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Friday, September 12, 2008

Bailing Out Statism

The key to understanding the saga of Fannie Mae and Freddie Mac — the newly nationalized twin government-sponsored enterprises (GSEs) that dominate home financing — is this:

They were created — intentionally — to distort the housing and mortgage markets. That is, government planners were not content to let voluntary exchange and spontaneous market forces configure those industries unmolested. So — holding the taxpayers hostage — they intervened.

Make no mistake: the collapse of Fannie and Freddie is government social engineering predictably gone bad.

Is it heresy to wonder if criminal charges are in order for their facilitators in the government?

In a free society supply and demand would govern markets. The demand for houses would be determined by people’s preferences and the resources at their disposal. Supply would be determined by relative profit expectations, which is to say, by the demand for housing and the competing demand for the necessary inputs.

A distortion occurs when government planners and rent-seeking corporate allies, under cover of humanitarian social policy, engineer a deviation from natural market outcomes. (Rent-seeking here refers to the quest for politically derived, as opposed to market-derived, profits.) Dressed up as promotion of the American Dream through home ownership, the planners used the political means — ultimately, the threat to imprison uncooperative taxpayers — to channel wealth to the construction, real-estate, and financial industries. The primary instruments of this social engineering were Fannie Mae, created as a government agency during the New Deal and — cough — “privatized” in 1968 to get it off-budget, and Freddie Mac, created as a “private” GSE in 1970.

The GSEs don’t make mortgage loans. Rather, using borrowed money, they buy mortgages from original lenders, encouraging banks to make more loans and immediately pass them on to others. Pooling lots of mortgages together, the GSEs create mortgage-backed securities (MBS). In fact Freddie and Fannie created the secondary mortgage market that has come in for criticism since the subprime problem developed.

As economist Arnold Kling writes, “The GSEs can either sell the mortgage-backed securities to other investors or retain the securities for themselves. In the 1990′s, Freddie gradually shifted from a strategy of selling most of its securities to a strategy of retaining most of its securities. Fannie has always predominantly held its securities in its portfolio. Whether it retains or sells the security, the GSE bears the default risk of the mortgages, which is the source of the recent crisis” (emphasis added).

Freddie’s and Fannie’s activities were designed to channel money to mortgage lenders so that they could loan widely, especially to people who might have been priced out of a fully private mortgage market. The system inevitably lowered lending standards and interest rates.

No Market Check

If these activities had been performed not by GSEs but by real private companies, they would have been subject to market checks. But they were not. They’re not called government-sponsored enterprises for nothing. As such they have special advantages over real private companies, permitting them to do things on a scale larger than would have occurred in a free market. They don’t pay local and state taxes like other companies do, and they can get government loans. Moreover, as Kling puts it, “In both the mortgage insurance business and the portfolio lending business, the GSEs have two important advantages . . . [:] a lower risk premium and lower capital requirements.” In brief, Fan and Fred could borrow money for less than private companies could because “investors believed that the GSEs would not be allowed to fail,” Kling writes. This is the “implicit guarantee.” (With the wink of an eye, the GSEs say their paper is not guaranteed. So why not hold their creditors to the letter of the contract?)

As for the lower capital requirements, Kling writes, “When banks engage in the mortgage insurance business or the portfolio lending business, they are required by their regulators to put more of their shareholders’ funds at risk than the GSEs are. This makes it difficult for banks to compete with GSEs.”

The result was a far more concentrated lending market and hence greater vulnerability to adverse changing conditions. Fran and Fed hold or insure $5.4 trillion in mortgage debt — half the national total — making the taxpayers ultimately responsible now that the GSEs are under federal conservatorship. Three-quarters of mortgages these days are GSE-backed. So the government has just become the country’s major mortgagee. It’s ironic that after making the GSEs dominant, the government now wants to shrink their role in the mortgage industry.

We can see, then, that the GSEs’ privileged status, which was intended to distort the housing and mortgage markets, did exactly what was intended. The whole shaky structure was vulnerable to a deterioration in home values, to which the GSE system itself contributed. (Other things contributed to the run-up and collapse of home values in particular parts of the country, such as land-use controls, which made housing more scarce and thus more expensive, and a social policy of encouraging banks to lend to credit-unworthy borrowers.) The GSEs have lost well over $10 billion since the mortgage meltdown occurred, and they were getting close to being unable to borrow enough money to roll over their debt. This and fear of a more general economic meltdown are what prompted the government to step in, exposing the taxpayers dramatically. The bailout will begin with a billion-dollar infusion. Then the government will start buying shaky Freddie- or Fannie-backed mortgage securities in the marketplace. A $5 billion purchase will get things going, but up to $200 billion has been promised. It will no doubt be more.

Where will this money come from: taxation, borrowing, or the printing press? What will that will do to our economic well-being?

The government also acquired the authority to buy as much as 80 percent of the common stock at under a dollar per share. Nationalization is the right word.

Private Enterprise, Indeed

It’s really an anticlimactic chapter in this story of putrid rent-seeking and political opportunism. The bailout of the GSEs’ creditors (not stockholders) creates a new round of the same moral hazard — private profits mixed with taxpayer-backed risk — that brought on the calamity in the first place. No one believes this will be the last bailout of those who are “too big to fail.”

The New York Times is wrong. This is not “an extraordinary federal intervention in private enterprise.” It is the state bailing out statism. As Oliver Hardy might have said, “Well, government, this is another fine mess you’ve gotten us into.” Let’s hear no more about the “laissez-faire” Republicans.

That myth serves only to protect advocates of state intervention regardless of party.

What now? First: no bailout! Cut the GSEs loose and let them do what other businesses do on hard times: renegotiate contracts and revalue assets. Will there be another Great Depression? Recall that what turned a recession into the Great Depression was the Federal Reserve’s deflation of the money supply. A bailout is not required to avoid that catastrophic mistake.

As James Surowiecki notes, “hybrid” corporations can be “reformed” in one of two directions: full privatization or full nationalization. Some prefer the latter because with it will come government regulatory oversight. Small comfort there. Will we need a super-oversight board to make sure the primary overseers are doing their jobs? How about a super-super-board to check up on the super-board? No regulator could know what he would need to know to regulate a financial market. The information just is not available.

Real privatization is the only way to go.

  • Sheldon Richman is the former editor of The Freeman and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America's Families and thousands of articles.