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Thursday
Aug262010

Newest FED Proposal To Bankrupt America: Blanket Government Guarantee Of Auto Loans & Credit Card Debt

The Fed is circulating a new paper calling for a blanket government guarantee of the entire asset-back securities market.  Trillions in personal loans could soon have the explicit backing of sweet Uncle Sam Uncle Sugar.

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New Proposal To Bankrupt America: Government Guarantee Of Entire ABS Market

Author Jeff Harding

Let us assume for the purpose of argument that our corporate bond market is and always has been backed by federal government insurance. In its many years of operations companies would float bonds at relatively low interest rates because of the government’s guarantee. Industry would be financed for their various projects, and, perhaps because of the lower cost, maybe this would be the preferred financing option for seasoned companies rather than common stock.

If anyone were to suggest that this market should shed its guarantee and rely on the private securities market to finance corporations, I am sure they would be laughed down by most economists and politicians. They would use the standard arguments against free markets. Everyone knows that without the guarantee corporate bonds would not get financed, or, there is not sufficient evidence that the private market would finance bonds without the guarantee, or, if they did, the lending covenants would be too harsh or the interest rate would be too high for corporations to afford. And, of course, the government has a “strong social interest” in maintaining a stable source of capital for corporations.

We all know, of course, that such thinking is wrong, and that the securities markets can well provide bond financing for business without the government’s guarantee.

Yet I just read an article about a forthcoming paper coming from two Fed economists recommending that the federal government guarantee all asset backed securities

Wayne Passmore and Diana Hancock, the associate director and deputy associate director, respectively, in the division of research and statistics at the Fed — argue that an explicit backstop of certain asset-backed securities could ensure the stability of the system in future financial crises and help eliminate the concept of “too big to fail” institutions.

People who hold mortgage-backed securities or asset-backed securities are happy as long as they know there is no credit risk,” Hancock said in a recent interview. “When they’re really concerned that there is credit risk, they may run. That’s not good for a securitization market.”

To protect against such securitization runs, which can dry up credit availability, the two economists said an insurance fund should be created to cover catastrophic risks on a wide range of asset classes, including mortgages, credit cards and auto loans.

“We are arguing we should create an FDIC-like entity to explicitly price this form of guarantee,” Passmore said in the same interview. “It will capture many of the benefits that have been associated with the GSEs, they will allow the government to accumulate an insurance fund, or reserves, to pay for supporting the fund up front. That’s really the essence of why people want the government in the mortgage market. It defines well what the government’s role will be.”

Just the other day Pimco’s Bill Gross said:

“Without a government guarantee, mortgage rates would be hundreds — hundreds — of basis points higher, resulting in a moribund housing market for years,” Gross said.

He said Pimco would not consider investing in a private, or privately insured, mortgage pool unless it was accompanied by 30% down payments — far above the current norm.

It is dismaying to see famous financiers and respected economists have so little faith in, or so little knowledge of, how free markets work. The bond market works well precisely because there are no government guarantees. Investors seem to be able to assess and accept risk.

Perhaps I should wait until the paper is published before I comment, but it is already making the rounds at conferences. According to the above article, the paper will be published just at the “critical juncture of the debate over the future of the government-sponsored enterprises.” It appears to be an idea that Chairman Bernanke favors.

I did read an earlier paper by Passmore and Hancock (“Three Initiatives Enhancing the Mortgage Market“) that argued in favor of this idea for the mortgage market. But now they are expanding it to include all ABS (asset-backed securities, such as auto loans, consumer loans, credit card debt, and the like). I also saw Dr. Passmore’s presentation material of the idea at a May conference sponsored by the Chicago Fed.

It appears from their writings that they believe the major reason for the bust of 2008 was because the ABS market lacked uniform explicit federal guarantees. They completely ignore the role of the Fed in creating the boom-bust cycle and the role of the government in creating the guarantees that encouraged and funneled vast sums of money into mortgage-backed securities and other securitized assets. Their solution looks to control the effects of the problem rather than cure the causes. It is much like the doctor breaking the thermometer of a fevered patient.

It was just this same kind of well meaning thinking that created the mess that is Fannie Mae, Freddie Mac, and Ginnie Mae (GSEs). As always, this well-meaning legislation was used by politicians for political ends rather than for market-driven goals. That is, they substituted their personal wishes for the choices of millions of individuals who vote in the marketplace every day with their own dollars. The rules were eventually corrupted to permit loose lending standards resulting in risky loans guaranteed by these agencies.

Who can forget Barney Frank’s comments about  the GSEs:

House Financial Services Committee hearing, Sept. 10, 2003:

Rep. Barney Frank (D., Mass.): I worry, frankly, that there’s a tension here. The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not seeI think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios

As of Q1 2010, Fannie had lost double its profits made for the previous 35 years. It has already cost taxpayers about $85 billion. Estimates of bailout costs range as high as $1 trillion if home values decline another 20% and foreclosure rates continue to climb.

Passmore and Hancock take a little different approach to the ABS guarantee markets than presently exists. In their version they envision a federal entity like the FDIC to insure ABS like the FDIC insures banks. Thus, securitizers would pay for the insurance as do banks for the FDIC guarantees. This new entity would probably replace the GSEs.

There are several things to consider about this proposal. First is the huge size of the market they propose to backstop. The U.S. mortgage market is about $10.5 trillion in size. If you add in all the other types of ABS securities, you could probably double that amount. It is likely that government guarantees would quickly become the standard insisted by the buyers of ABS, so we could expect the government’s role in this market to be dominant.

In essence these economists are saying that bureaucrats are capable of managing the insurance of markets that may exceed $20 trillion. I suggest that is fanciful and naive thinking, but not atypical, of central planners who think they have the ability to better manage the decisions of millions of people than those millions themselves. The history of most such central planning schemes have ended badly. In fact the ABS market that fared the worse in the crash were residential mortgage-backed securities, the underlying loans of which were often guaranteed by the GSEs; as guarantors of one-half of this mortgage market, those infamous toxic assets were created because of the implicit federal guarantees.

Second, the idea presupposes increased government regulation of the ABS markets that few bureaucrats understand. To guarantee the enormous ABS market, new rules and regulations need to be devised to define the conditions of the guaranty. In order to protect taxpayers they will establish rigid standards that would be more conservative than are currently required by the market. It is likely that the rules will initially tend to stifle the ABS market and inhibit innovation. At least until the special interests work their magic to allow special rules for their needy industry. Sound familiar?

The recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act gives a vast new federal bureaucracy almost diktat powers over the financial industry. There is almost nothing these new czars cannot do if they find that a company “threatens financial stability.” Passmore and Hancock’s idea is just another extension of the Dodd-Frank Act. Sadly, neither the Act nor the ABS guarantee idea do anything to prevent another boom-bust cycle from occurring.

While I understand the nature of Passmore and Hancock’s job, their idea is an excellent, yet unfortunate, example of short-term thinking coming from government economists and politicians. Perhaps they should have considered the real causes of the last crisis before they made recommendations to cure the next one.

To propose a vastly expanded system of government guarantees of financial markets in light of the failed history of Fannie and Freddie is irresponsible.

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Reader Comments (7)

New Fed Proposal To Bankrupt America: Government Guarantee Of Entire ABS Market

http://dailycapitalist.com/2010/08/25/new-fed-proposal-to-bankrupt-america-government-guarantees-entire-abs-market/

Great job jeff...thanks for sending our way...
Aug 26, 2010 at 1:03 PM | Registered CommenterDailyBail
If government guarantees all private debt, then what is to stop the people from simply incurring debt as recklessly as government. Oh, but wait ... that's the plan ....

OBAMASTEIN LIVES !
http://letthemfail.us/archives/5293
Aug 26, 2010 at 1:13 PM | Unregistered CommenterWil Martindale
Glenn Beck rally will be a measure of the tea party's strength

http://www.washingtonpost.com/wp-dyn/content/article/2010/08/25/AR2010082507063_pf.html
Aug 26, 2010 at 1:47 PM | Registered CommenterDailyBail
Democrats privately fear House prospects worsening

http://www.politico.com/news/stories/0810/41469.html
Aug 26, 2010 at 1:49 PM | Registered CommenterDailyBail
AUGUST 25--A Cincinnati woman was simultaneously masturbating with a sex toy and watching a pornographic video while driving last week, according to cops who arrested her on assorted criminal charges.

Colondra Hamilton, 36, was pulled over last Tuesday evening in a traffic stop triggered when cops noticed she was driving a 2008 Pontiac with overly tinted windows.

http://www.thesmokinggun.com/documents/bizarre/woman-nabbed-auto-erotic-crime
Aug 26, 2010 at 1:50 PM | Registered CommenterDailyBail
Another sign that finance and government have merged.

Nothing is as certain as debt and taxes.

Frank
Aug 26, 2010 at 1:59 PM | Unregistered CommenterFrank
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