Federal Use of Implied Guarantees: Some Preliminary Lessons from the Current Financial Distress

Abstract

The U.S. financial crisis and recession that began in 2007 poses profound challenges for public policy and administration. It also provides useful information about the effects of economic policies. This paper considers the implications of current developments for the use of implied guarantees as an instrument of public policy. It draws on experience with Fannie Mae and Freddie Mac to argue that implied federal guarantees have a severe disadvantage. Their costs are largely unmeasured, unrecognized in the budget, and unmanaged. Yet their use appears to be increasing in the current crisis. To minimize the costs of the expanded financial safety net, government should measure and manage those costs more effectively. To that end, this paper proposes new budgetary treatments of federal implied guarantees.

Getting the Dog to Bark: Disclosing Fiscal Risks from the Financial Sector

“…In theory, indicators of the government's debt and deficit could give some warning of the expected fiscal cost of a possible financial crisis. Phaup (2009), for example, argues that the U.S. government should recognize in its accounts the cost of implicit guarantees of the obligations of Fannie Mae and Freddie Mac. International standards for fiscal statistics and government accounts also provide some conceptual support for including implicit guarantees in government debt.…”

Unmet Duties in Managing Financial Safety Nets

“…They must also estimate whether some of the resources they transfer to distressed firms might be better used to increase the discounted value of restructuring and other benefits achievable during the restructuring and recovery phases. This multiperiod perspective makes it clear that it is imprudent and deceptive for officials currently in office to use a reporting system that fails to record and budget for the future costs that rescue strategies generate from constraining future policy options (Phaup, 2009). Unless authorities estimate the present value of the incremental taxpayer liabilities that rescue policies create and pass this opportunity cost through agency budgets and balance sheets, rescue strategies cannot be intertemporally optimal.…”

“…This is not easy and can at best only lessen --not eliminatesafety-net subsidies. The first step is to search for reliable and accountable ways to task TPFU firms and government regulators with conscientiously estimating, disclosing, and responding to changes in the flow of de facto safety-net subsidies (Phaup, 2009;Caprio, Demirgüç-Kunt, and Kane, 2010;Kane, 2009).…”

Contingent liabilities: monitoring exposures that are difficult to measure

“…A contingent liability may arise from a letter of comfort, in which the government makes a softer but possibly still significant commitment; or from a law, such as one guaranteeing bank deposits. Alternatively, officials may imply with a series of nods and winks that the government stands behind an entity's liabilities (Buchheit and Gulati 2014), or the extent of the government's involvement in the entity's activities may by itself suggest that it will do so, as in the case of many state-owned enterprises and the "government-sponsored" entities Fannie Mae and Freddie Mac (Phaup 2009;Frame et al 2015). Finally, the government may sometimes be expected to conclude, irrespective of any of its prior words or actions, that the costs of letting the entity default on its liabilities are greater than the costs of bailing it out-as with the US government's 2009 rescue of General Motors (Goolsbee and Krueger 2015).…”