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.
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?