.  But no one has suggested that they now need, or are likely to need any time soon, a cash infusion from the government to weather this storm.

But over on Wall Street, these swaggering hypocrites are only too happy to call the government's bluff.  And the Fed, which was wasting its time clucking over the GSEs when they should have been reining in the Street, is putting the government right in the middle of a bailout.

You'd think the folks at FM Policy Focus would be screaming bloody murder over this crude violation of the private sector's credo of "eat lunch, or be lunch."  But when push comes to shove, they were never really concerned about systemic risk.  They were just concerned over how to keep the GSEs from limiting their own voracious appetites for market share and risk taking.

I don't know if the Fed's bailout ultimately is a good thing or a bad thing.  Today's New York Times Business section has a trenchant piece by Gretchen Morgenstern that raises lots of issues.  What's more important to me is the complete breakdown of the fiction that Wall Street -- and probably the big money center banks -- are not as threatening to the financial system as the GSE's, or as likely to be bailed out if they threaten to fail.