In Fannie Mae and Freddie Mac rescue, Schwarcz sees implementation of key proposal

September 12, 2008Duke Law News

Sept. 12, 2008 -- As part of its rescue of mortgage giants Fannie Mae and Freddie Mac, the United States Department of the Treasury has agreed to purchase their securities to the extent investors do not do so. The aim of this measure, announced on Sept. 7 by Treasury Secretary Henry Paulson, is to stabilize the mortgage-backed securities markets and lower mortgage rates by reducing the interest rate these securities have to bear in order to attract investors, explains Professor Steven L. Schwarcz.

Duke’s Stanley A. Star Professor of Law and Business, Schwarcz is particularly pleased by the announcement, as it means the Treasury is prepared to act as a market liquidity provider of last resort in order to stabilize financial markets. This is a role for which he has advocated strenuously for more than a year as the subprime-mortgage and credit-market crises have unfolded, in several scholarly articles, in testimony before Congress, as an academic adviser to the Federal Reserve Bank of Cleveland, and in op eds and speeches, among other venues. “It is the first time the U.S. government — or, to my knowledge, any government — has agreed to do this,” says Schwarcz.

“As the source of corporate financing is shifting from banks to financial and capital markets, it becomes more and more critical to focus on protecting these markets to limit systemic risk,” says Schwarcz. “But until now, central banks and government officials have been focusing on institutions, not markets per se.”

The government, for example, has occasionally acted as a lender of last resort to banks and, more recently, to “near-banks” such as Bear Stearns. Acting in that capacity introduces a more serious risk of moral hazard, says Schwarcz, by potentially encouraging these entities — especially those that believe they are “too big to fail” — to be fiscally reckless. Also, loans made to these entities will not be repaid if the entities eventually fail.

In contrast, says Schwarcz, a market liquidity provider involves much less risk. “By investing in securities of panicked markets, a market liquidity provider can dampen the over-amplification of ‘marking to market’ that can lead to market collapse,” says Schwarcz (noting that marking to market is the otherwise beneficial requirement that a securities account be adjusted in response to a change in the market value of those securities). Furthermore, especially if it acts at the outset of a market panic, “a market liquidity provider can profitably invest in securities at a deep discount from the market price and still provide a ‘floor’ to how low the market will drop,” he says.

“For example, in the subprime crisis, in many cases the present value of the expected value of cash flows on the mortgage assets underlying mortgage-backed securities is almost certainly greater than the market value of those securities,” Schwarcz says. “This reflects that investors are panicked, so market prices are artificially low.” Buying at a discount then can even yield the market liquidity provider — in the case of Fannie Mae and Freddie Mac, the U.S. Treasury — a profit, he adds.

One might ask why, if a market liquidity provider can invest at a deep discount to stabilize markets and still make money, private investors wouldn’t also do so? “The answer, at least in part, is that individuals at investing firms may not want to jeopardize their reputations and jobs by causing their firms to invest when others have abandoned the market,” says Schwarcz. “Empirical evidence confirms that individuals often engage in this type of ‘herd behavior.’ A market liquidity provider may be needed to correct these market failures.”

Schwarcz believes that, had a market liquidity provider been in existence when the subprime crisis first started, “the resulting collapse of the credit markets would almost certainly have been restricted in scope and lessened in impact.” He is also continuing to advocate for an even broader role, long term, for a market liquidity provider. Financial markets rely critically on the supply of liquidity in the form of credit,” he writes in a forthcoming paper, “Complexity as a Catalyst of Market Failure: A Law and Engineering Inquiry.” A market liquidity provider “not only can reduce the chance of financial market collapse by restoring liquidity but also can de-couple the chance that a failure in one market will trigger a failure in other markets.”

Professor Schwarcz’s scholarship on this topic and on the subprime-mortgage and credit crises includes the following:

“Systemic Risk,” forthcoming 97 Georgetown Law Journal, issue no 1. (2008), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1008326.

“Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown,” forthcoming 93 Minnesota L. Rev., issue no. 2 (2008), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1107444.

“Markets, Systemic Risk, and the Subprime Mortgage Crisis,” forthcoming 61 SMU L. Rev. issue no. 2 (June 2008) (essay expanded from his 2008 Roy R. Ray Lecture at SMU Law School), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1102326.

“Disclosure’s Failure in the Subprime Mortgage Crisis,” forthcoming Utah. L. Rev. (2008) (symposium issue on the subprime mortgage meltdown), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1113034.

“Complexity as a Catalyst of Market Failure: A Law and Engineering Inquiry” (work-in-progress).
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