The Role of Fannie and Freddie
An older article, but relevant.
It is important to understand that, as GSEs, Fannie and Freddie were viewed in the capital markets as government-backed buyers (a belief that has now been reduced to fact). Thus they were able to borrow as much as they wanted for the purpose of buying mortgages and mortgage-backed securities. Their buying patterns and interests were followed closely in the markets. If Fannie and Freddie wanted subprime or Alt-A loans, the mortgage markets would produce them. By late 2004, Fannie and Freddie very much wanted subprime and Alt-A loans. Their accounting had just been revealed as fraudulent, and they were under pressure from Congress to demonstrate that they deserved their considerable privileges. Among other problems, economists at the Federal Reserve and Congressional Budget Office had begun to study them in detail, and found that — despite their subsidized borrowing rates — they did not significantly reduce mortgage interest rates. In the wake of Freddie’s 2003 accounting scandal, Fed Chairman Alan Greenspan became a powerful opponent, and began to call for stricter regulation of the GSEs and limitations on the growth of their highly profitable, but risky, retained portfolios.
The continuing notion that the credit crisis is a result of free markets is just laughable when you have the CRA, Fannie Mae, and Freddie Mac involved in the markets. The governments grubby paw prints are all over this mess. It isn’t the only contributing factor but to say, “Oh it is free markets,” is the liars position.
If they were not making mortgages cheaper and were creating risks for the taxpayers and the economy, what value were they providing? The answer was their affordable-housing mission. So it was that, beginning in 2004, their portfolios of subprime and Alt-A loans and securities began to grow. Subprime and Alt-A originations in the U.S. rose from less than 8% of all mortgages in 2003 to over 20% in 2006. During this period the quality of subprime loans also declined, going from fixed rate, long-term amortizing loans to loans with low down payments and low (but adjustable) initial rates, indicating that originators were scraping the bottom of the barrel to find product for buyers like the GSEs.
I see this in my work except in reverse. We call it signing up all the “low hanging fruit” for a given rate schedule. Eventually the new additions start to tapper off as all that is left are the “fruit” higher up in the tree.
In fact I’d even go so far to say that complaining about deregulation is missing the point many that many who oppose government involvement are making…or at least my view. My view is that government has a significant problem with discretionary policy (see here as well). The problem is that even with a government that is run by a benevolent dictator a policy that is preferred today will not necessarily be preferred in the future and hence people will not believe announced policies and sub-optimal outcomes result. For example, the government announces it is going to reduce inflation in the future, say next month. When next month arrives the government might now be reluctant to reduce inflation since doing so would raise unemployment. Since individuals are forward looking and once they realize this monetary policy becomes a much less effective tool. Potential result: stagflation–high inflation and unemployment. And this is the situation with a benevolent dictator–i.e. a government that really is concerned about the welfare of each and every citizen. Add in things like rent seeking (see the research of Buchanan and Tullock) and interest groups (see the research of Olsen) and it becomes even more of a mess.
So my beef isn’t that there is too much regulation or not enough regulation but that this idea that we can find just the right amount of regulation is not going to be possible in a discreationary policy regime. Such a regime is going to be subject to the problems of time inconsistency, rent seeking, and interest group pressures. Not only that but there are the problems with the beliefs and views of the electorate. Bryan Caplan lists four views that the general public/electorate tend to have that can result in bad economic policies.
- Anti-market bias,
- Anti-foreign bias,
- Make work bias,
- Pessimistic bias,
All of these biases will have an impact on elections, the candidates and the policies they will want to implement.
Overall my view is that government implements bad policies. Policies that redistribute misery, reduce incomes, and generally fail. Now this doesn’t mean that the market is going to result in nirvana or a utopia, but that we wont have systematic errors that can be very large like the current financial crisis, or the last very serious economic crisis the Great Depression.1 From 1854 to 1919 ther were 16 recessions, from 1919 to 2001 there were…16 recession. Why 1919? That was shortly after the creation of the Federal Reserve system which was to address banking panics. Never mind that less than 20 years latter we’d undergo one of the worst banking panics and financial crises in the country’s history. My view is that we should reduce the size and scope of government’s involvement in markets because their track record isn’t really all that good. With the current crisis the current reaction is to go in precisely the opposite direction despite evidence that it will probably not only not help, but may make matters worse.
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1My view is not that the government caused the Great Depression all by itself, but that government officials made a bad situation worse with such policies as the Revenue Act of 1932. That act raised taxes on people who made, in todays dollars, $96,000. Sound like one of the Candidates tax plans?
The Role of Fannie and Freddie: An older article, but relevant.
It is important to understand that, as .. http://tinyurl.com/6flp37
The Role of Fannie and Freddie: An older article, but relevant.
It is important to understand that, as .. http://tinyurl.com/6flp37
Exactly so.
And so, McCain’s blaming it on ‘wall street greed’ is as much nonsense as Obama’s position.
If it were only the bad loans that were causing the problem, your point would have more force. However, what is causing the systemic problem are the credit default swaps and the amount of unregulated leverage. So while “It is only the free markets” is a liars position, “the free markets made things far worse” is not.
The “mark to market” rules of the SEC helped drive the credit default swaps debacle. If these loans could have been properly valued we could have avoided those swaps and the ensuing panic.
The SEC and the AICPA failed to foresee this accounting blunder and offer better/alternative methods for valuation.
Steven,
Not buying that explanation, especially since Fannie Mae and Freddie Mac were involved in the CDS market as well.
Oh and Steven D. the CDS market was deregulated with the The Commodity Futures Modernization Act of 2000, so even if you are right, it only supports my initial point that government just can’t seem to get the right level of regulation. Add in the governments willingness to bail out entities like Fannie and Freddie and even some private insitutions and you compound the problem with moral hazard. So I reject your claim that “the free market made it worse” since it really wasn’t all that free when you know Uncle Sugar is going to bail you out of stupid mistakes.
Steven P.,
My first comment was aimed at Steven D. not you.
Steve V: Once before I asked how you felt the CDS’s fed into this mess but I did not get your answer before I lost track of your original post.
Can you please elaborate now or repost what you you answered?
If I recall correctly, I was reading your position as: gov’t reg- “bad”, bussiness- “good”, gov’t- get out of the way.
Your position seems to be a little more nuanced now.
I don’t believe I did, or if I did what my answer was.
My position is essentially unchanged. I don’t think government does what many think it does–try to promote the common good. I see the current crisis as a failure of government, not simply that there was too much, too little or whatever amount of regulation, but that the very notion itself is just not viable.
Here is one, maybe the CDS market so grossly of whack because people knew the government would intervene?
I dont remember anyone ever saying Fannie and Freddie had no role. However, any explanation you put forward needs to account for both its timing and its international nature. There was no Freddie and Fannie in the rest of the world. The timing does not match up for F and F as the biggest factors. The change in lending standards coupled with lots of money to invest and low interest rates would seem to be more important. None of it worked w/o the AAA ratings that were tossed out. This was the result of a long line of bad decisions. Attempts to blame it all on F and F are merely partisan.
Steve
Steve,
I don’t believe I said Fannie and Freddie where the only cause, but they sure did play a significant role with the securitizing of mortgages, snapping up lots of the sup-prime/alt-A loans, and couple that with the fact that they were backed by the government and you have a potential for a very serious problem.
Yes low interest rates and changes in lending standards played a role, but as the article notes Fannie and Freddie wanted some of those too–all the low hanging fruit had already been picked. To keep the thing going you had to make increasingly questionable loans.
Really very typical of a bubble, why this is such a problem for some I don’t know. But the fact remains the government certainly did aid and abbet this bubble’s growth if not its formation. Maybe it is that most people have grown up thinking that FDR and the government saved us from the Great Depression when that isn’t the case at all. In fact…Fannie can trace its origins back to the New Deal. Interesting that these two crises would be linked this way, no?
thanx steve
Bad wording on my part. I should have said, “I now read your position…”
Been trying to get my head wrapped around this for about a week now and found the BH 2002 report on line. (I am sure you have read it). In it Warren Buffett said something along the lines of, the accounting method used allowed valuation errors that allowed the traders and the CEO’s to report “impressive earnings”, and thereby allow them to claim rather substantial bonuses, when in fact there were no real earnings. The stockholders get stuck holding the bag.
In other words, “Who cares? I got mine.”
ps: anybody else interested in reading it the relevant part starts on page 13, under the heading “Derivatives”