These hybrids don't run

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. It is no coincidence that the most spectacular crashes of the recent financial turmoil involved the hybrids on both sides of the Atlantic. 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. 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 momentbecause politicians in both Germany and the United States wanted to have financial hybrids. This should be banned. Adam S. Posen

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