Scapegoating Regulation

The bailout of the two large US housing mortgage companies, Fannie Mae and Freddie Mac has attracted conservative criticism that these companies contributed to the sub-prime crisis. This is a standard conservative tactic of shifting the blame. Fannie and Freddie were caught in the negative externality of the housing bubble created by Wall Street. The true moral of the Fannie and Freddie story is that there is a case for nationalisation and greater regulation of financial markets.

Thomas I Palley (mail@thomaspalley.com), an economist based in Washington, runs the project ‘Economics for Democratic and Open Societies’.

Economic & Political Weekly

EPW

august 30, 2008

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any progressives in the west now believe the age of Milton Friedman may be drawing to a close. Their hope is the current financial crisis has shown the costs and dangers of inadequate market regulation, thereby discrediting the anti-regulation philosophy of Milton Friedman and his Chicago School colleagues.

Evidence of the changing times is supposedly provided by US treasury secretary Hank Paulson’s and Federal Reserve chairman Ben Bernanke’s public admissions about the need for regulatory change.

Yet the reality is far more complex, and economic conservatives will not roll over and surrender just because of a financial crisis. Instead, if history is a guide, they will blame regulation for the crisis. That was Milton Friedman’s modus operandi when he launched the modern era of deregulation and animus to government with his false claim that the Fed caused the Great Depression.

Blaming Fannie Mae, Freddie Mac

This tried and tested conservative tactic is already surfacing in the debate surrounding Fannie Mae and Freddie Mac, the giant mortgage financing companies. The c onservative argument is government’s provision of an implicit guarantee to Fannie and Freddie distorted the market by giving them subsidised finance. The implication is that this enabled them to pump up the housing bubble, while simultaneously

making them the dominant players in the securitised mortgage market.

This conservative tactic scapegoats Fannie and Freddie, making them the fall guys for the bubble’s financial excesses, when the true cause was inadequate regulation of mortgage lending and failed macroeconomic policy.

Fannie Mae (formally the Federal National Mortgage Association) was set up in 1938 as a New Deal measure to help the housing market, and it was privatised in 1968. Freddie Mac (formally the F ederal Home Loan Mortgage Company) was set up as a private company in 1970 to provide competition against Fannie. Both companies carry an implicit government guarantee of their debt. Hence the reason they are also known as the government sponsored enterprises or GSEs. However, a condition of that guarantee is they limit the riskiness of the mortgages they invest in.

The mission of Fannie and Freddie is to facilitate home ownership. They do this by buying mortgages from private lenders, bundling those mortgages as securitised debt, and then selling those securitised obligations on the open market to financial investors. They also retain some of the mortgages they buy as investments that benefit their own shareholders.

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Fannie and Freddie help increase both Fannie and Freddie have had limited homeownership by increasing the vol-asset growth, and Fannie’s assets actually

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ume of mortgage finance and decreasing its price. They increase the volume by buying mortgages from banks, thereby providing banks with fresh finance to make additional loans. They lower the price in two ways. First, by buying and bundling mortgages for resale as securitised debt, they create a highly liquid market that makes mortgage loans a more attractive portfolio investment. That increases investor demand for mortgages, which lowers the interest rate mortgage borrowers pay. Second, the fact that they have a government guarantee means Fannie and F reddie have a lower cost of capital, which enables them to buy even more mortgages.

Wall Street’s Anger

Wall Street conservatives have long disliked Fannie and Freddie. The two companies have been extremely profitable, and their business has exploded in size over the past 25 years as the securitisation (“originate to distribute”) model of mortgage lending has replaced the earlier “originate and hold” model. Wall Street has therefore coveted a piece of this action, and has resented Fannie and Freddie’s dominant market position.

That resentment has spurred a campaign against Fannie and Freddie aimed at shrinking them and making way for Wall Street to grab their business. One Wall Street argument is that Fannie and Freddie’s government guarantee should be removed as it gives them an unfair cost advantage. Another Wall Street argument is that Fannie and Freddie should be broken into several small private companies because their size creates a “too big to fail” risk for the financial system.

The difficulties of Fannie and Freddie, resulting from the current financial crisis and the implosion of the house price bubble, have been opportunistically seized by Wall Street. Thus, conservatives have begun an “I told you so” campaign that even insinuates Fannie and Freddie are responsible for the crisis.

The insinuation that Fannie and Freddie were primary movers of the housing market excesses of 2004 – 2006 lacks even superficial merit. This is because since 2003 fell significantly after 2003.

Moreover, the roots of the crisis lie in the sub-prime market. That is where “no doc” and “zero down” mortgages proliferated, where loan originations exploded in volume, where losses started, and where the bulk of losses have been so far. Yet, Fannie and Freddie are prevented from financing such mortgage products by their charters.

These facts should make clear that Fannie and Freddie did not cause the crisis. Instead, it was driven by loose and negligent lending by banks and Wall Street. That behaviour was due to lack of regulatory oversight, combined with a failed incentive system that rewards management and mortgage brokers for pushing loans rather than prudent lending.

Such loan pushing was even promoted by conservative animus to Fannie and Freddie, as Wall Street was encouraged to muscle in on the business of the two c ompanies. That is why the Bush administration sought regulatory limits on Fannie and Freddie’s asset holdings. However, unlike Fannie and Freddie, Wall Street has no legal restrictions on loan quality and opted for gorging on sub-prime.

Origin of Bubble

The bubble’s origins lie in the combination of a flawed economic growth paradigm that prompted the Fed to push interest rates too low for too long, plus loose l ending by banks and Wall Street. This combination inflicted a huge negative “p ecuniary externality” on Fannie and Freddie, driving up house prices in the normally sound mortgage markets they serve. Consequently, they too have been battered by the bubble’s implosion.

The bottom line is Fannie and Freddie had little to do with the bubble. That said conservatives raise a legitimate question of how to organise the securitised m ortgage market.

Fannie and Freddie’s implicit government guarantee has helped them lower the cost of mortgage finance, making home ownership more affordable to millions. In effect, the guarantee has made government’s lower borrowing cost available to the public, which is good. The downside is

august 30, 2008

EPW

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it has made Fannie and Freddie overwhelmingly dominant in the securitised mortgage market.

This suggests that in addition to tighter mortgage lending regulation, there is a case for nationalising Fannie and Freddie on grounds that they are natural monopolies owing to their access to government’s credit rating.

Nationalisation of Fannie and Freddie would also address another problem. That problem is too much of the benefit of government’s guarantee of Fannie and Freddie’s debt has been siphoned off by Fannie and Freddie’s management as excessive compensation and shareholder profit.

In sum, the true moral of the Fannie and Freddie story is about the case for

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nationalisation and greater regulation of financial markets. This is the very opposite of conservative arguments opposing tighter regulation and proposing disbanding Fannie and Freddie. That would leave Wall Street unreformed and strip away the support for homeownership that comes with access to government’s lower b orrowing cost.

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Economic & Political Weekly

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