Monday, July 14, 2008

Systemic risk and GSEs/FM

The latest event in the current financial crisis is the viability of Fannie Mae and Freddie Mac. Like Paul Krugman I think the fears are overblown although the volatility and uncertainty is good for some short sellers. Calculated Risk agrees in principle with Krugman but makes some good points in that the FMs were partially responsible for their current predicament even if they did not invest in subprimes. What might happen next?
1. The Fed and Treasury might take this opportunity to slowly dismantle the FMs.
2. I don't buy the argument that the GSE's are a necessary player in the MBS market. If anything, by an accident in history they became a monopoly and have exploited their position (and the perception that they are necessary).
3. The GSE's should be broken up and sold and I would argue that it is the responsibility of the Fed that the new entities should not become TBTF. The Fed and Treasury should seek to minimize the systemic risk that ANY institution can become TBTF or at the very least prepare for the eventuality if an institution does emerge to become TBTF. (See also my review of "Too Big To Fail" by Gary Stern and Ron Feldman who argue along the same lines.)

These are similar to arguments by Sebastian Mallaby although I don't believe nationalization is necessary. The terms currently being proposed allow the government to take an equity stake to recapitalize the institutions and might give it enough leverage to break the companies up.

Update: Mark Thoma rightly criticizes the break-up approach on the grounds that a 100 small firms with identical portfolios would leave us in the same position as 1 large firm. However, breaking up a firm might lead each manager to pursue different strategies.

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