Bailing Out Fannie and Freddie
How do the bailouts of the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association affect us?
Congress and regulators gave the GSEs a regulatory advantage in purchasing investment-quality loans, meaning loans to highly-qualified borrowers making substantial down payments (20 percent of the value of the home to avoid having to pay for mortgage insurance, or 10 percent of the value of the home if additional private mortgage insurance was obtained). Through regulatory differences, primarily in the form of capital requirements, banks were put at a disadvantage relative to the GSEs when it came to holding investment-quality loans.
However, the GSEs have recently suffered large credit losses on loans that were not of investment quality. These low-down-payment loans were similar to the subprime mortgage loans that fueled the boom and bust cycle in housing. It is not clear why the GSEs chose to purchase these loans, since they are outside of the GSE charters. One story has it that they were afraid of losing market share. Another story I have heard is that the GSEs were under pressure from Congress to do more to provide funds for “affordable housing,” and the GSEs interpreted this as requiring more high-risk lending.
As a result of these high-risk loans, the GSEs ran into difficulty, reporting large losses. This in turn made investors nervous, so that the interest rates that the GSEs had to pay to borrow in order to fund their portfolios went up. Historically, the GSEs had been able to pay unusually low interest rates so that they could afford to hold assets with lower rates of return than other institutions, such as banks, could afford.
Once investors lose confidence in a GSE, it can only sell its assets to institutions that have higher borrowing costs, which means that it has to sell them at a loss. As I wrote last Thursday, “Liquidation is not an option.”
In hindsight, Freddie and Fannie were allowed to grow too large. They used political connections to fend off any attempt to rein them in, as can be seen in a 1997 story on James Johnson, then-chairman of Fannie. More on the political/regulatory history of the GSEs can be found in a Washington Post article from July 14th.
The plan that Treasury Secretary Paulson announced on Sunday appears designed to shore up the GSEs and to return to the status quo prior to the recent loss of confidence by investors. In fact, however, I think it is unrealistic and undesirable to return to the status quo.
If you had it to do over again, you would not allow the GSEs to become more than 50 percent of the mortgage market. Instead, you would create a system that diversifies mortgage finance across many institutions. The “regulatory arbitrage” that the GSEs enjoyed should be replaced by a level playing field, which reduces the capital requirements for banks to hold investment-quality loans while increasing the capital requirements for GSEs should they continue to stray out of the arena of low-risk, high-quality mortgages.
In my opinion, the playing field should be leveled as soon as possible so that banks can begin to buy assets from the GSE’s. Let the banks feed off the carcasses of Freddie and Fannie, just as Freddie and Fannie once fed off the carcasses of the S&Ls.
More broadly, the GSE crisis is being discussed in the context of a long debate among economists over the role of markets and regulation in the financial sector. On the Left, Brad DeLong and Paul Krugman are trying to portray the GSEs as innocent victims of the wanton behavior of unregulated mortgage lenders, who fueled the subprime boom. Accordingly, their narrative is one of market failure and the need for more regulation.
Instead, I see the GSE crisis as a failure of central planning. The GSEs were the victim of no one, unless you count the meddling by the Congressional meddlers whom the GSEs needed to please. Anyone could see that the GSE dominance of the mortgage market was unhealthy. But the political process was unable to get the job done. What the central planners tend to forget is that political failure is even more entrenched than market failure.
Many (although not all) of the GSEs’ enablers over the past decade have been Democrats. Most of the calls for reining in the GSEs have come from the Wall Street Journal and from conservative politicians.
The Treasury plan shows that the response to a failure of central planning is likely to be more central planning. Intellectually, those of us who prefer markets have a good case. Politically, we are in the process of getting steamrollered. The Treasury plan is being attached to a housing bill that was rife with corporate welfare and unsound subsidies. It ought to be vetoed, but instead it will be fast-tracked.
As a homeowner and a taxpayer, what you should want to see is a sensible housing finance system, without excessive regulation and without expensive subsidies. Instead, what we are likely to see is much more regulation. To offset the costs of these controls, we also can expect an even more Byzantine structure of government subsidies.
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Arnold Kling is an economist who worked at the Federal Reserve Board in the 1980s and at Freddie Mac in the 1980s and 1990s. He blogs at Econolog.
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8 Comments
1. Sue:First, Mr. Kling, let me say that the S&L destruction was caused by bottom-feeders. In the late 90’s and early 2000s’, when the lending market exploded, investment bankers and Wall Street wanted “in” the action and proceeded to get more “flexible” securities and urged the sub-prime market to expand. During that time, many “investment bankers” bought out lending institutions and put them in the position of middle men of originating, funding and then handing off the profits to them. This overheated the housing market and fueled an unreasonable demand for housing for “investors” and anyone who felt that they could make money with real estate, without any experience, except for lying to lenders about their assets and their representatives, brokers, assisting in every way.
Jul 15, 2008 - 7:39 am 2. Jarhead:Now, those who bought in this fashion whine hourly and will get help they should not. Those that lost or are losing their home because there is no longer a market for lending professionals cannot get any assistance. Freddie and Fannie should never have gone private, that allowed the Liberal politicians of both parties to get rich at the expense of the taxpayers…as usual. Someone should check the mortgage of every single politician and their staffers to see just how large was the “Dodd” payback. You would be more than surprised. This methodology is business as usual for the likes of companies like Countrywide.
Dumb question.
Wouldn’t mortgage insurance be required on those low-down-payment loans the GSEs acquired? Shouldn’t the insurance companies be taking the hit?
Were they stupid enough to buy uninsured high-risk loans?
Jul 15, 2008 - 10:05 am 3. David Thomson:“Were they stupid enough to buy uninsured high-risk loans?”
How much of this mess is due to politically correct Democrats forcing lending institutions to provide loans to credit unworthy individuals because of their minority status? Once this ball got rolling—things rapidly got worse. If nothing else, lenders surrendered to avoid further bad publicity. Race hustlers like Jesse jackson pushed them to the wall. Loans inevitably were granted to people who were very high credit risks.
Jul 15, 2008 - 10:33 am 4. purpleslog:“Wouldn’t mortgage insurance be required on those low-down-payment loans the GSEs acquired? Shouldn’t the insurance companies be taking the hit?”
They are. Check out insurers like MGIC from my hometown. They are burning cash reserves fast.
Jul 15, 2008 - 1:47 pm 5. kabud:It is not clear why the GSEs chose to purchase these loans, since they are outside of the GSE charters. One story has it that they were afraid of losing market share. Another story I have heard is that the GSEs were under pressure from Congress to do more to provide funds for “affordable housing,” and the GSEs interpreted this as requiring more high-risk lending.
I heard another story: i heard that `enemy` did it to ruin our financial system.
Even in LENIN’ times it was openly discussed in communist russia as a method to gain world domination: attack on western finance system.
whoever that may be: kremlin, beijing or `islamists`: i think only russians have knowledge and expertise in this, and lots of russians work in finances in US, tens of thousands if not more: just go downtown new york and walk the street you will hear them talking.
I used to work as a head hunter for IT industry in the 90s. We placed dozens of russians and we were a very small agency. I know that many very high profile hedge funds are crawling with russians.
I know a financial organization called Money Garden: these people made their money through the unexpected death of a large investor from moscow who gave them 20 or 40 mil
Well it may be far fetched but it depends on how yuo look at it and what you know. From what i know - they planned it, they have capability to facilitate it, they wanted to do it. I am not sure how though.
Jul 15, 2008 - 4:28 pm 6. wGraves:The insurance companies, AMBAC, MBIA, et. al. are already toast. Oops.
Jul 15, 2008 - 6:03 pm 7. BizzyBlog » The Fred and Fan Folderol:[...] here are excerpts from that better column, by Arnold Kling at Pajamas Media (bold is mine): Fannie Mae and Freddie Mac are known as [...]
Jul 16, 2008 - 3:26 am 8. kabud:IMPORTANT READING HOW American Republic is going to fall VERY SOON. JUST READ IT. THINK.
http://www.financialsense.com/stormwatch/geo/pastanalysis/2008/0718.html
High Finance and Bolshevik Principles by J. R. NyquistIt was Joshua Rosner, writing in the Financial Times on Tuesday, who said it best. “In a capitalist economy, losers are expected to take losses and winners to gain.” But that’s not the way it works today, is it? More than three Decades ago, Richard Nixon famously said: “We’re all Keynesians now.” In 2008 we can go further. If George Bush had Nixon’s grasp of affairs, he would be forced to admit: “We’ve all become socialists, despite our lip service to the free market.”
Rosner says we have begun to nationalize bad assets. From there it is a small step to the nationalization of good assets. In fact, the two things logically entail one another. As Rosner asserts, we have officially lost faith in the market. We have lost faith in the source of our prosperity. We no longer abide the creative destruction of the market process. We do not want the suffering that naturally attends real growth. Good things and only good things are demanded. Losses are unacceptable, even though these always attend genuine achievement. Everybody has to be a winner. In today’s school system we find no child left behind, which exemplifies the ongoing catastrophe in American education.The logic of late capitalism (the declining form of capitalism) calls for the elimination of all suffering (and therefore, the elimination of real growth). This program is the basis of latter-day social democracy, which opposes the market because pain and tragedy are normal to the market system. Social democracy wants a world without failing corporations or banks. It is no wonder, then, that step-by-step they have ringed the market with “protections.” Today’s social democrat (and compassionate conservative) wants the benefits of the market without the pain of market process. The Austrian economist Ludwig von Mises once wrote: “Men must choose between the market economy and socialism. They cannot evade deciding between these alternatives….” No pain, no gain.So there you have it. A decision has been made (and nearly everyone agrees), that pain must be nationalized. Ergo, bad assets must be nationalized because bad assets involve pain. Someone somewhere figured out that nationalizing a thing makes it go away. Take, for example, health care. You nationalize health care and it’s gone. You nationalize any industry and it withers away. Apply this redistributionist principle to all human suffering and, well, you have socialism.The process is logical, based on the human desire for a free pass. And so, we nationalize the losses from Bear Stearns. The FDIC kicks in over IndyMac. Taxpayers must pay for the mega-blunders of Fannie and Freddie. Where will it end? The redistribution of liabilities is the first step. Let everyone hurt a little, with responsibility shifted onto everybody (i.e., nobody in particular). Say goodbye to pain, but also say goodbye to the U.S. dollar.The collectivization of financial loss necessarily entails the collectivization of financial profit. As for freedom itself, the system of government brought in by the Founding Fathers cannot survive a general acceptance of Bolshevik financial practices. According to the Austrian economists, Ludwig von Mises, “Every step a government takes beyond … protecting the smooth operation of the market economy against aggression … is a step forward on a road that directly leads into the totalitarian system where there is no freedom at all.”If only the Bolsheviks had understood the reach of their principles in 1917. Think how differently they would have handled the early Soviet period. Their tendency was to bring about socialism in the clumsiest, most violent way. They put the cart before the horse, got angry when the cart didn’t move and shot the horse. None of this was necessary. All they needed was to wait for bourgeoisie to self-tenderize.
The Bolsheviks didn’t need to storm the Winter Palace or starve the Kulaks. Purges and show trials were completely out of the way. All one needed to create a Union of Soviet Socialist Republics was patience. The capitalists themselves, weakened by their own promotion of hedonism, would inevitably seek refuge in the nationalization of investment risk. Thus, socialism would be installed at one stroke in the name of saving capitalism. There was never any need to arm the proletariat or hang businessmen on street lamps. The businessmen will hang themselves, in due course, by demanding a Soviet style of government. The proper ingenuity of the Communist is nothing more than the anticipation of his victim’s suicidal impulses.One only has to wait for the FDIC to detonate beneath a floundering Republic. If anyone thought U.S. Treasury bonds are a riskless investment, think again. Am I suggesting the U.S. government will default on its obligations? In my opinion, no other outcome is imaginable. If you doubt this conclusion, try to imagine federal, state and local government paying off $10 trillion. It’s not going to happen, as the readiest method of default open to government is the debasement of the national currency. This means an end to American international power – financial and military. It means an end to the old international order, which has existed since 1945.It means global revolution. Wave hello to socialism.
Jul 19, 2008 - 1:09 am