Financial Hybrids Do Not Work
by Adam S. Posen, Peterson Institute for International Economics
Op-ed in the Börsen-Zeitung for the series "Jenseits der Krise"
August 7, 2008
English version © Peterson Institute for International Economics
For automobiles, hybrid engines are a huge advance. For financial institutions, hybrids are the worst possible design. By financial hybrids, I mean institutions that are neither wholly public-sector bureaus nor private-sector companies. These are erected where political pressures require provision of credit to borrowers whom the market left alone will not serve, but the cost is too large or embarrassing to be funded on the balance sheet by the government. Inevitably, this charade ends up in tears, with a few hybrid managers and shareholders very rich, a significant share of the hybrid's borrowers in default, and the taxpayer with a large bill. And this is always revealed when the financial system is most fragile.
Thus, it is no coincidence that the most spectacular crashes of the recent financial turmoil involved the hybrids on both sides of the Atlantic. In the United States, it was Fannie Mae and Freddie Mac; in Germany, it was Sachsen LB and IKB. In both countries, these neither-fish-nor-fowl institutions were long recognized as financial accidents waiting to happen. But their political utility kept them open: Retired officials and politicians could get high-paying jobs there; government influence could direct credit to purposes with electoral rewards; a section of the electorate that would otherwise be denied credit got some, be it for mortgages (by the US "agencies") or for Mittelstand financing (by IKB and the German Landesbanken). All very popular, but pointless as public policy.
Ultimately, the financial hybrids cannot escape the contradictions of their goals when credit contraction hits. For Fannie and Freddie, their ostensible public purpose would be best served right now by expanding their balance sheets and increasing their lending to distressed mortgage markets. So doing, however, would defeat their for-profit mission because it would require them to raise new capital and thus to dilute the ownership stakes of their shareholders. Fulfilling that mission would also increase the share of their portfolios in potentially nonperforming loans, against the shareholders' interests.
If, on the other hand, Fannie and Freddie are allowed to reduce significantly their purchases of new mortgages during the current broader credit contraction—which is what they had been doing when left to their own managers' devices—there is little justification for guaranteeing their debt with public money. Clearly, their for-profit motive did not lead these agencies to make better decisions about what to do with their portfolios than if they had simply been a government program to make subsidized mortgages available. But the cost to US taxpayers of extending those mortgage credits via Fannie and Freddie instead of through direct subsidies has been much higher.
The Landesbanken, and IKB of a similar ilk, suffer from much the same tension, yielding much the same results. With expectation of their ultimate government guarantee, as demonstrated in recent months, the managers of these German financial hybrids could recklessly pursue profits in instruments they did not understand. With claims of their public—but actually special interest serving—purpose, they had ready built constituencies getting credit they otherwise would be denied (or for Sparkassen customers, subsidized capital flows they otherwise would have to pay market rates for). And their constituencies urged these hybrids' continued existence even as their solvency eroded.
Of course, the basic technical purposes of these financial hybrids had some merit. The purchase, repackaging, and securitization of mortgage debt, which had been Fannie and Freddie's initial mission, did increase, and still profoundly increases, liquidity in the American mortgage market. Sparkassen, like all banks, do need clearinghouse services, and those attained some economies of scale when they were originally combined to be handled by the Landesbanken. The reason that public legislation was required to bring them into existence in the first place is that neither of these constructive purposes, which benefited their respective financial systems as a whole, were inherently profitable. Moreover, once they were set up as hybrids, the political incentives for the institutions' managers and political patrons got these questionable institutions into businesses they had no business being in and that were ancillary to these more limited positive purposes. In the end, though, those ancillary activities are the ones that nearly or fully bankrupted the firms, leaving the taxpayers with the bill.
This situation has two major implications for getting beyond the crisis. The first is that clear resolution of these institutions' status is needed: Neither the US nor the German government should leave financial hybrids in existence. The American agencies should be nationalized, with the shareholders bought out at present low market valuations, while the Landesbanken should be privatized or shut down. The reason for the difference in which direction to resolve the private/public tension is simply the nature of the services they provide: Nowadays, Sparkassen and other customers can get clearinghouse services directly from the markets at low prices, while the mass securitization and underlying guaranteeing of mortgages in the United States still requires public intervention. If the covered bond market in the United States develops in coming years to approximate the German Pfandbriefe market in depth and liquidity, then the Fannie/Freddie securitization program could be shut down as well. The common point for both sides of the Atlantic is that if these institutions cease to be hybrid, it will be natural for their existence to depend upon their utility in serving their core mission, rather than on their political support and threat of failure.
The second implication is that the focus of public policy response should be on improving the incentives given by the specific structures of the financial system where they led to lax supervision and politicized regulation. All the talk about monetary laxity, credit booms, debt overhang, and the like (which many commentators have emphasized) are of secondary importance. Germany and the United States had completely different monetary and conjunctural conditions over the last several years, yet they suffered the same type of costly failures in the parallel parts of their financial systems at essentially the same moment—because politicians in both Germany and the United States wanted to have financial hybrids. This should be banned.