The Investment World and Public Policy

Public policy is determined by elected governmental officials and appointees who are responsible to them.  This is the nature of accountability and representative government.

As citizens we are all free to criticize and vote for our favorite choices.  One person, one vote.

At "A Dash" we are disturbed by recent commentary that suggests that trading in financial markets should dictate public policy decisions.  No one elected the financial managers nor the pundits.  Their interests are not necessarily aligned with the overall economy, the housing market, nor (especially) the GSE's --- Fannie and Freddie.

The dividing line is clearly stated in this article by Zac Bissonnette at Blogging Stocks.  He contrasts the opinions of two people whom we admire, Barney Frank and Warren Buffett.  Here is the analysis:

In an interview with Money, Frank was asked about Fannie Mae and Freddie Mac:
I believe Fannie and Freddie are better off than the market thinks. Over the long term the market is a very rational distributor of resources, but in the short term it can fall prey to hysteria. Sometimes you need to deal with that.

Part of the problem is rumormongering by short-sellers. Our hope is that just by making U.S. financial support available, we'll quiet the fears and eliminate any need for that support.

After a favorable mention of Buffett's viewpoint, he concludes as follows:

It's unfortunate that Congressman Frank has fallen into the trap of name-calling, questioning the motives of the handful of savvy investors who were prescient enough to foresee trouble at Fannie and Freddie. We're in an era of financial McCarthyism, where anyone who raises questions about companies is a "rumormonger" or a "short seller." That's dangerous for the market in the long run because it squelches dissent and contributes to speculative bubbles.

Some Facts

We are planning a series of articles in the interaction between financial markets and public policy decisions.  At this point we have some observations on the current issue, but it is a work in progress.  Comments are welcome.

Having said this, we urge discussants to consider a few facts:

• Many government officials, especially Barney Frank and Hank Paulson are extremely intelligent and able -- whether one agrees with them or not.
• Government officials have a different set of considerations and must be accountable to  the electorate.
• Government often creates agencies that are quasi-public, in an effort to use free markets to improve performance.  These include, with widely varying degrees of success, the TVA, the U.S. Postal Service, Amtrak, the GSE's and many others.  Local governments embark on similar initiatives, outsourcing tasks from trash collection to operating tollways.
• The blend of public purpose and private enterprise responsiveness creates a tension for the managers of these enterprises -- being profitable without sacrificing public purposes.
• Investors in these enterprises -- whether stockholders or bondholders -- have done so with the assumption that they are partnering with the government.  Breaking this trust undermines future government efforts for such partnerships.  It is similar to the moral hazard argument.  Do we, as a society, wish to discourage future partnerships?
• Wall Street pundits should be more careful in concluding that those in government are less intelligent or less able than they are themselves.  They might consider that other smart people may draw different conclusions from the same set of facts.

Some Inferences

With these facts in mind there are certain conclusions that stand out.  These conclusions are observations about likely behavior, not opinion about what should be done.

• Government actors wish to preserve and enhance existing institutions.  They see these as the best likely solution to public problems -- especially in housing.  Crushing existing partners, whether they be shareholders or bondholders, is not their idea of a solution.
• The Bush Administration does not want the nationalization of the mortgage market as part of its legacy.
• McCain does not want a perceived government takeover of Fannie and Freddie as an election issue.
• Democrats want to be seen as doing something positive for housing, which means expanding Fannie and Freddie capabilities.
• Everyone in government would prefer a solution that did not require a government takeover of GSE's.
• Wall Street pundits have -- just recently -- started judging GSE's according to private bank rules -- capital ratios, FAS 157, and the like.  To government types, this is like changing the rules of football scoring in the middle of the game -- field goals count for 2 and touchdowns for 9.
• The pervasive Street commentary has served to reduce financing options.  There is a drumbeat of opinion that more capital is needed, even when official rules say that it is not.  The relentless selling of FNM and FRE has restricted the ability to raise new capital in private markets.
• The Street consensus is that common stock in GSE's must go to zero and management must be fired.  This is inconsistent with the public purpose perceived by government leaders.
• Dissident leakers in government have aided in the Street perspective.

Investment Implications

What has happened is that Wall Street, unelected and unaccountable, has voted on the nature of Treasury policy regarding Fannie and Freddie.  The actual government officials do not agree.  News accounts show that Freddie is exploring options with widely differing effects on current shareholders.

Will Wall Street opinion force the final decision?  We doubt it, but no one can know.  We suspect that the specific solution recommended by Jim Cramer and others will not gain acceptance.  If Cramer is right, the market is in for tough sledding for the next few months.

The alternative viewpoint is that Paulson will find a way to infuse lending and enhance the GSE's as players in mortgage markets.  It is a challenge.  If he succeeds, he will win high marks from economic historians.

Those studying public policy will ask questions about the role of markets in shaping public policy.  There are other recent examples for this interesting topic.

[No position in FNM or FRE.]

Comments

[Lineu Vargas]

Hi Jeff,

Thank you very much for your answer. But perhaps I haven't made myself very clear: How would treasury go about eliminating the common shareholders against their will (lots of floated solutions seem to assume this)? Until FRE and FNM actually go bankrupt (or OFHEO declares them so), they hold the power to refuse a bailout. Presumably they would be indifferent between running the company into the ground (and the housing market with them) and accepting any offer that leaves them with zero. As any bargaining game (Nash comes to mind), the ultimate solution depends on the relative bargaining weights that can be attributed to the parties. My view is that the value of the common stock depends primarily on those and NOT on any "fundamental" considerations (who know what the fundaments are in any case) or any non-credible plans (as any that would completely dilute the shareholders seems to be). Any thoughts on this?

[oldprof]

Lineu - You are correct in noting that FRE and FNM still meet the official standard of capital adequacy. If the Treasury does intervene, the nature of its action will be important. There are various plans that would seriously dilute or eliminate common shareholders. As we have noted, the market has already taken care of that.

Thanks,

Jeff

[Lineu Vargas]

Disclosure: My fund is long FNM and FRE.

First things first: I am really thankful for the effort you put in your blog, presenting a view that is sorely missing in the "commentariat", that of the government official or the elected representative.
Actually, I have a question for you: How would the Executive actually go about wiping out the common stock or the preferred ? I mean, what is the legal procedure to do that. There is nothing in the recent Housing Bill that grants the Executive the unilateral power to do that, on the contrary it states quite clearly that any government purchase of FNM, FRE securities has to occur with the mutual aggrement of the FRE, FNM boards and Treasury. In a very fundamental sense, until FRE and FNM aren't bankrupt, the Treasury has very little power, because the common stock has veto power. That's one of the good things about the common after all.

[George]

Every-time that Feller with the beard opens his mouth it costs me a fortune.

[Lord]

Calls of McCarthyism do more to squelch dissent than opinions of those involved.

[Mike C]

"Comments are welcome."

Jeff,

I am unclear on what exactly you mean when you say that trading in financial markets "has been dictating public policy", that Wall Street has "voted" on Treasury policy, and that Wall Street opinion may "force" the final decision?

What are you advocating? IMO, individuals, pundits, Street analysts, should be free to advocate whatever view, analysis, opinion they so desire, and market participants should be free to buy, sell, or short based on the conclusions they come to.

Just my opinion, but I think Zac hits it exactly with:

"We're in an era of financial McCarthyism, where anyone who raises questions about companies is a "rumormonger" or a "short seller." That's dangerous for the market in the long run because it squelches dissent and contributes to speculative bubbles."

There is an unstated premise that government and government officials SHOULD be quite involved in the markets and economy. Not everyone shares that view, and those who do not should be free to advocate to that end.