It is a long-held perception that America is a nation where the government typically stays out of day-to-day business activities. Yet the U.S. federal government is in many ways the biggest and most influential financial institution in the world, with $10 trillion in federal guarantees and loans going to the private sector. Even before recent implementation of massive interventions meant to stave off financial calamity, the federal government directly or indirectly provided significantly more credit than any of the country's largest private sector banks. And, of course, the government's credit activities have recently expanded far beyond this core of traditional programs in the face of economic crisis. What does the true picture of this sector look like, and how does it affect the overall economy?
Uncle Sam in Pinstripes is an accessible primer on U.S. federal lending, providing an instructive look at one of the most important interfaces between the U.S. government and its citizens as well as the transactions that result. Douglas Elliott's introductory chapter makes clear the critical importance of federal credit programs and hints at some of their complexities. The remainder of this book fills in the detailsthe how, what, why, and the ramificationsallowing readers of all stripes to understand the history, current state, and key policy issues surrounding federal credit provision. No picture of the U.S. economy is complete without a fuller understanding of this increasingly important sector.
There is considerable evidence that taxpayers are not receiving the value for money that they should. The author believes that a number of steps should be taken to increase the effectiveness and efficiency of federal credit programs. These are explained in the final chapter and include the following actions, among many others:
Target borrowers more carefully. Take into account more fully the relative risk of different loans. Use the same budget rules for all federal credit programs. Use risk-based discount rates for federal budget purposes. Create a federal bank to administer all credit programs.
|Publisher:||Brookings Institution Press|
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About the Author
Douglas J. Elliott is a fellow in Economic Studies at the Brookings Institution, where he is part of the Initiative on Business and Public Policy. He was an investment banker for two decades, specializing in financial institutions, and also served as founder, president, and principal researcher for the Center on Federal Financial Institutions.
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UNCLE SAM IN PINSTRIPESEvaluating U.S. Federal Credit Programs
By DOUGLAS J. ELLIOTT
BROOKINGS INSTITUTION PRESSCopyright © 2011 THE BROOKINGS INSTITUTION
All right reserved.
Chapter OneThe Federal Government as Banker
The federal government is the biggest and most influential financial institution in the world, a fact often hidden by the widespread public conception that the American government largely stays out of business activities. The government's recent frenetic interventions in the financial system, such as the rescue of the banking system or the Federal Reserve's massive direct support for the financial markets, are therefore generally seen as aberrations. Yet even the narrowest measure of the government's traditional role in lending shows that it directly or indirectly provides credit in an amount significantly larger than the loans on the books of any of the country's largest private sector banks. In fact, as shown in table 1-1, the government's outstanding commitments in its traditional programs supporting loans and guarantees for housing, farming, education, and business totaled approximately $2.3 trillion in 2010, roughly one-third the size of the loans on the books of all the banks in the United States combined.
Moreover, the federal government's credit activities were recently expanded far beyond this core of traditional programs. Temporary government-controlled programs provided almost another $6 trillion of credit, primarily through Fannie Mae and Freddie Mac (the massive government-sponsored enterprises that guarantee mortgage lending), the extraordinary credit activities of the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Troubled Asset Relief Program (TARP), established to address the 200809 financial crisis. This list does not even include the Federal Home Loan Banks that hold nearly a trillion dollars of assets. These banks have close government ties and benefit significantly from a perception by most investors that the federal government would rescue these entities if they deteriorated further, as it did Fannie Mae and Freddie Mac. Unfortunately, most of this exceptional credit provision is likely to remain under federal control for some time. In particular, the federal government is likely to be closely involved for many years in winding down Fannie Mae and Freddie Mac's $5.5 trillion in mortgage-related assets and guarantees, even if a smaller government role in supporting new mortgage origination eventually emerges. The sale or transfer of these obligations to private investors in the near term is infeasible, as it would swamp the market, potentially causing a sharp increase in mortgage rates.
The Importance of Federal Credit Programs
Americans have a major stake in the federal credit programs, because the programs affect so many citizens in so many ways. Millions of Americans rely on government credit to buy a house, run a farm or small business, or attend college or for some other purpose. Millions more work for, or own stock in, a company that benefits from government lending, such as for energy projects, exports and imports, investment overseas, or support of a small business. Others work in the housing industry or another field where government loans are critical to sales. There are yet others who work for a bank that accepted money or other federal support during the recent financial crisis.
Still more Americans work for, or own stock in, businesses that compete with or cooperate with government lending programs, such as banks and other financial institutions. The profitability and growth potential of these firms is often heavily affected by the government's actions. Some government partnerssuch as Fannie Mae and Freddie Macwere extremely profitable for years because of their close government connections. Other firms have benefited from contracts to work with the government. Sometimes, however, the government displaces business that would otherwise go to the private sector, such as when it lends directly, eliminating the role of banks.
Americans as taxpayers also bear the considerable cost and risk of the government's lending programs: they are currently committed to more than $8 trillion in loans and guarantees. Most of this will be repaid with interest, but not all, so it is critical that the credit programs be run well. The loss of even 10 percent of the total commitment would represent an almost $1 trillion hit to taxpayers. According to the fiscal year 2012 budget proposal, the government budgeted a subsidy of $75 billion for its credit programs between 2009 and 2012. But this figure does not take into account the likely loss over time stemming from programs run by Fannie Mae and Freddie Maca loss that some analysts have projected to be as high as $400 billion, once the dust settles on the housing crisis.
Credit availability is also a major driver of economic activity, affecting everyone in the nation. The recent recession and the current sluggish recovery were caused in great part by a substantial contraction in credit, which has not completely reversed. To counteract the decline in private sector loans, the government has given trillions of dollars more in credit than it supplied even four years earlier. The government's credit support also shifts the composition of lending significantly toward favored areas such as housing. This can be good, if it promotes valid public purposes, but it can also be bad. For example, most analysts believe that the government went overboard in recent years in promoting homeownership and that this was one significant factor in the housing bubble that helped create our recent severe financial crisis. At a still more detailed level, the way in which the government lends can have substantial effects on the particular sectors it supports. Looser or tougher government requirements can encourage or discourage certain types of activities that are reliant on borrowing.
Policy and Political Reasons for Federal Credit Activity
Why do we have such large lending programs when a strong national consensus maintains that the government should not conduct business activities? There are both policy and political reasons why federal credit programs can make sense; these are listed below and expanded on in chapter 2.
Proponents of credit programs virtually always justify their existence on the basis of one or more market failures, such as the private sector's failure to act efficiently, to the detriment of society, or to take into account ways in which certain loans might provide larger societal benefits. For example, the ways in which financial institutions are organized or operate can make it difficult to offer certain types of loans that would in fact be worthwhile. Private financial institutions are not well suited to make long-term, uncollateralized loans to individuals, for instance, which is one strong justification for the federal student lending program. The private sector is also prone to booms and busts; the resulting collapse of credit availability can exact a severe economic cost for the nation as a whole. Many of the major federal credit programs began as a response to the collapse of private financial institutions and markets in the Great Depression. Similarly, the most recent financial crisis brought a flurry of additional programs to substitute for failing markets. Finally, financial institutions and markets are run by humans who can fall prey to prejudices that lead them to avoid certain economically sound transactions.
In other circumstances, private lenders may be acting sensibly and efficiently in their own narrow interest, but fail to make loans that would be good for society as a whole. For example, student loan programs benefit the economy by encouraging a highly educated workforce. Since many of these societal benefits could not be captured directly by the lenders, there is a need for the government to lend directly or to encourage lending through guarantees or other incentives.
In addition, lending in new areas or through innovative products can be hindered by lack of sufficient information to adequately evaluate the risks a lender is taking on. A federal program, such as the Federal Housing Administration in the Great Depression, can be used to demonstrate the feasibility of a new approach, and its experience can provide data for the private sector to use to repeat the success.
There are also counterarguments weighing against the establishment of federal credit programs. Sometimes the market failure could be cured more efficiently through regulation, information gathering by the government, or outright grants to encourage certain activities or redistribute wealth. Even if an alternative solution is not feasible or desirable, the costs and problems associated with federal credit programs may outweigh the benefits.
For example, political and bureaucratic barriers exist to making sound credit decisions in these programs. In particular, it is difficult for government programs to deny credit or charge more for it based on differences in the level of risk between different applicants. This adds to taxpayer costs and decreases the efficiency with which financial resources are allocated in the economy. It can also be quite hard to eliminate a federal program if the situation changes and it is no longer needed.
There are also more subtle costs to federal credit support. Federal credit programs tend to increase the total amount of credit offered to the private sector, but they also redistribute credit toward favored sectors and away from the rest. Worthy projects in non-favored sectors can find funding more difficult and expensive. In addition, encouraging an activity such as attending college tends to increase the price for that activity, as a simple function of supply and demand. One of the reasons for the persistent inflation of college costs is the ready availability of federally supported credit to pay the higher tuition bills.
Whatever the policy arguments, politics usually favors the creation of new federal credit programs as the solution when there is a perceived problem in the economy or markets. Credit programs can appear to provide much more impact for each dollar of budget cost than other government responses. Politicians can announce a $10 billion loan program for the same economic cost as, perhaps, a $1 billion grant program. Even better, from their point of view, they can use optimistic assumptions to assert that there would actually be little or no cost, which is difficult to do with a grant program or a tax break. The biggest political obstacle tends to be the resistance of existing lenders, but this opposition can often be co-opted by running the program as a guarantee program supporting private lending rather than a direct government lending program. This still leaves room for opposition by groups that believe government should not get involved, but they might well object to any program to direct resources to the favored sector and therefore may not exert additional political pressure to avoid lending as the tool of choice.
Tools Available for Providing Credit
The government has essentially four ways of aiding credit markets. It can directly lend money, guarantee loans made by the private sector, create or assist a market in purchasing loans that have already been made, or work through a partnership between the public and private sectors, such as a government-sponsored enterprise like Fannie Mae.
Direct lending can be the cheapest and most straightforward approach, and one that takes advantage of the government's low borrowing costs. However, government bureaucracies are not well designed to make complex credit decisions or to step in when a borrower becomes troubled, and they are subject to political pressures to underprice their loans and to favor borrowers in other ways. Programs that insure or guarantee repayment of private loans can partially avoid the problems of public sector lending by enlisting the profit motive of private lenders. A full or partial government guarantee of the repayment of principal and interest can be a strong incentive to lenders to make loans to a particular sector. (There may also be an interest rate subsidy offered to the lenders to encourage lower rates for borrowers.) If the program is structured to retain incentives for lenders to favor good borrowers, such as by offering only a partial guarantee, then the government can theoretically benefit from the private sector's ability to allocate credit to the best borrowers. On the other hand, private lenders may end up with too little at stake to apply their normal credit judgments. They will also have incentives to maximize the explicit and implicit subsidies they receive from the government, including the ability to lobby for changes that increase their profits.
Decades ago, the government played an important role in creating or expanding secondary markets, where lenders could gain liquidity by selling their loans. The ability to sell loans as needed made it easier and less risky to offer loans in the first place. This tool of government intervention has become less necessary as the private sector has improved its ability to create these markets on its own, leaving few opportunities for the government to do it better. Nonetheless, the government remains a major guarantor of secondary market activity, partly for historical reasons.
The government can also charter private corporations, which receive special privileges in exchange for taking on duties to the public. Most notably, Fannie Mae and Freddie Mac are government-sponsored entities focused on the housing sector. However, the recent massive financial disasters at those two entities make it unlikely that new partnerships will be entered into for some time.
History of Federal Credit Programs
The major government credit programs were, in general, born out of crisis, particularly as a response to the Great Depression. (Chapter 3 elaborates on this point.) There was relatively little federal credit activity from the founding of the republic until the creation of the Federal Reserve System in 1913. (Although one does not generally think of the Fed as a credit program, its original role, and still an important one, was to stand ready to make collateralized loans to banks that were experiencing runs by their depositors. Lately, of course, that credit role has temporarily expanded to include a much wider range of activity.) The Fed's birth was a delayed response to the Panic of 1907, which underlined the need for a true central bank in America.
Farm credit was the next area of federal intervention, with legislation in 1916 that authorized the establishment of cooperatively owned federal land banks, aided by federal seed money of $125 million, a significant sum at the time. This cooperative system was bolstered in 1923 by further federal legislation establishing another level of credit providers, the intermediate credit banks. In 1929 the federal government crossed the Rubicon by authorizing its first pure credit program, the Federal Farm Bank, which was allowed to lend up to a total of $500 million to support farmers.
The Great Depression, which started in 1929, was a watershed event for federal credit programs. It caused many financial markets to function so badly, and so obviously badly, that there was a clear reason for massive federal intervention. This led to the initiation of a number of major credit programs for housing, the expansion of the farm programs, and the creation of substantial new business lending initiatives. Thus three of the four biggest areas of federal credit activity were sparked by the Great Depression or substantially augmented in response to the problems of that period. Equally important, the Depression sounded the death knell for longstanding views that the federal government should essentially stay away from business, regulating as little as possible and avoiding any direct business activity, except in rare cases. After the Depression and the ensuing world war, the public and politicians were much more willing to consider federal intervention in business matters, including direct participation as a credit provider.
That said, the passing of the economic and military crises did lead to some retrenchment of federal credit activities in the 1950s as the private sector reasserted its desire and ability to provide the necessary financing for the country. During this period the Reconstruction Finance Corporation, which had provided credit widely to businesses, was cut back to leave just the Small Business Administration and the Export-Import Bank. Both of these were deemed to meet special needs that the private sector was not in a position to fill completely.
Excerpted from UNCLE SAM IN PINSTRIPES by DOUGLAS J. ELLIOTT Copyright © 2011 by THE BROOKINGS INSTITUTION. Excerpted by permission of BROOKINGS INSTITUTION PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents
1 The Federal Government as Banker....................1
2 Theoretical and Political Underpinnings of Federal Credit Programs....................19
3 History of Federal Credit Programs....................46
4 Overview of Federal Credit Programs....................53
5 Costs and Benefits of Federal Credit Programs....................67
6 The Emergency Federal Credit Programs....................83
7 Policy Implications of the Emergency Credit Programs....................103
8 Improving Federal Credit Programs....................123
What People are Saying About This
"Federal credit programs are as confusing and misunderstood as they are important. For the past decade, Douglas Elliott has been the conscience of federal interventions in pensions, flood insurance, deposit insurance, housing, and many other financial transactions. Now he has delivered a lucid, timely review and critique of everything from decades-old farm lending to the massive federal response to the 2008 financial crisis. This is a must-read for anyone serious about federal policy." Douglas Holtz-Eakin, president, American Action Forum,
former Director of the Congressional Budget Office
"Doug Elliott provides a comprehensive and insightful look into Uncle Sam's role in the credit business. His book describes a number of past mistakes and current challenges. It also outlines a range of sensible suggestions to help create a better future." David Walker, founder of the Comeback America Initiative, former Comptroller General of the United States
"In this timely book, Douglas Elliott provides an insightful analysis of the pervasive but underappreciated role of the federal government in U.S. credit markets. Uncle Sam in Pinstripes is a must-read for anyone who wants to understand the reach of federal credit policies and the challenges that they create." Deborah Lucas, Sloan School of Management, Massachusetts Institute of Technology, former Chief Economist for the Congressional Budget Office
"This is an extremely useful analysis of important, but too-often ignored,
government interventions in credit markets." Rudolph G. Penner, Urban Institute, former Director of the Congressional Budget Office