Brad DeLong's Semi-Daily Journal (2004)

First Fed gains oversight of Freddie & Fannie Mae bloat, declaring it a "serious concern" but not doing anything to curb it.

Then Medicare gains oversight of public obesity, declaring it a "serious disease", but not doing anything to curb it.

Then SEC rolls those oversights up and declares fiscal malfeasance, fraud and grand larceny by corporate principals is "petty ethical choices", and not doing anything to curb it.

Welcome to Big Brother, Big Government, Massive Deficit, Fox Watching the Wolves Rape the Sheep.

While we Prols high-five and belly-bump over their wishful thinking in the polls, Democrat and Republican kleptocrats are locking us down, and sidling away from class-action liability.

Can't you'all *see* their end-game?

"Sheep Look Up!" [John Brunner]

I don't think the ruling has any impact on the question of guarantee. Strictly speaking there is no guarantee, only an assumption by the market that the government would have to step in because the agencies are too big to fail. This new ruling doesn't change the strict reading - it's a logical leap from the government limiting debt issuance to it guaranteeing the rest. That is, there was nothing in black-and-white which said the government guarantees the debt in the past, and there is nothing in this ruling which makes this guarantee now. Still, the agencies are too big to fail, so the implicit guarantee remains.

I think a question that should be posed in general is "should companies be permitted to become too big to fail". If the government has to bail a company out, it is no longer responsible for its own risk, hence a serious moral hazard.

Fannie and Freddie are a superb case in point. It's not just the quantity of what they take on. I do work for mortgage industry concerns and the field is rife with fraud - "stated" incomes are widely understood to be stated as whatever is necessary to get the loan. The lenders don't care because they resell to the Mae's. The Mae's don't care because they're too big to fail. It seems at some point, someone is going to have to care, and if that someone is the taxpayer, I think the taxpayer has the right to impose whatever controls are necessary now.

But, really, *can* the government regulate the Mae's well enough to avoid insolvency? I doubt it. So perhaps the Mae's should never have been privatized. And perhaps as a principle, antitrust laws should not only proscribe behavior that eliminates competition unfairly, but also growth that makes moral hazard inevitable.

Has there ever been an economic debate on this point?

But in fact Freddie/Fannie debt basically *IS* government-guaranteed. The United States government cannot allow a melt-down of the mortgage banking industry (which is what would happen if Freddie/Fannie melt down), because this would cause an almost immediate evaporation of enormous amounts of wealth in America -- basically every homeowner would find their home reduced in value by 90% (i.e., the average down payment for a home would become the average price of a home). Nobody's going to pay $1,000,000 for a $100,000 house. They would default and let the bank take the house, then buy it back at auction for peanuts. The banks (or Fannie/Freddie and their investors in mortgage-backed securities) would see their assets evaporate. Only a massive bailout by the federal government to re-insert liquidity into the economy would prevent massive deflation and economic collapse on a scale not seen since the Great Depression.

It's no surprise that Freddie/Fannie are taking advantage of what is in effect a government guarantee without government oversight. That's a recipe for an enormous government bailout in the future, one that would dwarf the S&L bailout, and anything that can be done to insert sanity into Freddie/Fannie's lending and borrowing practices is way overdue.

- Badtux the well-housed Penguin

This is jawboning, and doesn't mean very much at the moment.

Doesn't it also send a positive message that government intends to limit its debt liabilities, thereby raising the value of what debt is issued? Could it also maybe signal that the government intends to cut these two quasi-state enterprises loose from the govt's implied guarantee, and force them to meet rigorous market standards?

Of course, this is the positive view, and given the Bush government's policy formulation and spending records, there's little evidence to conclude this is what they are doing.

What, you mean the Almighty Free Market isn't working perfectly???

I thought these liars were in favor of smaller government and less regulation??

[Caveat: I don't quite get the whole Fannie and Freddie thing. I don't even know what the right policy is here.]

Snow has said things like "we don't believe in the idea of too big to fail". I suppose that restricting the activity of Fannie and Freddie could be a way to preserve more business for the banking lobby.

Other than "this is just another administrative power grab" I can't tell what's going on. Are the lobbyists and ex-govt employees who work at Fannie and Freddie (and I know there are lots) mostly Democrats?

It's my understanding that the majority, if not the overwhelming majority of people who follow the secondary mortgage market are off the opinion that Fannie Mae and Freddie Mac are no longer essential.

Banking has changed to the degree that we could transition to a completely private (i.e. without an implied government guarantee) system.

That being the case, the issue should not be, "How do we regulate Fannie Mae and Freddie Mac", but rather, "How do we shut them down", or "How do we convert them to ordinary business entities.'

Matthew--

Going to a bank-financed mortgage system would not privitize it. One source of bank funds for mortgages--deposits--is backed explicitly by the Federal Government. Another source of funds--Federal Home Loan Bank Advances--comes from GSEs with very strange capital adequecy rules. And if Fannie and Freddie are too big to fail, what of Citbank, JP Morgan, etc?

At the same time, because Banks must take deposits, their liability structure means they would need to rely more on derivatives to hedge interest rate risk.

Full disclosure--I worked for awhile at Freddie (I also decided to leave Freddie).

I wasn't clear. I'm not favoring privatization (Freudian slip, I spelled it Piratization) for its own sake.

In fact, I think that generally it does not work.

The problem is that Fannie Mae and Freddy Mac are functioning with an implicit government guarantee, which gives them a competitive advantage, and that this competitive advantage has allowed them to become "too big to fail".

If we shut them down tomorrow, there would be chaos.

If we reduced them to less than 20% of the market over the next 20 years, we'd probably be OK.

So, how do we get there?

My personal suggestion would be to do the following:

* Place a cap on the mortgage amount that they can handle, say $500K, and keep that frozen until the line for 3x median annual wage crosses it.

I've pulled these numbers out of my ass, so feel free to tinker.

The current cap is actually lower (it is $333,700).

Why not attack the distortion directly? Put a Pigou tax on the portfolio that is equal to the funding advantage (we would need some consensus number on what this actually is). Then use the money to fund Section 8 housing.

Richard,
I agree that taxing away the funding advantage would have positive affects. Does this reduce the issue of risk to the financial system? Do we need to find a way to increase more private firms to fulfill this same function so that the risk can be spread? Keith

Keith, the risk comes from the fact that Fannie Mae and Freddie Mac are so big that the economy would collapse if either one failed.

Imagine one of them being involved in a Bearings bank scenario.

If you spread that among 30 firms, none with more than 5% of the market, it's still a big thing, but it's not the collapse of the US economy.

If an optimal tax is leveled, the cost of capital to Freddie and Fannie would be appropriate given the risk they carry, and therefore they would carry the "optimal" level of debt. But figuring out exactly what the tax should be is no trivial exercise.

Carrying the logic one step further...If both carry the optimal cost of capital, then this should theoretically slow their growth. They will no longer be able to support rapid growth based on low cost funding. This levels the playing field and allows some of Matthew's other 30 firms to begin to grow.

The problem is the timeframe. How long does this process take, and how much risk does the economy face while we are waiting for the risk to spread? In my mind we need two actions--one to equalize the cost of funds and one to jumpstart competition.

I live in Australia, and we have a bank-financed mortgage industry that works just fine without an equivalent of Fannie Mae or Freddie Mae.

Lenders then bundle and securitise loans all by their lonesome, and the only government guarantees are those that stop deposit banks falling over ... it seems to work just fine.

My understanding is that mortgages in Australia generally have prepayment penalties and variable rates. This means they better match bank liabilities than fixed rate mortgages without prepayment penalties.

If I am wrong about the charactersitics of Australian mortgages, I would appreciate it if someone would correct me.

For those talking about taxing Fannie/Freddie: Where do you impose the tax? Is it a tax on disbursed funds when they buy mortgages from banks? Is it a tax on received funds when they sell mortgage-backed securities to investers? Hmm.

In any event, current U.S. government policies, which favor investment over consumption (thus the 4% tax cut to the investor class and the negligible tax cut to the consumer class), would tend to say that Fannie/Freddie aren't going anywhere. Given that, the solution is to make it so that Fannie/Freddie won't go under -- i.e., regulate them.

The biggest problem faced by Fannie/Freddie is bad loans -- loans where the real estate backing them is not worth the face value of the loan (taking into account the expenses of reselling the real estate, foreclosing, etc. if that is necessary). This would tend to indicate that the solution is to tighten appraisal standards required, much as was done in recent years for federally-guaranteed loans like VA loans where appraisers must also take into account things like, e.g., years of life remaining on the roof, age of the heating/cooling systems, etc. so that a spacious shack in a neighborhood of well-maintained homes doesn't get appraised at the same value as the beautiful well-maintained home next door. It may be possible to find one fool to pay too much for that shack, but if that fool defaults, can the bank find another fool willing to overpay? That's the gamble, and due to lax appraisal standards it is one that Fannie/Freddie are far too exposed to.

In the end, the real estate must become the guarantor for Fannie/Freddie mortgage backed securities, not the U.S. government. Tightening up loan standards so that fewer bad loans are made (where "bad" is defined as "cannot make back our nut if we have to foreclose and resell the home") is the ultimate guarantee of Fannie/Freddie's future viability.

- Badtux the un-mortgaged Penguin