In the mid-1980’s, the US had a savings and loan crisis in which regulators failed to close down small banks as they approached insolvency and instead allowed them to rack up enormous liabilities. How and why? Because the bank owners lobbied senators and congressman who in turn lobbied regulators to not shut down their underwater banks. Why? Because the bank owners, or at least some of them, treated their failing banks like money-machines, paying themselves high salaries and giving out “loans” which were gifts to friends and family. Why would a bank owner do this? Because the owner could simply walk away from the bank when it was shut down, even though when depositors looked for their money it would be missing. Of course depositors also did not worry too much because their savings were insured. And the depositor’s money was insured by – you guessed it – ultimately we the taxpayers. When the banks were finally closed, the resolution trust corporation took on the assets and liabilities of these banks at an expected cost to taxpayers of about 400 billion. The ultimate cost was actually about half this, whether due to luck, good management, or initial mis-estimation, I am not sure.
Fast forward to today. Fannie and Freddie, the mortgage-insuring and repackaging giants lobbied senators and congressman to be allowed to buy and insure non-traditional, risky mortgages. In doing so, while times were good, they made lots of money. When times turned bad, we the taxpayers picked up the downside. How expensive is this going to be? A little more than the S&L crisis – from just these two institutions. The Federal Housing Finance Agency estimates that it will cost $221 billion to $363 billion. That is about $1,700 to $2,800 per US taxpayer.
Why did we bail these entities out? This answer is less clear. The two institutions were “government sponsored” enterprises (thus the term GSE), and so not like your usual private company. Many investors seem to have felt that the taxpayer was guaranteeing their debt. Among these investors, China and other foreign governments held a lot of these securities, and we the taxpayer had borrowed vast amounts from China over the past decade and were relying on them to keep our long-term interest rates low during the crisis. Also, bankruptcy would have been costly (the bankruptcy costs of Lehman are now passing the $1 billion mark), but on the other hand, relatively cheap for the taxpayer. Probably the most sensible answer is that without Fannie and Freddie, mortgage financing would have needed to come from some other source and/or rates would have risen a lot and homes prices would have fallen a lot until the new versions of Fannie and Freddie could have been built. This would have made the financial crisis worse, and maybe have made the Great Recession deeper. But on the other hand, we would have had lower debt and more resources in the future.
Both the S&L crisis and the bailout of the GSEs are examples of what long-time Kellogg faculty member Debbie Lucas has spent a significant part of her career working on. Here is some more technical material on “Measuring and managing federal financial risk.” (Unfortunately, after being at Kellogg from 1985 to 2009, Debbie has moved on to the CBO and then to MIT).