Fannie Mae and Freddie Mac: Too Big To Continue

If the public was unaware of Fannie Mae and Freddie Mac, they have received a quick education in the past few days. Unfortunately, the education that they are receiving can be summed up by the hypnotic mantra that has been repeated ad nauseam by politicians and financial commentators alike: Fannie Mae and Freddie Mac are too big to fail.

These comments by Mark Zandi, chief economist at Moody’s Economy.com, are fairly typical:

If the government hadn’t moved and Fannie and Freddie failed, the cost to taxpayers and the overall economy would be enormous. If Fannie and Freddie were unable to play their huge roles in financing new mortgages, the housing market would only suffer more, not to mention the turmoil for the financial institutions around the world that invest in Fannie and Freddie’s debt securities.

Zandi’s comments are exactly the opposite of the truth—if the government continues to bailout those who made bad bets on the housing market, the cost to the taxpayers and economy will be catastrophic, not just enormous.

Fannie Mae and Freddie Mac have engaged in fraud, have helped to corrupt the political process, and have helped to raise the price of housing. Their debt holders should not be made immune from the same sharp decline in the value of their securities that their shareholders have already suffered.

First, the fraud and corruption issue: In May 2006, the Office of Federal Housing Enterprise Oversight (OFHEO), released a “Report of the Special Examination of Fannie Mae.” The report covered the years from 1998-2004 and found that top management at Fannie Mae were engaging in fraud: “By deliberately and intentionally manipulating accounting to hit earnings targets, senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders.”

Fannie Mae is a prolific giver of campaign money to candidates of both political parties. Instead of responding to the serious accusations in the OFHEO report, they had the temerity, according to Bryon York, to lobby “Congress to cut OFHEO’s funds unless it got rid of the top official in charge of investigating Fannie Mae.” Further, they continue to spend much money lobbying Congress. In the first quarter of 2008 alone, Fannie Mae and Freddie Mac spent about $3.5 million on lobbying and hired 42 outside firms in this effort.

And how have they pushed up housing prices? Mish Shedlock looked at the mission of Fannie Mae: “We are a shareholder-owned company with a public mission. We exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market.” Mish pointed out:

Fannie Mae exists to expand affordable housing. Clearly Fannie Mae has failed its core mission. All government sponsored corporations fail their mission. The very nature of promoting housing makes prices go up, until the final blowoff top which we are now on the backside of, having reached Peak Credit.

And who is really being protected? London’s Financial Times reported that “Bill Gross, whose Pimco Total Return fund is the world’s largest bond mutual fund, has tripled his bet on mortgage debt, which now comprises about 61 percent of the fund’s assets. ” Gross commented, “Government policy is moving to sanctify the status of the government-sponsored agencies. It became a question of which institutions would be sheltered by the government umbrella.”

In other words, the taxpayer is bailing out the investors in Gross’s bond fund and others who bought securities issued by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are in trouble because they helped finance too many low quality mortgages; and in so doing, they pushed housing prices up to unsustainable levels. Matt Kibbe, president of FreedomWorks, commented, “The prospectus for every GSE (Government Sponsored Enterprise) bond clearly states that it is not backed by the United States government. That’s why investors holding agency bonds already receive a significant risk premium over Treasuries.”

Thus as Harry Long points out: Any bailout of the GSEs would not be about homeowners. It would be about charity to financial institutions and investors who have not behaved logically and stand to lose terribly due to sloppy decision making. I like to call it affirmative action for the rich and stupid.“ Bill Gross makes more in a year than most taxpayers will make in a lifetime—it is hardly in the interest of taxpayers that they subsidize him.

There are a few politicians in Congress who understand all of this. Just yesterday, during Senate testimony by Ben Bernanke, Senator and Hall of Fame pitcher, Jim Bunning said,

The Fed is asking for more power. But the Fed has proven they cannot be trusted with the power they have. They get it wrong, do not use it, or stretch it further than it was ever supposed to go. As I said a moment ago, their monetary policy is a leading cause of the mess we are in…

Now the Fed wants to be the systemic risk regulator. But the Fed is the systemic risk. Giving the Fed more power is like giving the neighborhood kid who broke your window playing baseball in the street a bigger bat and thinking that will fix the problem. I am not going to go along with that and will use all my powers as a Senator to stop any new powers going to the Fed.

The Fed is not the only institution getting bigger bats—Fannie Mae and Freddie Mac are too, and they are destructive bullies. Giving the bullies bigger weapons will only ensure that the once great American economy will continue to be destroyed.

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11 Responses to Fannie Mae and Freddie Mac: Too Big To Continue

  1. Jim D says:

    And people scoff when I tell them the revolution is coming. How much longer do these fat cats think the middle class will allow Wall Street’s and Government’s cronies to get rich at the expense of the working man?

    The fundamental flaw in the thinking of the people making these bad decisions is the fallacy that “other things being equal, such and such will happen”. Which simply isn’t true. If one or more of these big banks fail, we will simply do business with whoever is left, or find another way to do business. Its like saying Microsoft would need to be bailed out because without it we wouldn’t be able to use computers. BS! We’d simply use Linux, switch to Apples, or someone else would come up with an operating system.

    Jon Markman said it well when he summed it up this way: (paraphrasing) The bailouts and lack of oversight allowed banks to invest at 30 to one leverage with the government saying “if you win, you get to keep the profits, but if you lose, we’ll take the heat”. And we wonder why things are going south? This is nuts.

  2. E says:

    Government intervention in this case is appropriate (which I don’t really agree with). Only because government action made all of this possible. In 2000, Senator Phil Gramm slipped the Commodity Futures Modernization Act into a $384-billion spending bill. Gramm declared that the act would ensure that the new Credit Swaps markets would not be burdened by over-regulation (by the SEC and Commodity Futures Trading Commission). Credit Default Swaps cover the losses on securities in the event of a default. In the old days, financial institutions such as Bear Stearns would buy them as insurance in case their investments fold. It’s like Vegas bets (but on trading), with investment banks gambling on whether an investment (for example, subprime mortgages passed off as a security) will succeed or fail. Because of the swap-related provisions of Gramm’s Commodity Futures Act, $62 trillion dollars in market money (about four times the size of the entire US stock market) became unregulated, without the accompanyment of risk mitigation. A new day had dawned. Nobody was required now to check to see if banks or hedge funds had the assets to cover any losses they originally guaranteed, and, well, risk, what was that? Especially if you could make a ton of money off these bets before anyone noticed you hadn’t insured them. Essentially, Wall Street became the casino at the Bellagio — one big unrgulated betting pool… with trillions of dollars traded in a category of “high risk” and nobody was watching. This also led to another byproduct of the Commodity Futures Modernization Act — bets on the risk of any given transaction became more important than the underlying vehicle since everyone’s compensation was tied to them. Like homeowners who depended on rising housing prices to get rich, bankers were betting the subprimes would pay off before they needed the capital to cover (or pay back the guarantee on the security). This, basically, is the heart of the subprime meltdown because once people lost confidence in the system, everything folded in exponential sequence. Government, it would seem, was no-where to be found (except on bail-out day).

  3. Jim,

    You’re right–there is little appreciation of the market process among the public or decision-makers

    Right now it seems to me that most of the public is hypnotized by the oft repeated mantras about the bailouts being in their interest. Unfortunately When they truly begin to hurt they will probably turn to a politician who promises them even more government action (but supposedly tilted in their favor). It may be generations until the country is ready to restore free-market principles.

    E,

    I was unfamiliar with the Commodity Futures Modernization Act and I appreciate the information.

    I would disagree with your basic premise. One distortion doesn’t justify another one. If it did there is no end to this process or the resulting suffering.

  4. E says:

    Prof B, in principle, I agree that we should let banks and financial institutions fail if they make poor decisions. If you don’t mitigate your risk, or if you were lax in oversight of your own traders, or if you were just bone-headed enough to play roulette with your assets, then you should be allowed to suffer the consequence and go into bankruptcy lest we bail out every Joe Blow who decides he can “let it ride” and gamble with other people’s money. However, in this case, because of years and years of poor policy and no policing, allowing large institutions like Fannie and Freddie to fail would not be in the best interest of the economy at large. In such instances, panic will rule the day. Seeing images like people lining up in front of IndyMac just produces rampant and unmitigated fear; if not stemmed, you’ll see people with guns shooting at each other (think of Baghdad Bank). I think the Fed and everyone else are trying to avoid Depression Era issues — which is basically breakdown of order and fissues withing general operational processes. Perhaps allowing Fannie and Freddie to borrow money and repay it back to the government would be a better solution. Right now, the government is looking at option A, Bad, and Option B, Really Bad. Imagine if the biggest banks failed, and, say, 50% of DC’s houses were foreclosed upon. The resulting chaos would be seismic; on order of magnitude which could result in the US Economy becoming like Argentina or so. Right now, they’re just trying to right the ship (which should have been righted a long time ago). This is the premise. I’m not sure what the solution is, maybe just have everyone work and pay back what they owe (and stop using their credit ratings as a bank). That would be a good start.

  5. E,

    I agree with your sentiments with a big exception–I would reverse what will cause “Option A, Bad, and Option B, Really Bad.” If we allow those who made bad bets to fail while honoring FDIC promises etc. the situation will be horrible but the economy will begin to recover in a relatively short time. If we continue on our current path and continue to try and inflate away the mess, we are far more likely to face a catastrophic collapse which will indeed threaten the very fabric of society.

    I can only hope we are both wrong.

  6. E says:

    Prof B,

    I hear you. The problem remains — what can the government do? We, “the people”, are inflating away whether the repose is a mess or not. During prosperous times, government basically prints money. The logic, if such psychosis and error could be labelled as such, was that the Treasury could make up for it later; “look at how much the surplus receipts are, surely in the next five years, based on current growth, the surplus will be five times as large, so let’s just keep spending and implementing bad policy.” Then when the economy “pulls back”, there is a tendency to push for a “soft landing”. At this rate, the government is printing money, having no other recourse since low interest rates and other gimmicks have long been expended. The point is, this is the path of the United States. We’re in for rough future. No political party or leader wants to do the hard work, make the tough decisions. One party wants to redistribute the wealth to society at large, the other party has the mantra “Government is the problem” (Reagan’s slogan) and then acts in exact opposite when their unregulated, wild wild west free market model crashes. So where do we reverse this path?

  7. E,

    I generally agree, but we are very far from an “unregulated, wild wild west free market mode.” We have 60+ years of inflation, subsidies, and other distortions to undo. Funny thing is that a truly free-market can undo this mess fairly quickly (perhaps 1-2yrs) but there is no will to do so.

    We may be generations away from reversing our current path. In the meantime we are in for a rough ride.

  8. Jim D says:

    I agree with Prof B, if we’d simply let it play out, we’d find out how much of a non-event all this would end up being. All the hype surrounding it has veiled the fact that the rest of the country is quite capable of dealing with the problems. Actually, I’d have to say that of all the options we have left, the best would be to follow ex-FED chairman Paul Volcker’s example of handling the stagflation in the late 70’s. He raised rates, reigning in inflation and tightening things up until cooler heads could prevail. Instead, we’re doing what the Japanese did in the 80’s that lead to a full decade and more of stagflation. The morbidly sick thing about all this is Bernanke’s PHD covers the failures of the Central Banks in economic planning. That SOB (forgive me) should seriously know better.

  9. Frank v2 says:

    Dr. B.,

    You suggest that, “No political party or leader wants to do the hard work, make the tough decisions”. Actually I don’t think it is the politicians that are at fault, but rather it is “we the people” that are the problem. Most of us would not support a politician whose campaign mantra was built on the idea that short term pain would equate to long term gain. When an economic boo-boo occurs, the people turn to the politicians and say, “ouch this hurts, please make this pain go away”. The only recent politician that spoke any truth and made sense was Ron Paul, but the masses didn’t even want to hear what he was trying to say. We the people are unfortunately going to reap what we sew and we are not going to be happy with the resulting tapestry that we produce.

  10. Jim,

    It will be quite a bit more than a “non-event”, but the market process will handle it. Lew Rockwell has a fine column today The Greatness of the Market in a Crisis.

    Frank,

    I agree with you completely–we get the leaders that reflect our collective consciousness.

  11. Jim D says:

    I read Rockwell’s article, and it is right. Ok, so things might be a bit more than a non-vent, but if we act now to make things right, we’d find out that the doom and gloom scenario the press is painting for us isn’t quite the end of the world. We’d find out that the talking heads are just that–talking heads, and that the rest of us would find a way to get through.

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