Moral Hazard

In last week's article, "Fannie & Freddie and the Banks", we began our story with the present [dismal] state of their affairs. That is, we didn't really talk about how or why they reached that state. That entire topic will fill numerous books and PhD dissertations in months and years to come. Today, we want to highlight one aspect here, the so-called "moral hazard" endemic to their structure and position in financial markets. Apparently, "moral hazard" is a term unfamiliar to many of you. But these words used by economists describe an ethical dilemma you have surely faced and probably given counsel about any number of times.

Fannie & Freddie's Risky Business
As we did say last week, Fannie Mae and Freddie Mac are privately owned, but they were founded by the federal government to foster the development of national mortgage markets, helping to maintain the availability of reasonably priced loans for middle-income Americans. The firms conduct their business in three ways. First, they buy mortgages from local lenders or brokers, combine groups of these mortgages together in "pools" and issue bonds transferring ownership of the pools to private investors; through elaborate computerized systems, the investors receive the principal and interest payments on the specific loans in the pools. These investors, not Fannie & Freddie or the original lenders, bear the ultimate risk of loss should the borrower default. The bonds are called "mortgage-backed securities" (MBS). Second, Fannie & Freddie buy mortgage loans and hold them in their own portfolios. Third, they buy MBS securities for their own portfolios; these may have been issued by themselves, by their counterpart institutions, and by non-government-connected institutions. These last are "private label" MBS, sold by Merrill Lynch and other similar investment banks. While the mortgages comprising their own MBS have specified minimum credit quality and maximum size, the loans they choose to keep in their own portfolios and the other MBS securities they buy can include lower quality items, especially subprime mortgages.

Their Government "Connection"
While, as we also emphasized before, Fannie and Freddie have no direct, concrete government guarantee, everyone has always assumed that the federal government would back them up somehow. This "connection" [our phrase] means they can borrow in money and capital markets at low cost, markedly lower than purely private debt would cost.

Further, we said last week that, despite their recent multi-billion-dollar losses, their capital position remains well above legally mandated minimums. However, it is also the case that those minimums are considerably more liberal than general accounting standards would permit for a similar business without a government connection. This means they can borrow more and do more business with a given size capital base than ordinary firms can.

At the same time, these firms believe they must have skilled managers, people who might just as well choose to work in the private financial sector. So the scales and provisions of their compensation plans are at least as generous as those available for similar positions at private institutions: the packages include stock options and bonuses in addition to base salary.

A Recipe for Moral Hazard
So here's the picture: we have highly paid executives, whose pay increases with the size and volume of the firm's business, operating with low borrowing cost, liberal capital constraints and pass-through of much of the risk to downstream investors, along with a fuzzy, but apparent government "guarantee". Your low cost structure means more business opportunities are profitable, and risky business – assuming it pays off – is more profitable still. The government connection means that you can reach for that risk because someone else will suffer the loss if the risk winds up going against you. Fannie and Freddie have behaved in response to these incentives.

Reaching for more risk than you would otherwise incur because someone else will bear the cost of failure is moral hazard. Critics of the government's efforts to prop up Fannie and Freddie argue that the support validates the threat of moral hazard. Moreover, since it's the government, other institutions might see this rescue as a precedent and behave more recklessly as well, thinking they can make a plea for a similar rescue. Moral hazard begets more moral hazard.

Finance is hardly the only field that faces it. A classic example is seat belts. Accident rates have increased since imposition of mandatory seat belt laws. The injuries in car accidents are perceived to be less severe, so people drive less carefully, which is hardly the desired outcome. Damage per accident may be less, but total aggregate damage may remain the same or even increase. Insurance is another area of widespread moral hazard: the availability of health insurance has led to increased usage rates for various optional medical services. People "have it done" just because "the insurance pays". Teenage behavior is subject to moral hazard: if Dad is likely to pay off the arrears on the credit card bill or talk the English teacher into a better grade on the term paper, then the initial effort could well be less prudent. And your siblings think if he's done it for you, he'll do it for them too. Moral hazard.

No Simple Remedy
Now that your mind is on these issues, you've probably already come up with three or four other examples. And you know this is tricky. Clearly the dental insurance company means for you to get that new crown. And clearly seat belts prevent much serious injury. So too, the availability of government loans to Fannie and Freddie – as formalized over the last few days in new Congressional legislation – should prevent the spread of chaotic conditions that might otherwise paralyze mortgage and other financial markets. So we shouldn't withhold protection altogether.

We can put conditions on the protection, though. Dad can set inviolate limits on his bailout of Suzie's credit card bill and a new regulator can put more concrete determinants on the scope of Freddie's and Fannie's operations. The new law, passed this past Saturday (yes, Saturday) forms the Federal Housing Finance Agency to conduct their regulation; it is empowered to oversee their investment and loan practices as well as to lend them money, a specific quid pro quo arrangement. These things never turn out exactly as they are intended, but this approach looks to have good potential to effect reform. We hope so!

Fannie & Freddie and the Banks

Financial market forces are bombarding us from all sides these days. We wish we were ambidextrous so we could write two articles simultaneously, one with each hand, to cover all that's going on. "Are you going to write about Fannie and Freddie and the banks?" Mother Crafton asked us the other day, when the Geranium Farm farm-hands gathered for an informal lunch. "Well, sure, but we also have to write about oil and speculators – we have to talk about everything!"

While we're anxious to write about oil markets, we'll address these big financial institutions first, since there are some thoughtless headlines running around the Internet about banks closing doors. Such notions way overstate the problems even as the problems are far from trivial. A big California thrift institution was taken over 10 days ago by the Federal Deposit Insurance Corporation (FDIC) in the biggest failure ever of one of those consumer savings associations. That same weekend, the Treasury and the Federal Reserve announced contingency plans to shore up the Federal National Mortgage Association (FNMA or "Fannie Mae") and the Federal Home Loan Mortgage Corporation (FHLMC or "Freddie Mac"). Are we supposed to be frightened? or are these really "bailouts" of politically connected investors?

Bad Mortgage Loans Continue To Inflict Pain
Mortgage delinquencies and foreclosures are still increasing and house prices are still falling. The bad loans are just modest fractions of overall loans, but there are so many more than normal that it is hardly surprising that some lenders are experiencing sizable losses. Indeed, IndyMac, the California thrift, specialized in subprime loans and its losses were bigger than most. It "failed" when depositors got scared and lined up outside its doors to take out their money; fortunately with our deposit insurance system, they are likely to lose little if any of their funds, and that bank re-opened after the weekend under FDIC auspices, even initiating a new program to help beleaguered borrowers try to avoid foreclosure. Importantly, while the depositors come out all right, the shareholders lose everything. They are not "bailed out" in the least.

Deposits Insurance Works;

Overall Banking System Is Sound
It seems to us that there are two important facts to keep in mind about the banks generally. First, as we note, nearly all individual bank deposits are fully insured, up to $100,000. Hardly anyone loses their money if a bank or thrift "fails". There are specifications on the $100,000 – it's a per-person limit, so if you have two accounts you're still only covered up to the one total. Make another account joint with someone else to double the coverage. Here's a link to a helpful article about this, http://www.walletpop.com/blog/2008/07/15/how-safe-is-your-money/?icid=200100397x1205902459x1200301280. ["Walletpop" appears to be a new blogsite associated with AOL's Personal Finance pages; we don't know more about it, but this article is itself thoughtful and clear. The FDIC's own website has good information too, of course, www.fdic.gov.]

The other fact to remember is that, despite losses by IndyMac and other big names in the business, the banking system as a whole is quite sound. There are about 7,250 banks in the country and 1,250 thrifts. In the first quarter, the FDIC classified 90 of these as "problems". In recent history, the largest number of problem institutions at any given time was 1,496 at the end of 1990; the smallest was 50 at the end of 2006. Of the 1990 problems, 382 of them "failed"; in 2006, there were no failures at all. Most currently, there were 3 failures during all of 2007 and 2 during the first quarter of this year. So yes, there are troubles, but the vast majority of them are overcome without federal assistance.

Fannie Mae & Freddie Mac Foster Nation-wide Mortgage Markets
What about Fannie and Freddie? These two big companies, founded and organized under Congressional charters, took their current forms about 40 years ago. Back then, home lending was localized. The thrift or bank in your neighborhood granted you a loan, which it added to its balance sheet. If the community was growing, the bank could keep lending. But suppose a local manufacturing company had layoffs, and the bank's deposit base decreased? Then it had to decrease lending, exacerbating the community's financial woes.

Fannie and Freddie were designed to ease these conditions by providing a conduit to national capital markets for the local mortgage loans. They buy loans from the local lenders using money they borrow from major institutional investors, including, among others, mutual funds and banks in other parts of the country. With their federal government charter, their debt is very highly regarded; even foreign investors get involved, including the central banks of other countries, looking to invest the dollars they hold in their foreign exchange reserves.

They Have Big Losses Too
These companies grew very rapidly, especially from 1999 through 2003, and then again more recently. They handle through direct ownership or "pass-through" arrangements, some 45% of all residential mortgages. The same delinquency and foreclosure issues have hurt their income, and they're also hurt by reductions in the values of securities in their internal portfolios. Consequently, Fannie Mae suffered an outright loss of $2.2 billion in the first quarter this year and Freddie Mac, $166 million. Both had had much larger losses in the fourth quarter of 2007. Investors are rightly dismayed by the losses and have driven the stock prices down sharply. Bond investors have driven up the interest rates they both pay on their debt. This has created a very sticky situation. These companies, though federally chartered, are privately owned – their stocks trade on the New York Stock Exchange – and they receive no government funding. They and the government are also clear that there is no government guarantee on their operations. But of course, the government "sponsorship" gives an aura of safety that has enhanced their status considerably.

What's a Treasury Secretary To Do?
Last week, Secretary of the Treasury Henry Paulson announced a contingency plan aimed at maintaining the flow of Fannie's and Freddie's business. The Treasury presently has authority to lend to them, but only a minimal amount. Paulson asked Congress for expanded lending ability and for the ability to make a modest ownership investment. As an addition to the present regulatory office, the Office of Federal Housing Enterprise Oversight (OFHEO, part of HUD), he requested authority for the Federal Reserve to exercise some regulation of them. Separately, the Federal Reserve Board voted to allow its system to lend directly to Fannie and Freddie, similar to the outreach it made in the spring to security dealers. [That facility, which ran as high as $38 billion in early April, has been virtually zero the last two weeks, a quite favorable sign.]

Is this a "bailout"? Is it "bad"? Technically, no, it is not a bailout. First of all it is a contingency plan and so far, nothing has happened. Members of Congress are jockeying with the politics of relevant amendments to legislation already in process. Apparently, neither institution has needed to borrow from the Treasury or the Federal Reserve. In fact, we should note that despite the plunge in their stock prices of late, both Fannie and Freddie have well above their legally required minimum capital and they have sizable amounts of cash to meet any liquidity need. On Thursday last, Freddie Mac, in a regularly scheduled auction, successfully sold $3 billion of its 2-year notes. The interest rate was somewhat higher than it has been paying, but bidding was strong and foreign bidders were as active as ever. Other data from the Federal Reserve shows that foreign central banks increased their holdings of Fannie and Freddie debt by $9.3 billion in the week before the auction, one of the largest weekly gains in recent months. These "official" investors own about one-third of Fannie and Freddie's direct debt. And again, shareholders have suffered dramatic reductions in the value of their ownership investment. They are surely not "bailed out".

So we argue that the Federal Government is trying to tiptoe through what amounts to a mine field here, putting out the word that it stands ready to lend support to these organizations it created and respecting a moral obligation for the benefit, not of private shareholders, but of the good faith of debt-holders, especially the foreign central banks.

Many argue that none of this does anything for homeowner-borrowers, just for the big investors. To the contrary, maintaining the flow and operation of these gigantic conduits for mortgage financing provides the most favorable environment possible for borrowers, troubled or healthy, in these volatile times. I don't even want to contemplate an alternative scenario.

Even after this long article, we are hardly finished with these issues. For instance, Mother Crafton also wants to know about "moral hazard". An intriguing phrase, isn't it? Stay tuned; more to come . . . .

An Investment Recommendation from John Templeton

At the request of one of Debbie Hodgepodge's readers, we are working on some commentary about speculators and the price of oil. In the meantime, for your consideration, here is a "Letter to the Editor" of the Wall Street Journal, appearing July 14, 2008. It speaks for itself.

I was sorry to hear of the passing of Sir John Templeton . . . . In 1987 Mr. Templeton was speaking at the Annual Financial Planning Association meeting which was held in Chicago. At the close of his remarks, he said he wanted to disclose the best investment anyone can make. The attendees listened carefully as he said "the best investment anyone can make is spelled T-I-T-H-E." I have found that it works and have shared his wisdom with many of my clients.

Timothy P. Bogert, CLU
Southfield, Mich.

The Opposite of Christopher Hitchens

Mother Crafton wrote her eMo yesterday about Christopher Hitchens, a thoughtful and articulate atheist. Also yesterday -- possibly not entirely a coincidence -- God came and took home a most thoughtful and articulate Christian, Sir John Templeton.

Templeton is a man after our own heart: he was a savvy and forward-thinking investor who has used his wealth to further the cause of religious ideas and ideals. Also, almost as a follow-on to our commentary Monday about the American Revolution, he highlights the ideals of the rags-to-riches opportunities that are possible in this country. According to his obituary on Bloomberg, a leading financial news service, ". . . Templeton was born . . . in Winchester in rural Tennessee. Ever industrious, at age 12 he purchased a broken-down Ford from a local farmer and rebuilt it with some friends using spare parts he took from another old car. He drove it until the end of high school, when he became the first person in his town to attend college." College was Yale, where he went on scholarship and finished first in his class in 1934. He then read law at Oxford* as a Rhodes Scholar. He was always investment-minded, focused on profit and free enterprise, but frugal. And while he lived well in his later years, ostentation apparently never had a place in his style.

As an investor, Templeton was a pioneer with global vision. He introduced the Templeton Growth Fund in 1954, the first widely distributed mutual fund to invest in companies outside the United States. His worldwide diversification brought gains to his numerous funds in many periods when more insular investors suffered losses.

Templeton was also actively religious. He was a devout Presbyterian and an Elder, a senior lay position in that denomination; he frequently began business meetings with prayer and he argued that businesses must be operated in a moral way or, eventually, they would fail. He also wanted science to reach out to religion and vice versa. He devised the Templeton Prize in 1972; the first recipient was Mother Teresa in 1973. The prize, the largest monetary award to an individual –bigger than the Nobel Prizes – is meant to foster connections of religion and science; Anglicans are possibly most familiar with it through a priest of the Church of England, John Polkinghorne, a particle physicist and sometime President of Queens College Cambridge, who was the recipient in 2002.

We occasionally write here on topics concerning the sociology of religion and other social science studies of religion issues. One of the major funders of those studies is the Templeton Foundation, which he founded in 1987. Its website explains, "the Foundation has roughly $1.1 billion in assets. In 2008, we anticipate giving out almost $60 million in grant awards. Our suburban offices are in West Conshohocken, outside of Philadelphia."

Templeton was 95 and died of pneumonia in a hospital in Nassau, Bahamas. Also not to be missed among the details of his life is the change in his nationality: in order to escape U.S. tax burdens, he became a British subject in 1962 and was a resident of the Bahamas. He was knighted by Queen Elizabeth in 1987 for his work in science and religion.

As we reflect on this singular 20th Century life that aimed at excellence and emphasized learning, we think of Thomas Aquinas. Here is the collect for him,

Almighty God, you have enriched your Church with the singular learning and holiness of your servant Thomas Aquinas: Enlighten us more and more, we pray, by the disciplined thinking and teaching of Christian scholars, and deepen our devotion by the example of saintly lives; through Jesus Christ our Lord, who lives and reigns with you and the Holy Spirit, one God, for ever and ever.
Amen.

May the soul of John Templeton rest in peace and may light
perpetual shine upon him – and his legacy. Amen.

+ + + + +

*(7/11/08) Corrected from Cambridge, reported in initial post

For this commentary, we accessed obituaries from the Wall Street Journal – where it appeared in the financial section right in the middle of the daily mutual fund quotes – the New York Times, the New York Sun and the Bloomberg story, which we found through a Google search.

The American Revolution and the Common People

The American Revolution raises up ordinary people. We use the present tense here, even though the Revolution formally took place more than 200 years ago, because the event continues to impact American and world society today.

Last year for Independence Day, we described the extraordinary and historic significance of common people in America through an essay on a Pulitzer Prize history book, The Radicalism of the American Revolution by Gordon Wood. This has turned out to be a "popular" Ways of the World article. The counter of visitors to this website, down at the bottom there, keeps track of where visitors have been just prior to coming to Ways of the World. If they arrived via a search engine, we can see the relevant list of search results. “The Radicalism of the American Revolution” has been the single most frequent subject. So clearly, this idea about the social character of the Revolution is a noteworthy one. Readers' interest has encouraged us to explore it further.

Two Revolutions and Consumer Spending
We encountered T.H. Breen, economic history professor at Northwestern, and his work, The Marketplace of Revolution. Breen enlightens us more on the significance of ordinary people – even women – in establishing the climate for Independence. They formed ad hoc associations, they developed means of communication among the various colonies from New Hampshire to South Carolina and they changed their personal spending habits in their everyday shopping in order to loosen economic dependence on the Mother Country. As Breen elucidates, it is one thing for propertied and educated leaders to develop high-sounding themes about liberty and independence, but quite another for common folk to see how those play out in their daily lives and how the success of those notions depends on people’s own actions.

The mid-Eighteenth Century also marked the onrush of the Industrial Revolution. Many often think negatively of that historical development as the new production methods it brought are seen as depersonalizing and demeaning of labor. There is another side to it, of course, and without debating the first point, we cite a substantive, unimpeachable benefit. The Industrial Revolution reduced the costs of merchandise so much that working class people could afford a better lifestyle. For the first time ever, for example, young women outside of nobility might enjoy a nice, ready-made lace-trimmed dress. The vast majority of folks could now eat off quality dishes and have a knick-knack or two to decorate the sitting room. It was the beginning of “consumer spending”: no need to make your own pottery, you could go down to the dry-goods in the village and buy some. They quickly got accustomed to this and enjoyed their newfound selections and abilities to choose among varieties of each new thing. However, local manufacturing was in its infancy, and much of what people bought was imported from Britain.

Paying a War Debt Out of Americans' Pockets – Without Asking Them
These years also saw the French and Indian War, 1756-1763. Britain won this encounter, but spent huge sums doing so and ran up considerable debt. Since the London Government now saw a need to maintain troops in the American colonies, it only seemed logical to pay on the debt and the army expenses with revenue collected here. Fees and duties through first the Stamp Act and then the Townshend Acts were thus imposed. It did not, though, seem logical to give the Colonists voice in how this revenue might be raised, and besides, it was said, even though no colonist sat in Parliament, the people were “effectively represented” through the Members who served the districts in England from which the goods were shipped – or some such pretext.

The Grass-Roots Origin of Protest
Colonists had already been skeptical about whether the Imperial Government regarded them on the same standing with residents of Britain itself, and these unilaterally imposed taxes convinced them that they were indeed perceived as only second-class citizens. A resolve then developed to avoid paying the levies. Earlier laws dictated that all shipping in and out of colonial ports had to pass directly through British ports, so technically, everything that arrived in America was an import from Britain. Some goods were specified in the Townshend duties, paper, glass, “painters’ colors” and tea, among others. In order to avoid the duties, then, people had to refrain from buying these items. Initially they appealed to the merchants to stop stocking them, but this evoked only a half-hearted effort. Final consumer demand was the key. An unprecedented inter-colony, grass-roots endeavor was needed and people realized this.

The result was a precipitous drop in British sales to the Colonies, in some places by as much as two-thirds. Ordinary people, besides cutting their spending, wrote letters to the editor of their local newspaper describing their restraints and urging their neighbors to join in a boycott. The papers were circulated elsewhere, and soon, folks in other communities could read that people far away were active in the consequent non-importation movement. The movement took on momentum. Official colonial assemblies were often under the thumb of the Royal Governor, so people formed “non-governmental organizations” [have I heard that term somewhere else?] to establish enforcement procedures, often resulting in bad publicity for community residents known to be indulging in the taxed merchandise. A new procedure emerged, the “subscription”, a document resembling a petition, to which people signed their names, pledging not to purchase the specified goods. Everyone could sign this public document, an historic and innovative approach: property owners, the high-bred, but also the “man on the street” – and his wife and daughter!

Indeed, in this program of non-importation, it was largely up to the women, who did most of the shopping after all, to carry it out. Some took this responsibility quite seriously and through public statements cajoled the men that they should do the same. The men, in turn, were apparently taken aback by this forward, critical attitude on the part of the womenfolk, hardly in keeping with their usual stereotypical frivolity.

Even the Upper Classes Had To Follow
While everyone could participate in these actions, it was also the case that no one could be above participation. At one point, Thomas Jefferson, in the initial construction of Monticello, ordered windows from a British concern, 14 pairs, complete with glass sashes. Only when he was notified of their imminent arrival did he realize what an awful statement this purchase would make. He appealed to the local “Virginia Association” and apologized for this oversight, and he refused delivery of the windows. As Breen emphasizes, being able to write potent words about the grievances of the colonists would result in a protest that falls flat if the author himself doesn’t uphold the community spirit in his own actions. Jefferson learned a personally expensive lesson. [Why have we not heard this story before? Maybe you have?]

The Unification of an American Spirit
This entire episode, through the Boston Tea Party (December 16, 1773) and its painful aftermath, had a substantive impact on the people of the American colonies. In fact, while the punishment for the destruction of the tea in Boston Harbor was formally imposed only on Boston, other communities shared feelings with that city. Breen quotes resolutions passed by local governments and town meetings in Huntington, Long Island, Queen Anne’s County, Maryland and Caroline County, Virginia, for three, with statements such as “the cause of Boston, in its consequences, [is] the common cause of America”. Thus it was that the individual colonies, Breen says, “had begun to think continentally . . . . a decade of protest in the [consumer] marketplace had forced them to define themselves as not fully British. Indeed, in defiance of parliamentary taxation, they increasingly saw themselves as Americans.”

T.H. Breen, The Marketplace of Revolution: How Consumer Politics Shaped American Independence. New York: Oxford University Press. 2004.

Similar sentiments from another Gordon Wood piece, this a brief and highly readable summary of the entire Revolutionary period.
Gordon S. Wood, The American Revolution: A History. New York: The Modern Library, an imprint of The Random House Publishing Group. 2002.