Saturday, November 29, 2008

"But the GSEs have been nationalized. Their obligations are already U.S. government debt. What’s going on here?"

John Hempton of Bronte Capital with comments on a Krugman post that I also commented on:

"I used to think that if the government only made the GSE obligations full faith and credit (FFC) obligations the remaining problems in the conventional mortgage market would go away. Paul Krugman still thinks it:

The Fed is confusing me

OK, so the Fed is
planning to buy obligations of the GSEs — as well as securities guaranteed by the GSEs. This is in an effort to lower spreads. The Fed will in effect pay for these purchases by having the Treasury issue U.S. government debt.

But the GSEs
have been nationalized. Their obligations are already U.S. government debt. What’s going on here?
It’s true, as the Fed’s statement says, that
Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late. But that’s presumably because the Bush administration, weirdly, has refused to declare that GSE debt is backed by the full faith and credit of the US government. Why not just make that declaration, turning GSE debt into Treasury obligations, rather than stuff the obligations onto the balance sheet of the Federal Reserve?


Is this some kind of strange political game? Is there something else going on here? Inquiring minds want to know.


He is of course wrong. The Goldman Sachs obligation is full faith and credit of the US Treasury - and trades at an irrationally wide spread. Nobody has given a plausible explanation (except lack of trust in the government) as to why the spread on FDIC paper issued by Goldies but backed by the full faith and credit of the US Treasury is 200 bps.

For once the world is even stranger than Paul Krugman thought and stranger than his models.

Now there is an implication here - which is if the market will not believe that something is full faith and credit of the US Government then the government should buy it, issue treasuries and make an arbitrage profit. There is a free lunch here. Of course this mucks government accounting around (the debts wind up on balance sheet of the government rather than just contingent). However it does not change the economics from the government perspective.

And in the process we go from the government buying the troubled assets of financial institutions to the government buying the guaranteed liabilities of financial institutions.


John Hempton

Very interesting points by Hempton as per usual. I love the idea of Government Arbitrage Profit on distrust of the Government. Here is my comment:

Let me make the announcement for them:

Implicit Government Guarantees are actually Explicit. Watch what we do, not what we say. Otherwise, our words and actions will not make sense to you.

Oddly, it amuses us to see you perplexed.

— Don the libertarian Democrat

Now, of course, there's the question of why not come out and say it? Apparently, there are some tax reasons, etc. But that doesn't negate the fact that the government is on the hook. Presumably, the idea is that this debt is held to be less guaranteed than other debt. I don't believe it. I believe that it is implicitly guaranteed, which, by now, should be clear means explicitly guaranteed. I do agree that they see some advantage to leaving the door open that these debts are less secure than other government debts, but I don't believe that it lies in the FDIC Prospectus.

In that sense, I think that Nick Rowe might be both and right and wrong in his comment on Buiter, who might be accepting the demarcation the Fed is maintaining:

"One small point of disagreement:

“By continuing to accept instruments issued or guaranteed by Fannie and Freddie as collateral, the Fed clearly does not accept assets that were safe from the perspective of the US tax payer, because what safety there is comes from that tax payer’s own guarantee.”

But since the taxpayer owns the Fed, there is no extra risk for the taxpayer if the Fed buys these securities. (Note the parallel to the Bank of Canada buying CMHC-insured mortgages, where CMHC is clearly owned by the government.)

Posted by: Nick Rowe | November 29th, 2008 at 10:15 pm "

I think that this is like a shell game with three peas. The shells are The Fed, F & F, and Congress. The peas say that the taxpayers pay. Now, the point isn't to convince us that we can win, since, lucky for us, we win each time. Rather, it to create the illusion that we might lose, which, unfortunately, we cannot. The Fed wants to have it both ways. Convince everyone that these debts are less than FF Guaranteed, and yet imply that they are. The point is that the taxpayers need to actually know which it is.

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