Coyote Blog

I know that most non-financial folks, including myself, have their head spinning after this past few weeks' doings on Wall Street.  Doug Diamond and Anil Kashyap have a pretty good layman's roundup on Fannie/Freddie, Lehman, and AIG.  My sense is that their Lehman explanation also applies to Bear Stearns as well.  Here is just one small piece of a much longer article:

The Fannie and Freddie situation was a result of their unique roles
in the economy. They had been set up to support the housing market.
They helped guarantee mortgages (provided they met certain standards),
and were able to fund these guarantees by issuing their own debt, which
was in turn tacitly backed by the government. The government guarantees
allowed Fannie and Freddie to take on far more debt than a normal
company. In principle, they were also supposed to use the government
guarantee to reduce the mortgage cost to the homeowners, but the Fed
and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits
and squeeze the private sector out of the "conforming" mortgage market.
Regardless, many firms and foreign governments considered the debt of
Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly. 

Fannie and Freddie were weakly supervised and strayed from the core
mission. They began using their subsidized financing to buy
mortgage-backed securities which were backed by pools of mortgages that
did not meet their usual standards. Over the last year, it became clear
that their thin capital was not enough to cover the losses on these subprime
mortgages. The massive amount of diffusely held debt would have caused
collapses everywhere if it was defaulted upon; so the Treasury
announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government
would wipe out shareholders if it carried through with the guarantee),
no self-interested investor was willing to supply more equity to help
buffer the losses. Hence, the Treasury ended up taking them over.

Lehman's demise came when it could not even keep borrowing. Lehman
was rolling over at least $100 billion a month to finance its
investments in real estate, bonds, stocks, and financial assets. When
it is hard for lenders to monitor their investments and borrowers can
rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.

This was especially relevant for Lehman, because as an investment
bank, it could transform its risk characteristics very easily by using
derivatives and by churning its trading portfolio. So for Lehman (and
all investment banks), the short-term financing is not an accident; it
is inevitable.

Why did the financing dry up? For months, short-sellers were
convinced that Lehman's real-estate losses were bigger than it had
acknowledged. As more bad news about the real estate market emerged,
including the losses at Freddie Mac and Fannie Mae, this view spread.

Lehman's costs of borrowing rose and its share price fell. With an
impending downgrade to its credit rating looming, legal restrictions
were going to prevent certain firms from continuing to lend to Lehman.
Other counterparties
that might have been able to lend, even if Lehman's credit rating was
impaired, simply decided that the chance of default in the near future
was too high, partly because they feared that future credit conditions
would get even tighter and force Lehman and others to default at that
time.

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments.
While its core insurance businesses and other subsidiaries (such as its
large aircraft-leasing operation) were doing fine, these contracts,
called credit default swaps (C.D.S.'s), were hemorrhaging.   

Furthermore, the possibility of further losses loomed if the housing
market continued to deteriorate. The credit-rating agencies looking at
the potential losses downgraded A.I.G.'s debt on Monday. With its lower
credit ratings, A.I.G.'s insurance contracts required A.I.G. to
demonstrate that it had collateral to service the contracts; estimates
suggested that it needed roughly $15 billion in immediate collateral.

A second problem A.I.G. faced is that if it failed to post the
collateral, it would be considered to have defaulted on the C.D.S.'s.
Were A.I.G. to default on C.D.S.'s, some other A.I.G. contracts (tied
to losses on other financial securities) contain clauses saying that
its other contractual partners could insist on prepayment of their
claims. These cross-default clauses are present so that resources from
one part of the business do not get diverted to plug a hole in another
part. A.I.G. had another $380 billion of these other insurance
contracts outstanding. No private investors were willing to step into
this situation and loan A.I.G. the money it needed to post the
collateral.

In the scramble to make good on the C.D.S.'s, A.I.G.'s ability to
service its own debt would come into question. A.I.G. had $160 billion
in bonds that were held all over the world: nowhere near as widely as
the Fannie and Freddie bonds, but still dispersed widely.

In addition, other large financial firms "” including Pacific
Investment Management Company (Pimco), the largest bond-investment fund
in the world "” had guaranteed A.I.G.'s bonds by writing C.D.S.
contracts.

Given the huge size of the contracts and the number of parties
intertwined, the Federal Reserve decided that a default by A.I.G. would
wreak havoc on the financial system and cause contagious failures.
There was an immediate need to get A.I.G. the collateral to honor its
contracts, so the Fed loaned A.I.G. $85 billion.

Update:  Travis has an awesome post with his own FAQ about what is going on.  Here is a taste:

Lots of financially naive folks think that we can remove all risk,
inflation, etc. by only ever trading apples for chickens on the barrel
head, and doing away with paper money (so that all money is gold) and
doing away fractional reserve banking, so that when I deposit one gold
coin in the bank, the bank can then take that actual physical gold coin
and loan it to someone else. It turns out that the friction involved in
doing things this way is so huge that the effect would make The Road
Warrior look like a children's bedtime story. You want to borrow money
to buy a car? The bank can't just loan money that's been deposited in
someone else's checking account - the bank has to get that person to
sign a note saying "yes, I understand that this money is on deposit
until that dude buying the card pays the bank back IN FULL". And the
lender, if he wants his money out ahead of time, is SOL. And even then,
there can be a flood, and your car gets totaled, and you get
Legionaire's disease, and you can't make the payments.

or this:

Now, for the next complication, let's also imagine that there are
300 million other people watching all of this, thinking "How bad is
this? Should I go down to the gun store, stock up on .223 and 12 gauge
shells, then stop by the veterinarians to see how much antibiotics I
can cadge before heading to the hills" ?

And the Feds really don't want 300 million armed folks heading
for the national forests, so they first try to tell everyone who owns a
bicycle "Hey, the value of your bike didn't really drop! It's still
worth $9!".

But no one wants to believe that.

So then they go to the guy who's writing insurance policies on
the value of bikes and they say "if you got $100 million, would that
calm things down a bit?".

Due to the very nature of political pressures as well as poor accounting, a lot of government services are provided to the public below their true cost or market clearing price  (there are exceptions, like intra-city mail, but in these cases the government must pass laws to prevent private competition in order to maintain its market share).  When the government provides these below-cost or below-market-price services, it tends to crowd out private options.  So I am wondering why Kevin Drum is so surprised:

I guess rescuing them was the right thing to do. I'm still a little
taken aback by the apparent fact that American banks are now almost
flatly unwilling to make mortgage loans unless they're backed by Fannie
or Freddie, but that seems to be the case whether it takes me aback or
not. So rescue them we must. I suppose my next question is whether it's
worth thinking about how to restructure the American home mortgage
industry so that it can operate efficiently even in the absence of
massive levels of government backup. Or is Fannie/Freddie style backup
just the way the world works these days and there's no point fussing
over it?

As evidenced by the current bailout (and their huge accretion in market share over the last several years), Fannie and Freddie were under-pricing the service they were providing.  So of course, all things equal, bankers will demand the Fannie/Freddie backing because that will be a more profitable product and will be less work for the banker.  This seems like a "duh" kind of thing.  Like the "mystery" of why in Massachussetts, while everyone is obligated to sign up for health insurance, only the ones who were eligeable for free coverage did so.

I have written before of a similar phenomenon in business loans, where loans with SBA backing have crowded out everything else out there, such that a small business really can't find a lender who will make small business loans except with SBA backing.  Bankers are people too, and they can get lazy.  They have come to rely on these government programs, but certainly the lending function would still exist in a robust form if these programs did not exist.  Bankers would have to find other risk-mitigation tools, or else the loans would be more expensive, reflecting that the banks could not get rid of all the risk and had to price that into the loan.

By the way, don't you love the technocratic hubris of "thinking about how to restructure the American home mortgage
industry so that it can operate efficiently even in the absence of
massive levels of government backup."  Why do I, or Drum, or anyone outside of banking have to think about this at all?  I don't personally know the best private alternative to government mortgage gaurantees.  So what?  The financial field has been rife with innovation over the last several decades.  Just remove the government backup and let the the banks figure it out.  And let them go bankrupt when they figure wrong.

Postscript: As an ironic aside, the bank that holds my SBA loans was closed by the FDIC last week, my guess is due to a bad mortgage book in the Las Vegas area.  This doesn't have a lot of impact on me except that as I have paid down my loans, they became wildly overcollateralized, and I was in the process of trying to renegotiate some of my collateral out of the deal.  That will have to be put on hold, I guess.

Update:  More on government crowding out private options, in an entirely different industry:

Basic
dental care in Britain is free to those under 16 or over 60, the
unemployed, students, military veterans and some low-income families.
For others, government dentists offer lower prices than private
practitioners.

However,
the government does not cover cosmetic dentistry, and a recent
reorganization of the way dentists work has prompted many to leave the
public sector. Katherine Murphy, a spokeswoman for The Patients
Association, an advocacy group, said it was proving increasingly
difficult for Britons to get anything beyond basic dental care from
Britain's National Health Service.

Update #2: More on Fannie and Freddie, again via Rick Perry:

The
Fannie Mae-Freddie Mac crisis may have been the most avoidable
financial crisis in history. Economists have long complained that the
risks posed by the government-sponsored enterprises were large relative
to any social benefits.

We
now realize that the overall policy of promoting home ownership was
carried to excess. Even taking as given the goal of expanding home
ownership, the public policy case for subsidizing mortgage finance was
weak. The case for using the GSEs as a vehicle to subsidize mortgage
finance was weaker still. The GSE structure serves to privatize profits and socialize losses.
And even if one thought that home ownership was worth encouraging,
mortgage debt was worth subsidizing, and the GSE structure was viable,
allowing the GSEs to assume a dominant role in mortgage finance was a
mistake. The larger they grew, the more precarious our financial
markets became.