By charis michail on February 26, 2014

Freddie Mac, European Central Bank and Cyprus Cooperative Sector: One Story of too many tales?



A not unambiguous story of state guarantees


Their exists a weird symmetry in the world today. Policy shifts are being increasingly emulated globally and analyses on local institutions can be attempted because of the common denominator under single global converging force that is globalisation.


In this specific, we will examine a staggering underlyingfactor that provides a solid narrative for the explanation of the US subprime mortgages institution crisis, the European two-speed Optimum Currency Area experiment failure and the Cyprus Co-operative institutions High Non Performing  Loans.


We can obviously not compare these three organizations in terms of scale, global ramificaticatons and complexity. However this sort of narrative allows me to connect them in a very causal and scale lineary way when moving from the general to specific.


All three institutions are shared entities on one crucial aspect which seems to permeate most of the “developed world” and its a very dangerous remnant of the Keynesian past that the market seems to have embraced. That crucial leg of the modern economy, is the state guarantees to market involved semi-state entities; and as we will argue it is the white shiny elephant in the room of moral hazard. Its a showcase of how wrong conventional wisdom can produce unintended consequences when political compromise forces organizations to move from statehood to markethood and the implicit systemic risks that it can cause.


Fannie May and Freddie Mac were government sponsored enterprize that were set up in the 1930s by US president  Franklin Delano Roosevelt amidst the Great Depression to support the collapsing mortgage market by creating a liquid secondary market through the securitizaton of mortgage loans guaranteed by the state thus ensuring more favourable low-interest, long term (30yr) mortgage  payments to the middle class. When this industry was privatized, the explicit guarantees were lifted but implicitly investors realised their different state of this enterprize, which teamed with intenselobbying strategy to keep them from adhering to more stringent liquidity regulation, kept the market growing than it would be possible under full private constrains. When the big investment firms in Wall street created the structured bonds, the circle was complete were the incentives were there for all participants to expand the market beyond its natural limit, thus creating a truly massive bubble, that has been the catalyst in the recent crisis.


A somewhat similar story occured in Europe when banks and investors assumed an implicit guarantees, that norhern surplus countries would guarantee the debt overreach of southern countries in the expanding European Monetary Union, which partially flattened and normalised bond prices in European market and indeed interest rates in the Banking sector, but opened the floodgates for a massive overstretch both in government and private debt in what Hayek would probably call, malinvestments.


Our third pillar of this scaling down narrative is a local state guaranteed institution, Cyprus’s Cooperative Banks. These highly local scaled down organisations came into being in the 1930s and where highly specific to the agriculture sectors as opposed to the novel local banking sector that was emerging at the time.After the 1974 war both the Monetary Financial Institutions and the Cooperative Banks blew up, but where the banks increased their market penetration and expanded in related fields like their worldwide counterparts, the Cooperative movement, spurred by the loss of its traditional field, agriculture, expanded in markets outside its competencies like housing, business, student and consumer loans for, for the lack of better term, subprime borrowers. As with the stories above it rested on direct and direct guarantees by government agencies, established in the 80s, like the Organization for the Equal Distribution of Burden and the Housing Finance Organization, that focused on low repayment-low interest loans for specific segments of the population.


The stated purpose and intentions behind these guarantees are not morally questionable. For example, the two US agencies guaranteed long term, fixed mortgages that were well above market rates. Even  the much more contested, recent subprime housing lending has opened the door  for otherwise marginalised, disenfranchised and discriminated by the financial system, black and poor communities to engage in formal financial activities that are partly responsible for an improvement in racial inequality in the USA or the ability of  underdeveloped countries of south and east of European Union to access funds necessary for growth and development of their economies, the Cooperative institution allowed for low income, refugees to send their children to study, get a decent house and live in relative sync with the rest of the population, than they would otherwise be able to. So in all three cases the phenomenical normalization of risk,backed by the government, improved the livelihoods of millions.


Starting 2008 risks that were amassing in all three institutions exploded and brougt them to the brink of collapse, only to be saved by their state gurantees,thus systemitizing the risk  . When the housing bubble finally burst in the US and the refinancing was no longer viable the non-repayment experienced a spike, the likes of which were considered impossible by market pundits.This led to the cease of tradability of financial instruments as the value of these where based principally on expectations and not foundations. Which led to the global liquidity crunch.


In Europe the overleveraged and heavy involved banks to the US market started consolidating their portfolios and started re-evaluating and cutting back their expectations for vulnerable countries with high debt ratios, thus increasing borrowing rates by just enough to make debt unsustainable in certain countries. In Cyprus, an economy based primarily on retail and government and to a lesser degree tourism was particularly hit by the liquidity stagnation which had profound effects on the large monetary institutions, due to direct involvement in overseas investments, but is turning devastating to the Cooperative movement, where consumer liquidity is a paramount factor in their loan portfolio and led to Non-Performing loans of up to 90%.


However,  you may ask, wouldn’t all these three institutions be bount to be saved by the state because they became so systemic that any other option would be terrifying even to contemplate?


This argument goes right in the heart of the problem. Yes, these state guaranteed institutions did become too importand to be left to fail. The problem is the reason they were allowed to become so huge. One of the major empeirical advantages of having a capitalistic organisation is that businesses need to adhere to solid societal principles that keeps them in check. By removing their need to compete and constraint their ambitions governments are in effect removing the very think that keeps the animal spirit in check, shareholder pressure and competition. This fact, has implicitly enforced the incentive of private participants to assume exorbitant risks, thus negating the sobering risk assessment that unguaranteed market forces seem to induce.


The second analytical step takes us to the need to clearly identify the business whether the benign societal benefits should be kept clearly under the auspices of either the market or the state. This means, creating a new organisation when a transition from state to market is decided so that no illusions remains in the eyes of a prospective investor.


The consequences of spreading surplus risk in the macroscale of nations and international relationships creats tensions and conflicts within and between countries.


The conclusion we reach is clear, we have to judge and decide what parts of the economy we feel should be privatized and then truly set them free and parts of what we considered of national interest, be kept under state control.


This ideologically induced quasi market institution just does not seem to work. The market fallacy that the risk was valued at its correct price was correct in a way. The states assume and pay out these risks. However, this creates a much more potent risk. The risk of war.

By Haris

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