Whom Do You Trust? A Bond Salesman or Government Official?
Fannie Mae and Freddie Mac, the notorious government-sponsored enterprises (GSEs), had before their failure very high leverage and very small capital ratios, with credit risk of about 60 times their capital. Yet together they were able to borrow $5 trillion from buyers of their bonds and mortgage-backed securities around the world. How were they able to get people to buy this massive amount of their debt?
You know the answer: investors did not view it as Fannie and Freddie's own debt, but rather as an obligation of the United States Treasury.
If we think of this issue as it was discussed before Fannie and Freddie's financial collapse and taxpayer bailout, there were two competing assertions, one prominently represented by bond salesmen, and the other by government officials. Whose word, as an investor or a taxpayer, would you trust - a bond salesman or a government official?
Bond salesmen all over the world said something like this to their investing customers: "You can't go wrong buying this GSE debt, because it's really debt of the U.S. government - even if Fannie or Freddie get into trouble, the government will make sure that all interest and principal will be paid. And you get more yield on GSE debt than on U.S. Treasury debt, so it's more reward and no risk!"
The opposite position was taken by a notably GSE-loving senior Congressman, Barney Frank, later Chairman of the House Financial Services Committee. He memorably said about whether GSE debt was backed by the government: "There is no guarantee. There's no explicit guarantee. There's no implicit guarantee. There's no wink-and-nod guarantee. Invest and you're on your own."
Switching political parties and branches of government, a Republican Secretary of the Treasury, John Snow, said this about Fannie and Freddie's debt: "We do not believe there is any government guarantee, and we go out of our way to say there is not a government guarantee. We need to be on guard against this perception. It is a perception. It is not, in our view, a reality."
But needless to say, it really was a guarantee and it was a reality, alas. Ordinary Americans are and will continue to be taxed to pay off every penny of interest and principal due to the domestic and foreign creditors of Fannie and Freddie.
In short, the bond salesmen were absolutely right, and the most charitable thing you can say about the government officials was that they were entirely wrong.
Writing of the mounting financial problems of Fannie and Freddie in 2008, then - Secretary of the Treasury Henry Paulson tells us: "Treasury had been getting nervous calls from officials of foreign countries ... Foreign investors held more than $1 trillion of the debt issued or guaranteed by the GSEs, with big shares held in Japan, China and Russia. To them, if we let Fannie or Freddie fail...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 guarantee."
Paulson issued instructions: "Make sure to the extent we can say it that the U.S. government is standing behind Fannie Mae and Freddie Mac." To what extent did it stand behind them - or more precisely behind their debt? Completely. It was a rather far cry from "Invest and you're on your own."
Paulson further relates a subsequent conversation with Wang Qishan, China's vice premier for financial and economic affairs: "I always said we'd live up to our obligations, I reminded Wang."
So indeed they did. But even in the process of in fact guaranteeing Fannie and Freddie's debt, the U.S. government still formally denied that it was a guarantee. The agreement by which the Treasury put taxpayers' money into Fannie and Freddie in order to protect their creditors provided that the bailout was "not intended and shall not be deemed to constitute a guarantee."
Why did government officials want to deny that what they obviously intended to do, and what they obviously were doing, was what it was?
Because they wanted to keep Fannie and Freddie's debt off the government's books. In this they succeeded and continue to succeed. Thus the bailout of 2008 reflected the 1968 legislation which created the fateful GSE structure, the purpose of which was to get Fannie's debt off the government's books.
We couldn't have the government honestly telling us how big its debt is, could we?