Monday, October 27, 2008

Public wisdom and private folly? Or government sponsored irresponsible risk taking?

The current financial crisis’s origin (or at least its trigger event) is widely attributed to the subprime mess in the U.S. housing mortgage market. Since the institutions that fostered the development of marginal, high risk, loans have been taken over by the government after losing some 90 per cent of their equity, many people assume that they were purely private corporations, and thus excessively greedy.

Not so. According to an excellent entry in Wikipedia (“Fannie Mae”), Vernon L. Smith, 2002 Nobel Laureate in economics, has called Freddie Mac and Fannie Mae “implicitly taxpayer-backed agencies” ( “The Clinton Housing Bubble”, The Wall Street Journal, December 18, 2007) and Alan Greenspan expressed the belief that Fannie Mae’s (weak) financial position was the result of markets believing that the U.S. government would never allow Fannie Mae (or Freddie Mac) to fail (“Fed Chief Warns of a Risk to Taxpayers”, The New York Times, February 25, 2004). This perception of the public regarding implicit government guarantees, alone, has allowed Fannie Mae and Freddie Mac to save billions of dollars in borrowing costs. Estimates by the Congressional Budget Office and the Treasury Department put the figure at about $2 billion per year. It also allowed the two institutions to expand their activity well beyond the regulations’ required capital/asset ratio, thus taking excessive leverage risks in the securitization business and providing banks with additional liquidity that was used in turn to grant more marginal and risky loans to homeowners.
On top of that, Fannie Mae is exempt from state and local taxes.

Fannie Mae was founded as a government agency in the wake of the Great Depression in 1938, as part of Franklin Delano Roosevelt’s New Deal in order to facilitate liquidity within the mortgage market. In 1968, the government converted Fannie Mae into a private shareholder-owned corporation in order to remove its activity form the annual balance sheet of the federal budget. The role of guarantor of government-issued mortgages, as a consequence, was transferred to a newly created government agency, Ginnie Mae (Government National Mortgage Association). Since then, there has been debate surrounding their role in the mortgage market, their relationship with the government, and whether or not they are indeed necessary. This debate gained relevance due to the collapse of the U.S. housing market and subprime mortgage crisis that began in 2007.

In 1999, Fannie Mae had came under pressure from the Clinton administration to expand mortgage loans to low and moderate income borrowers. At the same time, institutions in the primary mortgage market pressed Fannie Mae to ease credit requirements on the mortgages it was willing to purchase, enabling them to make loans to subprime borrowers at interest rates higher than conventional loans.
The same year, the New York Times reported that with the corporation’s move towards the subprime market “Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s” (Steven A. Holmes, “Fanny Mae Eases Credit to Aid Mortgage Lending”, The New York Times, September 30, 1999). Alex Berenson of the New York Times reported in 2003 that Fannie Mae’s risk is much larger than is commonly held (“Fannie Mae’s Loss Risk Is Larger, Computer Models Show”, The New York Times, August 7, 2003). Nassim Nicholas Taleb wrote “The government sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deem these events ‘unlikely’.” (The Black Swann: Quotes & Warnings that the Imbeciles Chose to Ignore, April 2007, ).

As is well known to insurers, risks do materialize in the end.

One can conclude that, in this sector at least, the crisis was created not by unregulated market capitalism but by government intervention, implicit subsidies and distortion of market mechanism and public regulations, as well as by government created monopoly positions in housing refinancing. The general call for more regulations heard from various quarters is thus quite misplaced and should give way to a requirement of more competition and general respect, by the government itself of rules of his own making and existing public regulations.

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