The Real Cost of the Agency Guarantee

Dan Gross says that if and when the federal government bails out Fannie and Freddie, "the bailout will be a bargain for American taxpayers, because any cost of it will be overwhelmingly offset by the tangible and quantifiable economic benefits that taxpayers have collectively received over the years from the market's expectations that such a bailout would materialize if needed".

He's wrong, for two reasons.

Firstly, Gross quantifies the "benefits that taxpayers have collectively received" by looking at the interest rate they paid on their mortgages. He reckons that because of Fannie and Freddie's implicit government guarantee, those interest rates are 25bp lower than they would otherwise have been, and that the "present-day value of the historic implied guarantee" is on the order of $100 billion.

But if I'm a homebuyer, I don't put in an offer on a house and then go shopping for a mortgage: I put in an offer which is directly correlated to the amount of money that a bank is willing to lend me. Let's say I can afford $2,000 a month in mortgage payments: then if those mortgage payments will land me a $450,000 mortgage, then I'll bid $20,000 more than if those mortgage payments will get me only a $430,000 mortgage. A lower interest rate will increase the amount I have to pay for my house; it won't decrease the amount I pay on my mortgage each month.

In fact, Americans are paying more in mortgage payments today than they have at any point in history. Does that sound like they're saving money to you?

Now there is a group of people who have indeed realized "tangible and quantifiable economic benefits" from the GSEs' implicit government guarantee, and that's the shareholders of Fannie and Freddie. True, they're not feeling particularly well-off right now, but that's another story. If Fannie and Freddie had been government agencies rather than government-supported agencies, then the benefits of the government guarantee would have accrued to all taxpayers, rather than being dividended out to the GSEs' shareholders. But they weren't.

Here's Gross:

Until this week, the cost of this benefit has been effectively nothing--save for some foregone taxes and the cost of regulating the companies.

Effectively nothing? The cost of the implicit guarantee is not foregone taxes, it's foregone profits. The US government has essentially been insuring the debt of the GSEs against default, while neglecting to charge any insurance premiums.

And now that the guarantee is explicit rather than implicit, just look what's happened to US sovereign debt:

This is the first time in my career that I truly believe U.S. Treasury bonds sold off on credit concern. By this I mean, the credit of the U.S. Government. Long time readers know I'm not an alarmist type, and I'm sure not saying the United States is going belly up, but credit default swaps on the United States of America moved 11bps wider today (from 9bps to 20bps). The 10-year Treasury moved 15bps higher. All on a day when people are scared shitless and there should have been strong demand for "risk-free" assets.

That's a real cost, Dan. It might not be a line item in any GSE bailout, but when the US has to pay more money to roll over its trillions of dollars in liabilities, every basis point counts.

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