GSE debt growth leaves U.S. taxpayers exposed

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  • Expansion of agency #debt imposes risk losses on #taxpayers & increases the cost of the Treasury's direct financing

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  • Agencies aren't official government debt, but they increase interest on Treasury securities, thus the #deficit

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  • "The expected cost of defaults...do not account for the uncertainty about how costly such defaults ultimately will be."

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Over the last several decades, we have engaged in a financial experiment, or adventure, of exploding agency debt relative to Treasury securities.

In 1970, Treasury debt held by the public was $290 billion. Agency debt totaled only $44 billion. At the height of the housing bubble in 2006, Treasury debt was up to $4.9 trillion, but agency debt has inflated to $6.5 trillion. While Treasury debt had increased 17 times during these years, agency debt had multiplied 148 times.

At the end of 2010, Treasury debt was $9.4 trillion, and agency debt was $7.5 trillion.

In 1970, agency debt represented only 15% of Treasuries. By the peak of the housing bubble in 2006, this had inflated to 133%. At the end of 2010, agencies were 81% of Treasuries, or about the level of 1997-98, just before the housing bubble, still a notably high level.

If we add these two types of debt together, we can get a total of "effective government debt" (debt dependent on government credit) held by the public.

The expansion of agency debt not only imposes risk and realized losses on taxpayers (we do not need to mention the $160 billion which the U.S. Treasury has been forced to put into Fannie and Freddie to prevent their financial collapse), it also increases the cost of Treasury's direct financing, by creating a huge pool of alternate government-backed securities to compete with Treasury securities, and thus increases the interest cost to taxpayers.

So although agencies are not "officially government debt," they undoubtedly increase the required interest rates on Treasury securities, in my judgment, and thus increase the federal deficit. The greater the amount of agency securities available as potential substitutes for Treasuries, the greater this effect must be. As a manager of a major institutional investor told me recently, "We view Fannie and Freddie MBS as Treasuries with a higher yield-so now we own very few Treasuries."

It is difficult to put an exact number on the counterfactual question of how much this increased cost has been. However, a quantitative suggestion is implied by a recent Federal Reserve analysis. The authors conclude that by taking $1.7 trillion in securities out of the market by Federal Reserve purchases, of which more than $1 trillion were purchases of agency securities, the interest rates on 10-year Treasuries were reduced by "somewhere between 30 and 100 basis points."

Suppose we run this logic in reverse: if the supply of effective government debt is increased by trillions of dollars of agency debt, perhaps that would increase the cost of long-term Treasuries by at least a like amount.

"Managing the issuance of Treasury securities under the circumstances of the last decade, deals with only about half, and sometimes less than half, of the effective government debt." -- Alex Pollock

This result depends on the idea that investors will substitute agency debt for Treasuries and thus reduce the demand for Treasuries from what it would have been. We can observe a striking example of this substitution in the aggregate balance sheet of the commercial banks.

In 1970, commercial banks owned $63 billion in Treasuries and $14 billion in agency securities. Their Treasury holdings were more than four times their agency holdings. By 2006, at the peak of the bubble, all commercial banks owned only $95 billion in Treasuries, which was dwarfed by their $1.14 trillion in agencies. They then had 12 times the investment in agencies as in Treasuries.

At the end of 2010, the corresponding totals are $299 billion of Treasuries and $1.35 trillion in agencies.

Expressed as a percentage of banking assets, investment in Treasuries falls from 12% to less than 1%, then recovers to only 2% under current circumstances. Meanwhile investments in agencies inflates from less than 3% of banking assets to over 10%, then ended last year at 9.4%.

How was it possible for agency debt, and the corresponding taxpayer exposure, to grow so much for so long?

Well, bond salesmen, peddling trillions of dollars of Fannie, Freddie and other agency securities to investors all over the world, told them something like this: "You can't go wrong buying these, because they are really a U.S. government credit, but they pay you a higher yield. So you get more profit with no credit risk."

In contrast, a senior member of the Financial Services Committee memorably opined that Fannie and Freddie had "no explicit guarantee...no implicit guarantee...no wink and nod guarantee." Official voices liked to point out that the offering memoranda for GSE debt said right there in bold face type that these securities were not guaranteed by the United States.

Nonetheless, what the bond salesmen said was right, as events have conclusively demonstrated. A good sense of the resulting situation is described by then-secretary of the Treasury Henry Paulson in his memoir of the financial crisis: "Foreign investors held more than $1 trillion of the debt issued or guaranteed by the GSEs...To them, if we let Fannie or Freddie fail and their investments got wiped out, that would be no different from expropriation. They had bought these securities in the belief that the GSEs were backed by the U.S. government. They wanted to know if the U.S. would stand behind this implicit guaranee-and what this would imply for other U.S. obligations, such as Treasury bonds."

Note how in this description, the belief that agency debt is simply government debt links to discussion of Treasury securities themselves.

Of course, using the credit of the United States to make, guarantee, insure or finance mortgage loans though any of the agencies which do so entails credit losses. This in itself is not a problem: if we knew what the losses would be, or knew what they would be within a narrow range, the losses could be easily priced and budgeted for.

For entities subject to the Federal Credit Reform Act, the expected (best guess estimates) of losses must be reflected as costs in the federal budget. This requirement was without doubt a major improvement over previous practice, but it does not address the fact that we do not know what the losses will be.

As the Congressional Budget Office points out, the FHA, for example, has often had to increase its estimates of credit losses. In fact, the expansion of leverage created by the very programs in question, may make the losses bigger.

Huge increases in loss estimates characterized the failure of Fannie and Freddie. The limits of the most expert knowledge of the future extent of losses is highlighted by this statement of the then-director of the Office of Federal Housing Enterprise Oversight: "Let me be clear-both (Fannie and Freddie) have prudent cushions above the OFHEO-directed capital requirements." This March 2008 statement was indeed clear, but wrong; only six months later both agencies collapsed.

Two months before the collapse, in July 2008, the chairman of the Senate Banking Committee pronounced: "What's important are facts-and the facts are that Fannie and Freddie are in sound situation."

As the Congressional Budget Office correctly says: "The expected cost of defaults...do not account for the uncertainty about how costly such defaults ultimately will be." We need to consider both, but indeed, the uncertainty, as opposed to the estimated cost, is the hard issue.

To help take the uncertainty into account, the CBO advocates using fair value cost estimates for Fannie, Freddie and the FHA, which draw from the market price for bearing credit loss uncertainty. I believe this is a reasonable thing to do, but even using such estimates, we would have greatly underestimated the losses imposed on the taxpayers by the use of the government's credit to back agency debt.

Managing the issuance of Treasury securities under the circumstances of the last decade, deals with only about half, and sometimes less than half, of the effective government debt.

Alex J. Pollock is a resident fellow at AEI.

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