Fannie, Freddie And Citi: The Rise Of The New Government-Sponsored Enterprise


JPMorgan Chase: $3.6 billion in profits in the last quarter. Goldman Sachs: $3.03 billion. Analysts expect a string of sky-high profit announcements to follow from other major Wall Street banks, all of them squirreling that cash away for historic bonus payments to executives.

In other words, it's been a good year for government-sponsored enterprises -- known in the industry as GSEs.

Traditional GSEs such as Fannie Mae and Freddie Mac have been tagged as culprits in the financial collapse, with critics arguing that the institutions took on too much risk because their losses were guaranteed by the federal government. Such a situation, it was said, is unsustainable.

Today's GSEs have different names: AIG, Citigroup, Bank of America.

"That's how I look at them as an analyst. I treat Citi as a GSE. I feel bad, because I know a lot of people that work there and I know they're trying to turn it around, but between the loss sharing and the equity that will probably be consumed by the losses, it's going to be an expensive operation for the U.S. government," said Christopher Whalen, a financial analyst who co-founded Institutional Risk Analytics.

Even the Treasury Department has made the comparison. "The growth of the major financial firms over the past few decades -- including Fannie Mae, Freddie Mac, and the major investment banks -- also likely stemmed in part from the assumption by investors and counterparties that these firms would receive government assistance if they became troubled," assistant treasury secretary Michael Barr said at a speech earlier this month at the National Economists Club.

Implicit government sponsorship allows big banks to access capital cheaper than private banks. It also saves them money on insurance premiums. Why pay for guarantees that the banks can get free?

When Bank of America bought Merrill Lynch in January, it insisted on getting up to $118 billion in losses guaranteed by the U.S. government in exchange for going through with the takeover. BofA agreed to pay a 3.7 percent fee for the guarantee -- close to $4 billion.

At the end of September, it paid a fraction of that -- $425 million -- to the Treasury to get out of the deal. "The BoA folks are smart people," said economist Dean Baker of the Center for Economic and Policy Research. "Why pay for something you can get for free?" (BofA claims it escaped the deal so that it would be less reliant on government support -- though, of course, the implicit support has gone nowhere.)

A recent paper by Baker and Travis McArthur shows that the too-big-too-fail guarantee also allows GSE banks to access capital cheaper than regular banks. The difference over the last several quarters adds up to an annual $34.16 billion taxpayer subsidy to major banks -- roughly half of their projected profits. That subsidy is more than twice what taxpayers spend on the major welfare program, Temporary Assistance to Needy Families.

The report, "The Value of the 'Too Big to Fail' Big Bank Subsidy," is based on data compiled by the Federal Deposit Insurance Corporation and compares the cost of capital for banks smaller and larger than $100 billion. For the 18 banks above that threshold, capital was cheaper by 0.78 percentage points from the fourth quarter of 2008 through the first two quarters of 2009. From the first quarter of 2000 through the fourth quarter of 2007, the spread had only averaged 0.29 points -- meaning that the gap increased by roughly half a percentage point.

During the early part of the decade, the previous recession also saw the spread widen, but by a smaller amount, the report notes. The circumstances were much different, as well: the past recession didn't include widespread fears of the insolvency of the biggest banks -- the type of concern that -- under a free-market theory -- should make capital cost more, not less, for such banks. Yet smaller banks, which played little role in the crisis, received fewer bailout dollars and are considered more financially stable, are the ones paying the price.

"Private banks can't compete with a GSE," said Whalen.

Major banks have been able to sell toxic assets to the Federal Reserve and also have access to capital at close-to-zero percent interest rates from the Fed. By using zero-percent money from the Fed and lending it back to the U.S. government by buying Treasuries that pay higher rates, banks can squeeze out an extra subsidy. But there is no way of knowing how much of that capital banks have taken advantage of because the Fed doesn't make the information available.

"The numbers in [the report] suggest that to a large extent the recent rise in the profitability of the TBTF banks may be attributable to the fact that they enjoy the protection of the government's backing at a time when the banking system as a whole continues to experience substantial strains," write Baker and McArthur. "This should concern policymakers, since it would imply that a substantial portion of the profits of the largest banks is essentially a redistribution from taxpayers to the banks, rather than the outcome of market transactions. It is not clear that Congress and the public would support this redistribution if they realized that it was taking place."

It's clear, in fact, that the TBTF situation has virtually no support at all.

"I can't comment specifically on BofA, but what it does illustrate is in the debate about the regulations that are coming before the banking committee, we're going to have to be very, very careful not to allow the situation to exist where implicitly there is a federal guarantee or a backup of any of these institutions by virtue of the things we've put into place to deal with some future crisis," Senate Republican Whip Jon Kyl of Arizona told HuffPost.

"If they're too big to fail, they're too big," former Federal Reserve Chairman Alan Greenspan told the Council on Relations in New York on Thursday. Greenspan acknowledged that breaking up banks cuts directly against his free-market ideology and opposition to government interference, but said that there was no choice. "If you don't neutralize that, you're going to get a moribund group of obsolescent institutions which will be a big drain on the savings of the society...Failure is an integral part, a necessary part of a market system."

There is precedent for such a break up. "In 1911 we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole. Maybe that's what we need to do," Greenspan said.

Senate Democrats agree, too. "Too-big-to-fail is a doctrine that has to go," said Sen. Byron Dorgan of North Dakota, a member of Democratic leadership. "We need to address the doctrine and essentially abolish this no-fault capitalism called too-big-to-fail."

Even JPMorgan CEO Jamie Dimon acknowledged in September, "It would be a very bad long-term policy error to have banks that are too big to fail."

What he meant, however, was that other banks shouldn't be allowed to grow as big as his own, not that his should be broken up. "By that I don't mean make the banks smaller. We're large because we have a reason to be large," he quickly added.

They have billions of reasons to be large, of course, but there is a simple way to reduce their size, Whalen said. Banks that fail or are approaching failure could require their creditors to convert to stock holders instead of having their investment covered by taxpayers. The politics of the solution are difficult, because bondholders have an immense amount of political power.

"We can do this short of bankruptcy if we want to be reasonable people, but nobody in Washington's got the balls to have this conversation, except for [FDIC head] Sheila Bair," said Whalen.

Allowing failed firms to carry on undermines the entire system, Whalen noted. "In a free market society, if you don't have terror along with the exuberance then you're not a free market," he said. "If we don't have the courage to make the bondholders -- who are really legally responsible here -- come in and play a part, then we're basically just socialists and we will have all the negative effects that the socialists have faced in Europe by subsidizing their banks, which is a dead banking system."

The administration's approach is less direct and begins with greater oversight and higher capital requirements for big banks. "Going forward, our strategy is to impose supervisory and capital charges that offset the benefits of perceived government subsidies. We must substantially reduce the moral hazard created by the perception that these subsidies exist," said Barr in the same speech.

Greenspan, however, said that wasn't enough. "I don't think merely raising the fees or capital on large institutions or taxing them is enough," Greenspan said. "I think they'll absorb that, they'll work with that, and it's totally inefficient and they'll still be using the savings." That puts Greenspan -- an Ayn Rand acolyte -- on record for more government intervention than advocated by Michael Barr, a longtime labor economist.

Rather than break up the financial firms, Treasury proposes that it be given authority to unwind major financial institutions when they run into trouble. If investors become convinced that the government will, in fact, exercise that new authority, then their investment isn't as safe and the implicit subsidy isn't as large.

From Barr's speech:

The final step in addressing the problem of moral hazard is to make sure that we have the capacity - as we do now for banks and thrifts - to break apart or unwind major non-bank financial firms in an orderly fashion that limits collateral damage to the system.


Under our proposed special resolution authority, the government would be able to seize control of the operations and management of a major financial firm that is in default or in danger of default, to act as a conservator or receiver for the firm, and to establish a bridge entity to effect an orderly sale of the firm or liquidation of its assets. In the main resolution authority is not about keeping these firms alive, it is about letting them fail - making sure that they fail in a way that causes less collateral damage to the economy and to the taxpayer.

It is imperative that we minimize the risks that taxpayers pay the price of any future rescue of the financial sector. Therefore, under our proposal, any losses that might be incurred by the government in this special resolution process would be recouped through assessments on other large financial firms.

In a speech directed at Wall Street in New York in September, President Obama put the banks on notice. "Those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall," Obama said.

Today's profit statements tell a different story: Yes, Mr. President, they can.

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