The job fell to me, as it does at times, to do a radio interview. And the topic was — what else? — Fannie Mae and Freddie Mac and the state of the banking system in the United States.
While preparing for this interview, I felt an unusual sense of foreboding.
Why was this, I wondered? My usual attitude going into such exchanges is one of optimism, because the message of economics is essentially optimistic. And I am optimistic — about the economy, its resiliency, and the good times ahead, no matter the current state of affairs. Life is too short for despair, and my study of the economy rarely justifies it.
But not this time. I could not think of much positive to say about Fannie and Freddie, the quasi-public entities that purchase mortgages from banks for resale to investors as mortgage-backed securities, nor about the quality of the political and professional class calling the shots now that they are insolvent, nor about what was likely to result from the proposed solutions to their problems.
Also, this is a complex issue — one that is not well suited for radio, where matters requiring deep thought or reflection tend not to work. Trying to describe this banking crisis recalls the proverb of the blind men trying to describe the elephant. They each latch on to a particular part, describe it correctly, and walk away with completely different and insufficient explanations for what an elephant is all about.
Some History First
There were enough confused people out there misdiagnosing this issue, and making it worse, that I thought I had to get my two cents in. So I resolved to tell the host what I knew about the history of Fannie and Freddie and what brought us to the situation we are in today. It is easy to say today that FDR was wrong to start Fannie Mae back in the 1930s to promote home ownership through a banking industry that he had effectively demonized.
In my opinion, with all of the crowding out that the New Deal programs were causing — meaning the upward pressure on interest rates resulting from the government’s raiding of the loanable funds market to finance an unprecedented expansion of government — Fannie was created to avert the political backlash against the unintended effects of 1930s-era economic policies.1
From the beginning, first Fannie and then Freddie (which was created in 1970) served the purpose of shielding the public from the adverse effects of expansive government — and bad fiscal policy in particular. This makes government relatively more tolerable to the rank and file.
The creation of both entities, I told the host, was a mistake, because it created greater investment in housing and home ownership than would have been justified by market forces. The result is an inefficient use of resources — a malinvestment. Furthermore, entities like Fannie and Freddie forced out private firms that otherwise would have satisfied the demand for housing, but couldn’t, because they lacked the preferential treatment from which Fannie and Freddie benefited, especially in terms of taxes and regulations.
By the 1960s, Fannie was turned into a GSE — a government-sponsored enterprise. (Freddie was created as a GSE from the beginning.) This structured their operations so that they would become more like private firms, required to offer stock and compete in the marketplace, with the understanding that they would finance themselves out of their own profits. This is not an arrangement that has worked well for the post office or Amtrak, but with the first of the baby boomers getting their starter homes, and then later when the dollar’s last remaining ties to gold were severed, it worked better for Fannie and Freddie, especially since they were allowed to maintain some of the privileges denied their competitors.
For most of their history, Fannie and Freddie were (in my opinion) relatively benign. They never should have been created, but they didn’t do much harm. This would change in the 1990s, when they became big players in the economy. That is when the current problems began.
This is when a man who came from a working-class family in Seattle became the head of Fannie Mae, and its purpose seemed to change. Franklin Raines was a political appointee and operative, and during his reign, Fannie and Freddie’s importance to the political class changed. There was, it seemed to me, an agreement that emerged that in exchange for political support, Fannie and Freddie would target mortgage activity by congressional districts. What’s more, certain parts of the country that were facing adverse economic times could also receive an influx of credit, thanks to Fannie and Freddie’s efforts. They weren’t lenders of last resort — that was the Fed, of course — but they could make sure that by aggressively targeting where mortgages would be bought up, they could enhance the short-term economic effects of money creation, by state or region.
Also under Raines, Fannie and Freddie began taking on riskier investments, including a large exposure to financial derivatives, based on the assumption that their growing political importance meant that they would not pay the full price if such investments failed. Their protected status made for a good deal for investors, who stood to profit if these investments increased in value, but a bad deal for taxpayers, who assumed the risk if they didn’t. It was this exposure that cost Raines his job eventually, although he exited Fannie a multimillionaire. Who says public service doesn’t pay?
Nonetheless, Raines established Fannie (and Freddie by extension) as indispensable to the political class.
Then 9/11 happened.
Crisis and Leviathan
By now, I wonder if I have lost my host. Is he nodding off over there in the studio? No, but it is time for a commercial break, and he still wants to go into how we got to the current situation. During the break, I wonder how I can improve my presentation. This is, after all, economic history, and practically dry by definition. Would a football analogy work? Is there even one that would apply?
I pondered this point until the commercials ended and we resumed our discussion. I told the host that after 9/11, an insecure federal government — with its credibility threatened — embarked on one of those expansions of the state that have become both predictable and generational. As with the Progressive Era, the New Deal, and the Great Society, the United States was due for another period of government expansion, and the Federal Reserve stood ready to abet it by allowing the largest increase in the money supply in its history. Money went out into the banking system, and banks were flush with excess reserves, allowing new money to be created out of thin air (through multiple deposit expansion, which I failed to define for the listeners).
It was sort of a Hail Mary, I said, in reference to the football play. The host thought I meant the prayer, and I resolved to leave sports analogies to sports shows. They are beyond my competence.
But the growth of government in the 2000s expanded the welfare, warfare, and corporate states — and with a vengeance. Such efforts always create malinvestments, class division, dependency, and unforeseen consequences; to counter these effects, Fannie and Freddie grew even more important to the political classes.2 They continued targeting spending to politically important regions while taking on risky loans that were necessitated when all that new liquidity showed itself in a housing bubble.
The bubble priced middle-class workers out of the housing market, thus creating adverse selection for lenders. Middle-class wage earners may leave California if they can’t afford the $400,000 for old houses that might have been priced in the five figures just two years before. It doesn’t take much use of the old gray cells to know that there’s increased risk that they will default on their mortgages. Under normal circumstances, the banks wouldn’t approve them. But since California is — among other politically important regions in the country — an important electoral state, banks made many of these loans. They could only do this because of the knowledge that Fannie or Freddie would take those loans off their books.
Such activity fed the housing bubble, as Fannie and Freddie took on a growing number of increasingly risky loans. Complex hedge funds, employing sophisticated algorithms to help balance risk, started buying them as well, even when the bubble grew to the point at which housing could only become affordable through riskier, adjustable-rate mortgages, some of which did not even require proof of income. Such risk was welcomed, and if it could have been balanced, it would not necessarily have been a bad thing.
But in this case it was a bad thing, because so many loans went into default. The result is that Fannie and Freddie are bankrupt today, along with many banks. I went through this history, and my patient host announced another break. When we returned, he asked me to discuss the proposed solutions.
What Now?
This was the part of my interview that I had been dreading. Up until then, I had played the role of economic historian, but my less-than-optimistic side, which rarely shows up, was about to rear its ugly head.
The fact is that I think I have a pretty good idea of what needs to happen. Fannie and Freddie should be shuttered. Their corporate ownership should be subjected to the Enron treatment, and their assets should be auctioned off to private mortgage guarantors. Also, the Fed’s complicity in this affair needs to be made well known, especially the role of one former Fed chairman who encouraged the use of subprime mortgages in the early 2000s. In hindsight, his statements look like desperate attempts to minimize the adverse effects of his post-9/11 monetary policies and shield himself and the political establishment from the backlash that rightly follows periods of monetary inflation.
This is my optimistic scenario. Think of the housing market that would follow. As housing prices adjust downward, the role of housing as a middle-class inflation hedge would end. Millions of mortgage holders would foreclose, and many millions more would find themselves upside down. This would be a disaster for many, sure, especially for undiversified households with equity primarily in their houses. But consider the upside as well. Housing would become affordable, which would be a true godsend compared to both today’s market and what will follow if Fannie and Freddie are bailed out. What’s more, the quality of mortgages after the bubble bursts would be much better than what exists today. Imagine: a mortgage market dominated by debtors of financial means! There would be short-term pain in the economy, but in the long run the housing market would be sustainable again, and general prices would fall, thus raising real incomes. The Fed, if it survives, would be more chastened and independent than it has been in many years.
Besides, sticking the knife into Fannie and Freddie is the kind of market reform that the United States regularly urges developing nations to carry out, sometimes even requiring it in exchange for foreign aid. The US economy would reap huge dividends. As Joshua Rosner wrote recently in the Financial Times,
Instead of protecting those who made bad bets, we should use our rule of law to address the situation. That would mean we allow weak players either to fail or to reorganize through an orderly transfer of good assets from weak hands to strong hands. This would protect the once-mighty US dollar and affect the necessary repricing of assets to sustainable equilibrium. Doing so would also decrease moral hazard and send a strong message of faith in our great system as the model for global financial advancement.
But, unfortunately, I do not see the situation resolving itself in this manner. What I see instead is another case of Westley’s Law: the public sector is held to lower standards than are applied to the private sector, and the government will grow as a result. Instead of roadblocks placed on the road to serfdom, we’ll be greasing the skids.
So I became, on the radio, for the first time in my professional capacity, a grumpy economist. Fannie and Freddie are going to be bailed out by taxpayers, I told the host, and the resulting inflation will make a weak dollar weaker and prop up corrupt banks that market forces would otherwise force out of business. Congress will hold hearings next year to demonize the productive, to find scapegoats (will Volcker be reappointed to the Fed?), and to otherwise deflect attention from its role in this mess, while wealthy investors who deserve to lose their shirts will be bailed out by the hapless taxpayer (again). A U-shaped (prolonged) recession will sink in some time after the November elections. Indeed, if it weren’t for the impending elections, the political classes would have given in to the economic inevitable months ago.
Every economic crisis creates an opportunity to allow market order to reassert itself. The current case is no exception. But such crises are more often seized as opportunities to expand the level of state intervention in the economy, even when previous episodes of intervention caused the current crisis. Fannie and Freddie should be shut down. The bad news is that, at great cost, they won’t be.
I hope I am wrong. It has happened before. But what made me think this message would make for good radio?
- 1The Great Depression can be considered a market correction that was extended unnecessarily for 17 years by government policies designed to thwart the downward pressure on wages and prices. In the same way, the creation of Fannie and Freddie can be viewed in an opposite manner, as Depression-era institutions created to thwart the upward pressure on interest rates.
- 2
Associated Press noted last Thursday, “For years, mortgage giants Fannie Mae and Freddie Mac tenaciously worked to nurture, and then protect, their financial empires by invoking the political sacred cow of homeownership and fielding an army of lobbyists, power brokers and political contributors.” See Tom Raum and Jim Drinkard, “Battered Mortgage Giants Spent About $186 Million on Lobbying, Political Contributions,” Newsday.com, July 17, 2008. Raum and Drinkard add
“They have always understood that the political risk was huge for them, and they put millions of dollars into using contributions, jobs and consulting contracts to stay in the good graces of people in power,” says Wright Andrews, a veteran banking lobbyist. “They had both parties — and particularly the Democrats — under incredible control.” To help keep themselves free from unwanted regulatory and congressional prying, the two mortgage giants have surrounded themselves with scores of well-connected allies. Fannie Mae’s 51-member lobbying stable, according to its most recent disclosure, includes former Reps. Tom Downey, D-N.Y., and Ray McGrath, R-N.Y.; Steve Elmendorf, a Democratic political strategist and former congressional aide; and Donald Fierce, a longtime GOP operative. Freddie Mac’s list of 91 lobbyists includes former Reps. Vin Weber, R-Minn., and Susan Molinari, R-N.Y.
