StanCollender'sCapitalGainsandGames Washington, Wall Street and Everything in Between

Fiscal Stimulus, Executive Branch Style

05 Aug 2010
Posted by Andrew Samwick

This conjecture from Jim Pethokoukis would be shocking if it comes to pass:

Main Street may be about to get its own gigantic bailout. Rumors are running wild from Washington to Wall Street that the Obama administration is about to order government-controlled lenders Fannie Mae and Freddie Mac to forgive a portion of the mortgage debt of millions of Americans who owe more than what their homes are worth. An estimated 15 million U.S. mortgages – one in five – are underwater with negative equity of some $800 billion. Recall that on Christmas Eve 2009, the Treasury Department waived a $400 billion limit on financial assistance to Fannie and Freddie, pledging unlimited help. The actual vehicle for the bailout could be the Bush-era Home Affordable Refinance Program, or HARP, a sister program to Obama’s loan modification effort. HARP was just extended through June 30, 2011.

The move, if it happens, would be a stunning political and economic bombshell less than 100 days before a midterm election in which Democrats are currently expected to suffer massive, if not historic losses. The key date to watch is August 17 when the Treasury Department holds a much-hyped meeting on the future of Fannie and Freddie. A few key points:

Read the whole thing for the reasoning behind his conjecture.  If it happens, it will be just another example of why the government should not be involved in running business enterprises that could be done, even if imperfectly, in the private sector.  It will also be another example of how we have moved a bit further away from democracy in allowing such a move solely by the executive branch of government.

What about mark to market?

A couple responses to this:

1) Its just too rich to complain about unilateral action by the executive in a context where legislative action by (large) majorities in both houses of congress has been effectively stymied via the abandonment of long standing norms of behavior in the Senate. It has just never been the case, at any point prior to January 2007, that the Senate minority would routinely filibuster, multiple times, legislation (or appointments) that every single member of the minority then subsequently votes for. But this is what the Republican's are doing! I agree it would be better for the Senate majority to reassert its constitutional right to "make the rule of its own proceeding" by the vote of a simple majority of quorum, but until that happens, extraordinary exercises of executive power (totally legal, by the way) are just what we should expect. If you don't like that, don't give aid and comfort to those who are jamming up the legislative works.

2) From a macro point of view, there's no question that principal reduction on a large scale will generate large, positive, social returns. We are in a balance sheet recession, with the household sector needing to rebuild its balance sheets. Since unemployment is high, and wages are at best stagnant, there seems little chance such rebuilding will happen quickly through savings. If households were a business, they would use bankruptcy to reorganize. If households were a sovereign borrower, they would impose a restructuring on lenders, ala Russia in 1998 and Argentina post-2001. With large-scale principal reduction, households will be under much less pressure to raise savings rates (now over 6%), and will be much more willing to spend. In addition, we should expect a wealth effect boost to consumption in the neighborhood of 5% of the total value of the principal reduction.

3) Even from the point of view of lenders, principal reduction may be the optimal path forward. As John Geanakopolis has argued in detail, negative equity is highly correlated with default. Since the return on a mortgage loan is a function of both the cash flows the loan generates and the likelihood that those cash flows will actually materialize, principal reduction can increase the return to the holder of a mortgage asset by reducing the probability of default. As mortgage lenders have for nearly four years been experiencing unexpectedly high default rates, it seems very likely that lenders will recover more of their initial investment by accepting lower but much more certain future cash flows from borrowers. The positive macro effect of principal reduction (allow households to lower, or at least stop increasing, savings rates as well as the wealth effect) will also lower unemployment, further reducing default rates.

4) As a matter of equity, bear in mind that mortgage borrowers are rarely "in the business" of borrowing: most borrow to buy the home they will live in. Consequently, we can't expect mortgage borrowers to have expert knowledge of real estate price dynamics. Conversely, mortgage lenders are in the business of mortgage lending, and should be very knowledgeable about real estate price dynamics. From 2001-2007, we had an epidemic of trading at false prices in real estate markets, both residential and commercial in the US, and in residential in many other countries as well (in most cases, European housing bubbles were much larger than the US one). So there were powerful forces driving false-price-trading in real estate markets, one consequence of which was that a lot of mortgage loans were issued based on house prices far above any reasonable estimate of fundamental value. Who should bear the burden of the price correction, now that the market has returned to (more or less) true prices? I do not see how any reasonable argument could be made that the entire burden should be borne by those with the least knowledge of or expertise in real estate pricing, those who could not reasonably be expected to have recognized false-price-trading and acted on it. Instead, the burden should be borne, disproportionately if not entirely, by those who knew, or should have known, or in a pinch could reasonably be expected to have known, that real estate markets from 2001-2007 were trading at false prices and to act accordingly.

5) Finally, I think there could be some legitimate concern about moral hazard, and more broadly the political legitimacy of selective principal reduction. My own view is that universality is the solution to moral hazard, such that a principal reduction calculated to reflect the excess price increase above the long term trend at the time a mortgage loan was made, should be applied to all mortgages issued during the bubble, not just those where the borrower is delinquent or unemployed. Such a policy would maximize the macroeconomic benefits of principal reduction, avoid introduction moral hazard on the borrowers side (since responsible borrowers will benefit more or just as much as irresponsible borrowers), and also penalize lenders for failing to act on the expert knowledge they had or should have had.


Stock trading can be quite a gamble. Your chances of earning can just about equal to your chances of losing, and in some cases, there are even greater risks of losing more.

CR doesn't take it seriously

So why should we?

Good comment, Rich

I'd just add one point about moral hazard. As you point out in paragraph 4, it is the lenders rather than the borrowers who have (or should have) most of the expertise in evaluating the viability of mortgages. So, even if a policy makes borrowers less careful (because they expect to be bailed out if things go bad), that won't matter much if the lenders do a good job.

Re-underwrite the loans to be forgiven

This floats the loan above water for those who are able to make payments and amortize the loan. Many others should become renters.

There's no evidence that this

There's no evidence that this proposal was ever considered by the administration. The idea came from a Wall Street analyst, not from a bureaucrat or a politician. If it was a trial balloon, it was shot down pretty fast.

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