Fannie’s follies, Freddie’s foibles
(posted by Angelica)
In my post, After Greed comes Fear, I excoriated the role of the unregulated market in the current sub-prime mess we’re in. Quasibill cried foul, pointing out quite rightly that the whole concept of mortgage-backed securities started off with Fannie Mae, Freddie Mac and all the rest of those cutely acronym-portmanteau-ed government-sponsored enterprises. To quote ‘Bill directly, “to lay this turd at the feet of “unregulated markets” has the causation entirely backwards.”
My response? I both agree with ‘Bill, and I stand by my post. It is possible for there to be both simultaneously too much government influence AND too little regulation. Read on…
Too often, when libertarians and liberals argue, the conversation gets flattened into a single axis with a totally unregulated market on one side and complete state control on the other. Each participant pick the point on the spectrum that they reckon is optimal, dig in their heels and start playing tug.
However, the reality is considerably more complicated, with all sorts of permutations and combinations of public and private. In addition, a situation with relatively high levels of regulation can have positive or negative outcomes depending on the quality of the regulation. Situation with relatively high levels of market freedom can also have positive or negative outcomes depending on all sorts of things from culture to extant levels of infrastructure to external factors such as what other countries are doing.
Kevin got at this oft-ignore complexity very effectively with his post, Libertarian Self-marginalization. Many of those he terms “vulgar libertarians” find themselves defending all sorts of unsavory institutions such as sweatshops or big-pharma because, argues Kevin, they are ignoring the government distortions that underlies the market that produces those results. They are too busy tugging.
In the case of Fanny and Freddie, what we have is an unholy hybrid of the public and the private that should never had been allowed to live. Bill Mann of the Motley Fool put it really well: “The duality of Fannie and Freddie as publicly traded ventures and government-backed entities is the real conflict.” Any time you have a situation where the profits are private and the risks are public, you can bet that it is a matter of time before the whole thing start stinking to high heaven. And so it proved.
I recommend Mann’s article What does Fannie Mae do highly. It was written back in 2004, but recent events have ensured that it remains compelling. (Of course, Fannie haven’t enjoyed AAA ratings for a while now.)
Fannie Mae doesn’t just hold onto all of these mortgages, though. It will take your loan and package it up with hundreds of others and market them as mortgage-backed securities (MBS) that it then sells to investors (for example, insurance companies, pension funds, or even mortgage REITS like Annaly Mortgage (NYSE: NLY)). Fannie Mae provides a guarantee to these investors that they will receive timely principal and interest payments, no matter what happens with the underlying mortgages. If there are large numbers of defaults, Fannie Mae will have to make the investors whole. If there is a massive crash and defaults overwhelm Fannie Mae, it has an ace in the whole: your tax dollars. Even though the company’s debt offerings clearly state otherwise, the financial markets believe that Fannie Mae’s status as a government-sponsored enterprise implies that the government will provide full faith and credit for Fannie’s debt. It is for this reason that Fannie Mae maintains a AAA credit rating, even though at a 78:1 debt-to-equity ratio it is levered many times what is allowed international banks. (Debt is defined as mortgages on its books plus the value of its guarantees.)
Fannie is exempt from regulation by the Securities and Exchange Commission (though Fannie Mae has in the last few years begun filing 10-Ks and 10-Qs), it is also exempt from state and local taxes. The U.S. president gets to appoint several board members, and the U.S. Treasury Department approves Fannie Mae’s debt issuance. And it has approved and approved and approved. Fannie Mae and Freddie Mac have virtually unlimited access to capital, at funding costs that are below the rates otherwise available on the market. As Fannie and Freddie have approached saturation in their core businesses, they’ve branched out, basically by taking on more risk. Fannie and Freddie have been arguing against the need for statutorily required mortgage insurance for loans above 80% of the value of the home, the bailiwick of private mortgage insurance providers like MGIC (NYSE: MTG), Radian Group (NYSE: RDN), and PMI Group (NYSE: PMI). Why would they do this? Because Fannie and Freddie want to cut out the expense of paying the PMI providers, even though it increases the risk of their overall portfolio.
You may, between the last two paragraphs, already be able to discern how it is that avarice at the top could maul Fannie Mae. It has a AAA credit rating, despite the fact that its debt levels in no way warrant such a rating, and it has a nearly limitless channel to capital, at interest rates that are below market. Add to these elements the fact that Fannie Mae is not a governmental operation, but a for-profit corporation, and you have the recipe for — well, for what’s going on right now. Why worry about risks when you have the implied backing of the federal government? Why worry about capital structure when no matter what your cost of debt is fixed at a below market rate?
Fannie and Freddie are both poorly-regulated and not part of a free market. The same goes for other public/private monstrosities such as the Medicare prescription drugs coverage plan and any number of poorly thought out privatizations schemes.
Tags: , Fannie Mae, housing
March 13th, 2008 at 7:21 am
Well, I’m not sure that there’s anything I disagree with in this post, but it doesn’t change the point I made on the other post - the MBS fiasco would never have happened absent the federal government’s efforts to *create* a market for them. It is not the fact that MBS are unregulated that caused this mess, it is the fact that there *is* no easy way to rationally price them, a fact that buyers in the market were well aware of in the ’50s. It was only when fedgov stepped in to socialize the risk side of the equation that they became marketable at all. After that, the “me, too” effect (people saw how successful investing in the socialized instruments was, and copied the activity blindly) stepped in and the uncontrollable avalanche of debt was on.
As for regulation, I’m all for it, as long as it is voluntary on the part of all parties. I agree that some “regulation” is a good thing, and that the question of what level is a very complicated one. Which is why, pursuant to Mona’s favorite theorist, I don’t believe any one centralized organization can possibly achieve the proper balance - they will never have enough of the proper information at their disposal. The distributed knowledge of voluntary agreements between independent agents solves the problem far better than any dictator or fiat by bureaucracy.
March 13th, 2008 at 7:25 am
Oh, and I forgot to add -
“Fannie and Freddie are both poorly-regulated and not part of a free market.”
Condition b (not being part of the free market) necessarily implies condition a (being poorly regulated), by definition, if free market is defined properly.
March 13th, 2008 at 9:34 am
I would say that every market needs a watchdog. That watchdog might be a public sector regulator, it might be a private information gatherer like Consumer Reports, it might be a private accreditation or testing firm, it might be the tort bar, it might even be insurers who price risk and thereby send informed signals about risk. We can debate which of those entities is the optimal one for a particular case, and whether the optimal entity will get involved spontaneously in the absence of state intervention. But clearly there is a need for watchdogs when people are doing business.
Where the state is at its worst, it drives out competing watchdogs but then fails to watch over those most in need of monitoring.
March 13th, 2008 at 12:10 pm
Yes. In situations where something is both the product of state intervention and poorly regulated, the regulation is not a regulation of market activity at all. It’s a restraint or amelioration of a special privilege created by the state in the first place.
Frankly, regulatory constraints on how those poor, put-upon capitalists can abuse wealth and power granted by the state are at the very bottom of my outrage list.
The libertarian approach to reducing the size of government ought to be “First, do no harm.” Eliminate the primary forms of government intervention from which privilege and unearned wealth are derived, and save for last the secondary forms of intervention aimed at ameliorating the effects of that privilege. In many cases, the second form of intervention will become moot, or nearly so (for example, the minimum wage might be relevant to a lot fewer people if Taft-Hartley were repealed).
March 13th, 2008 at 12:20 pm
Much of the mess is the result of the government’s war on redlining. First the problem was lenders not giving loans to the disadvantaged who would have a hard time paying them back, now the problem is that they gave out loans to the disadvantaged who have a hard time paying them back! Pardon me if I don’t trust the same people/institution that pushed us into the hole in the first place to be entrusted with any similar task.
March 14th, 2008 at 5:56 am
I agree with Angelica and thoreau that regulation isn’t necessarily antithetical to the task of getting government out of these affairs. But read what Kevin is writing very closely. Part of the problem with the regulatory impulse is that it is so consistently reactionary, always on the defense trying to ameliorate the problems that government privilege created. Until we address the root causes of the power imbalances that create such unhealthy “markets”, regulation will always be playing catch up (hey, some people really like the feeling of handing out crutches).
That’s a problem, and it is not to say that regulation is bad or unnecessary. It’s to say that it’s not addressing the root cause of the problem. Yes, we’ll always need a healthy corps of boys with their fingers in the holes of the dike if we refuse to repair the dike. But another way is possible.
March 14th, 2008 at 7:55 am
Not to defend either institution, but it looks to me that the major cause of the “lending crisis” was the bundling that took place on wall street, and could not have happened until existing regulation was changed to allow it. We have an administration that purposely changes regulations to the benefit of those who want to make money any way they can. The mortgage crisis should have been no more surprising than the S&L crisis. Both were caused by changing the laws to favor the non-productive money makers.
March 17th, 2008 at 1:08 pm
I know that everyone seems to have moved on, but reading the other comments, it’s not clear that I communicated my point clearly. I’ll use an example suggested by a rural relative:
You have an arsonist who sets fire to a barn, killing some horses inside. After the fact, what do you say about the incident?
a) The arsonist was wrong for not opening the barn doors after setting fire to the barn; or
b) The arsonist was wrong for setting fire to the barn?
In my view, saying that the federal government’s lack of regulation caused the MBS mess is option a). The fedgov set fire to the investment market, inter alia, by creating a market for MBS. Failing to regulate its creation properly is not only beside the point, but quite likely to have been the purpose in setting the fire in the first place.
March 18th, 2008 at 2:34 pm
Quasibill,
I’ve already outlined our areas of agreement in my post. However, I think the picture is more complicated than the one you have painted with your analogy.
Let’s not forget that MBS were traditionally very safe.
What made the situation combustible in recent years was a combination of factors from Greenspan’s low interest rates to the rise of exotic products such as sub-primes.
If I were to come up with my own analogy, this is more like a clueless parent giving the car keys to an irresponsible teenager who then drinks and drives and gets in an accident. The vehicle, MBS, is just one of the contributing factors in the accident.
March 18th, 2008 at 3:01 pm
“Let’s not forget that MBS were traditionally very safe.”
That’s the whole point!
***No, they were not!!!!***
They were traditionally extremely risky, which is why noone bought them the first thousand times they tried to market them. It was only when the government stepped in to socialize the risk side through Ginny Mae that they became safe.
And then, people saw how much money people were making on the Ginny Mae MBSs, they jumped in on the Freddie Mac and Fannie Mae MBSs in a classic follow the money behavior. And then, when the Greenspan put came into play, people jumped onto the “private” MBSs.
So I’ll stick to my analogy because I think yours gives entirely too much credit to the utility or value of MBSs in the first place.
March 18th, 2008 at 3:26 pm
The nut of the issue is this: If the government is going to be pushing MBS then they should also make sure they are safe (Ginny Mae style) and keep the market regulated. If they are not prepared to do so, then they should not be pushing MBS.
What we have is the worst of both worlds in Fannie and Freddie: Investor goes nuts because they assume the government has got their backs. In the end when the shit hits the fan, the gov. then have no choice but to step in to put out the fire.
March 18th, 2008 at 9:49 pm
For me, the whole point is this: it’s ridiculous for libertarians to get outraged over the secondary forms of state action whose main purpose is to regulate the exercise of special privileges in the first place. The original grant of privilege is sure enough something to get worked up over. But if anything, the sort of “market reforms” advocated by usual suspects like the Adam Smith Institute (leaving the grant of privilege intact and just “deregulating” its exercise) makes society less free.
For example: some “free market” outfits are up in arms over the proposed introduction of a Canadian-style card check system for NLRB union certification. Now, if they just want to scrap Wagner and Taft-Hartley, and abandon the whole model of bureaucratic unions as enforcers of contracts against the rank and file, I’m all ears. On the other hand if they want to leave that model intact, but whine about making the *method* of certification more genuinely democratic, they can ESAD. If we’re going to have a statist framework of labor relations anyway, then by God better a statist framework that helps workers than one that helps bosses screw us.
March 18th, 2008 at 11:16 pm
Amen, Kevin,
That’s really well-put.
Quasibill,
Just thought of something. OK, let’s stick with your metaphor. The barn is on fire right now. What do you do? Open the doors to let the horses out or let them burn while correctly assigning blame to the correct arsonist?
In the meantime, let’s get some regulation going.
March 19th, 2008 at 3:56 pm
I’d say option b) is to put out the fire, and that’s what I’d vote for. And I’ll agree that until the fire can be put out, let’s open up the barn doors - but don’t expect that to solve the fundamental problem of the burning barn.