Wednesday, September 17, 2008

Looking for a Prophet?

Forget the bible. Try Ron Paul. Here he is discussing Fannie Mae and Freddie Mac 5 years ago. An excerpt is below:

This isolation from market discipline is the root cause of the recent reports of mismanagement occurring at Fannie and Freddie. After all, if Fannie and Freddie were not underwritten by the federal government, investors would demand Fannie and Freddie provide assurance that they follow accepted management and accounting practices.

Ironically, by transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market. This is because the special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans.

Despite the long-term damage to the economy inflicted by the government's interference in the housing market, the government's policy of diverting capital to other uses creates a short-term boom in housing. Like all artificially-created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.

Perhaps the Federal Reserve can stave off the day of reckoning by purchasing GSE debt and pumping liquidity into the housing market, but this cannot hold off the inevitable drop in the housing market forever. In fact, postponing the necessary, but painful market corrections will only deepen the inevitable fall. The more people invested in the market, the greater the effects across the economy when the bubble bursts.


Vinny said...

That is an interesting thought, but Fannie and Freddie did business for more than sixty years without creating a housing bubble. The bubble did not happen until after bank deregulation was pushed through Congress in the late 1990's by people like Senator Phil Gramm. This was followed by by Alan Greenspan holding interest rates artificially low for several years when banks and mortgage companies abandoned sound lending practices in a binge of sub-prime lending.

Fannie and Freddie were over-levered, making them especially vulnerable to a decline in housing prices when the housing bubble burst, but they were not permitted to engage in the kind of sub-prime lending that caused the bubble.

Jon said...

I'm curious, Vinny, what was it about deregulation that contributed to the problem?

But it seems to me that this is going to drive up prices. Freddie and Fannie provide mortgages to people who otherwise couldn't afford them. This in itself drives up prices. More people now have the money to purchase a house than would have under free market conditions. This is increased demand for homes, which drives up prices. It further forces other banks competing for loans to make riskier moves, because Freddie and Fannie are swallowing up their clients. All of banking is riskier business, due to the government backing of Freddie and Fannie.

Vinny said...

I'm curious, Vinny, what was it about deregulation that contributed to the problem?

I will confess Jon that I am not there yet.

I have been trying to read what I can on the topic, but I have yet to figure out where all these financial institutions got the idea that you could take a pile of sub-prime mortgages and turn them into AAA bonds simply by packing them together and slicing them up as collateralized debt obligations (CDO’s). I think it is pretty clear that Greenspan’s 1% interest rates made it easy to borrow money to fund the mortgages and buy the CDO’s as well as making the yield on the CDO’s look very attractive to investors.

The brokerage firms that jumped into the CDO business did not do so because they were unable to compete with Fannie Mae and Freddie Mac. Bear Stearns and Lehman brothers had never been in the business of making residential mortgages. They thought they saw an easy opportunity to make big money in securitization of mortgages and they misjudged the risks involved.

As a matter of chronology, the explosion in sub-prime lending took place after the repeal of the Glass-Steagall Act in 1999. This makes me very sympathetic to the arguments that banking deregulation contributed to the lax lending practices that contributed to the sub-prime crisis, but I have not sorted through enough of the arguments myself to get to the point where I am ready to say exactly what I think the connection was. The following comment makes a great deal of sense to me intuitively though: "[W]e did not consider the dangers of financial deregulation. We failed to recognize that if risks can be taken and transferred freely, most of them will end up being taken by the most foolish investors, not the most suitable." Edward Hadas,

The fact that Fannie Mae created a secondary market for home mortgages that functioned perfectly well for sixty years makes me very skeptical of attempts to blame the GSE’s for the crisis. They may in fact have been poorly run, over levered businesses, whose flaws were exposed by the decline in the housing market, but they were limited to buying high quality mortgages.

I realize that a Ron Paul fan is unlikely to be sympathetic to any institutions created by the New Deal, but I think that there were instances when the free market needed to be shown where profits could be made. In 1929, most rural areas of the United States had no electricity because the utilities did not believe that they could be services profitably. It took government pressure to get them to do so at reasonable rates. It turned out that there were great profits to be made. The lives of the people were greatly improved by access to modern appliances and it turned out that they used a lot more electricity as the prices came down.

The free market is probably the best tool available for producing economic prosperity, but I don’t think it should be promoted from a tool to an ideology.

Jon said...

I'll have to look into this further. Incidentally, it looks like Paul voted against the bill that repealed Glass-Steagel. The roll call is here.

Liberterians often point out deregulation bills as falsely so called. It's usually more about providing benefits to certain favored groups, special interests, etc.

Vinny said...

Liberterians often point out deregulation bills as falsely so called. It's usually more about providing benefits to certain favored groups, special interests, etc.

I realize that I have to be careful about lumping people together. As with any philosophy, there are authentic adherents who actually have thought things through and there are people who adopt the rhetoric when it suits their purposes.

Vinny said...

As I am reading more, I find that I was wrong about the GSE's. They were buying sub-prime and alt-A. However, it appears that they did not jump into the market until 2005-2006 just as the housing bubble was starting to burst.

Anonymous said...

The variable rate interest mortgage presumes that the mortgagee will be preparing for that fateful day when the interest rate on their mortgage begins to float (upward).

But the mortgagee doesn't prepare and the risk of this happening was not carefully considered.

And when the mortgagee can't pay the original lender is off the hook because failing mortgage was sold two years prior in the secondary market place.

Also, too many people followed the notion of "Get the credit you deserve!!!".