Macro Podcasts

Former Director Reinhart Says U.S. Asking Too Much of Fed

Parry Says Fed Is Facing `Serious' Policy Challenges

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With Fannie and Freddie, is the government mistaking a ‘first-generation’ crisis for a ‘second-generation’ crisis?;

There are two main types of crises. In a “first-generation” or fundamentals-based crisis, investors choose to flee from a currency, or actively speculate against it, because they correctly recognize that the country’s policies will not support a fixed exchange rate forever. Leaving the fixed exchange rate regime is inevitable, but the timing can be forced by market participants when they sense the government’s vulnerability. In the corporate world, if a company’s debt service is so rickety that eventually it will become insolvent, investors will flee as soon as they realize that. They will not wait until the corporate cupboard is bare.

In a “second-generation” or self-fulfilling crisis, speculators are in the driver’s seat. A country’s resources might be sufficient to maintain an exchange rate peg indefinitely, as long as the country is not forced to pay an unduly high risk premium in markets. But if investors come to doubt its ability to defend the peg, those doubts become self-fulfilling and the risk premium balloons. In other words, the peg does not hold because investors doubt that it will.

Similarly, a company might be viable as long as it can roll over maturity debt. If investors trust the firm to be viable, it can access markets. However, if its survival comes into doubt, the markets will be shuttered and, eventually, so too will the firm.

Secretary Paulson has been working on the assumption that the travails of Fannie and Freddie stem from a self-fulfilling speculative attack: in other words, that this is a “second-generation” crisis. If that is true, those speculators can be beaten back by an overwhelming show of force. Thus, the Federal Reserve has thrown open its discount window to the GSEs and the Bush administration has sought from Congress an unlimited authority to lend to Fannie and Freddie. The Fed and the White House hope this will convince market participants that GSE debt will always be honored and that all maturing obligations can be rolled over at narrow spreads to Treasuries. The mere possibility of a massive governmental infusion of funds should squash the crisis of confidence without any need for disbursement.

Meanwhile, the Securities and Exchange Commission (SEC) has prohibited the “naked” short selling of the shares of certain financial firms, including those of Fannie and Freddie. (A naked short sale involves selling an equity you do not have in your possession.) In addition, the SEC is apparently becoming more aggressive in dealing with rumor-mongering among traders.

Again, the assumption is that the financial woes of the GSEs derive from speculative withdrawal rather than from weak fundamentals. But this assumption might be wrong. Fannie and Freddie are called the two housing giants for a good reason: they own or guarantee over $5 trillion worth of U.S. mortgages—more than half the market. Which means they have a large, under-diversified exposure to a sector that has plummeted.

Mistaking a “first-generation” crisis for a “second-generation” crisis is a lot like countersigning a loan for a relative who turns out to be feckless. Three unfortunate developments ensue.

Messages from Merrill’s Misfortunes;

Perhaps more firms will follow Merrill’s path and seek to raise new capital. But aggregate financial losses may wind up dwarfing private-sector resources. In that case, the health of the U.S. economy may require an injection of government funds into the financial sector. One lesson of the savings-and-loan debacle of the late 1980s—and also a lesson of banking crises worldwide—is that delaying such a government capital injection will raise the overall tab. With federal resources already stretched thin and many national priorities unfulfilled, the idea of sinking still more money into large financial firms seems distasteful. But we must accept the fact that our national economy is hostage to the financial system.

Repel the calls to contain competitive marketsBy Alan Greenspan