Let me admit up front: while I understand the mechanics of the parts involved in the Fannie/Freddie rescue, I’m not fluent enough in the involved markets to truly appreciate the various big picture results.  So I’m turning to sources that I trust to understand these things better than me. The first place I go is the Wall Street Journal – their Op-Ed page may be run by poo-flinging monkeys, but their financial reporting is consistently excellent (and their general reporting is reliably good, too). So here we get the outline of the rescue plan:
[C]ontrol of [Fannie Mae and Freddie Mac go] to their regulator and allow[s] the Treasury Department to purchase billions of dollars of the firms’ senior preferred stock.
The plan, offered jointly by the Treasury Department and Federal Housing Finance Agency, also gives the Treasury authority to purchase mortgage-backed securities from the firms in the open market and a lending facility through the Treasury from its general fund held at the Federal Reserve Bank of New York.
Again, I understand the mechanics, but need a little help on the meaning. Jerome a Paris provides quite a bit of help. He explains what the second paragraph above means:
This is huge. This is the federal government taking over the “toxic waste” in a way that will have an impact not just on Freddie and Fannie, but on the whole market. By “buying” mortgage-backed securities instrad of taking them as collateral, the Treasury does two things at the same time:
- it takes off the assets and liabilities off the balance sheet of the two companies in a definitive way (rather than temporarily) and assumes, for sure, the associated risk;
- it sets a price on these securities. This has been the biggest problem to solve the credit crisis: nobody has been willing to set a price on these assets, because of the uncertainty on the real value of the underlying assets (or because everybody could see that they were falling by the day). By setting such a price, the government creates a highly significant precedent – and, in all likelihood, provides a floor to these prices, ie an implicit commitment (or at least the expectation of a commitment) to buy more such securities.
I quite recommend reading both articles, but the takeaway is:
This would seem to be an incredibly ambitious gambit: a nationalisation, an attempted bailout of ALL the banks, and an open-ended commitment of taxpayer money to save the financial world.
US Treasury Secretary Paulson’s no idiot, but neither is he much of a public servant. This is worth worrying over.
sasha
Not directly related to the immediate Fannie/Freddie, issue, but This American Life did a fantastic show on the mortgage/credit crisis called “The Giant Pool of Money”. I really recommend it.
EJ
Also posted in your other Fannie/Freddie post. Someone had blamed privatization and deregulation as the reasons for this mess.
This Fannie/Freddie fiasco is not due to deregulation and privatization, but quite the opposite. Both of these GSEs have operated somewhere in between private and public entities creating a dangerous combination. They are privately owned but regulated and implicitly guaranteed by the federal government.
But first a brief history. Both used to be government agencies, where the government directly subsidized home ownership and absorbed housing risk. However, LBJ plagued with a deteriorating fiscal situation due to Vietnam and social spending semi privatized then in order to technically remove liabilities from the government balance sheet, He basically did some creative accounting.
So now what we have is the private market incentive of the firms management which is to maximize profits, which is good for a normal competitive wellfunctioning market, The problem is, we have this incentive mixed with an unnatural government subsidy, that being the “implicit guarantee†of the GSE’s which is their whole nature whole nature. The result was, the firms have no incentive to minimize risk, because they will be bailed out should a problem occur, and investors in their securities are willing to buy without regard to risk because of this guarantee. Essentially the government has promoted reckless financial investment over all these years.
Now mix this with the 1995 community reinvestment act, which went into affect in 1997, which basically forces banks to lend to “undeserved clients†(read: subprime), and very poor monetary policy from the FED in the early 2000s when they left interest rates too low and caused an asset bubble, we then have the perfect storm that came together to create the mess we are in.
Now this doesn’t mean that a lot of investors, borrowers, and firms didnt also mess up here, but what too many people (especially on the left) dont realize is that markets react to incentives and to think that people wont do so out of some blind faith in central planning is naive. They call supply and demand the law of for a reason.
Our government has one, forced lending to less credit worthy homeowners, two, subsidized risky investment behavior, three, very poorly manipulated money supply growth through monetary policy. In the end, though not sufficient conditions for this whole housing mess, the government was very much a necessary condition in the three areas mentioned. In short, this is a result of what happens when through naivete and arrogance of central economic planning distorts markets and creates unintended consequences. So when looking for those to point the finger at, look no farther then very bad government intervention.
Mark Brooks
So the Andrew McCains and Neil Bushes of the world can now bleed us dry directly, without having that pesky ‘waiting for a bailout from Uncle Sam’ to slow them down.
This way we don’t even need to set up any oversight at all, they can just start writing checks on the US Treasury as soon as they can.
Yeah, this is gonna suck.
As Everet Dirksen once said, ‘…a billion here, a billion there, pretty soon it adds up to real money…’.
MB
Ah, the old “we couldn’t help ourselves!” approach. Sort of like guardrails promoting reckless driving. Okay.
Ah, this is what Mark Ellmore was talking about. How did the act “force” banks to lend to “undeserving” borrowers, exactly? And if it went into effect in 97, what of the gap between then and the real run-up in housing values and expansion of lending activities?
Wait. Is this another one of those cases where it’s the governments world, and private forces just live in it? Because as best I can recall, the market was just a whoopin’ and a hollerin’ every time there was a rate cut and when it was left low. Are you saying that the gov’t should have known better?
Who thinks that? Seriously.
That’s at tension with the rest of your paragraph, though, isn’t it? Look no farther? Forget the borrowers, the poorly controlled institutions, the markets that rewarded fraudulent behavior? It’s all the government’s fault for . . . something, I guess.
EJ
First off, my typo on “undeserved”. Meant to be under served. Its the technical term used in many of these financing and credit union bills. My mistake, sorry for that one.
How the government “forces” is that banks are not allowed to single out certain groups within a given community. If they want to do business in a town, they must also lend a sertain percentage of their portfolio to all the poorer peopel if they want in. (not coincidentally, small banks are given an exemption, and small banks have largely weathered this recet storm better thent he large ones). I dont want to go into all the detail, of which i dont totally understand myself, but a bank is charged more via FDCI premiums if you dont comply and there are other ways to restrict bank actions based on capital standards regulation.
Now it didnt dirrectly creat subprime, as the idoit ellmore states that you make reference to, but what it did was require lending to these people, which in an enviroment where housing was in a bubble, largely triggered by FED policy, the only way to lend to these people was subprime loans. Now yes there was some euphoria and bubble mentality in the market where irresponsibility was common. Banks via independent brokers (what ellmroe is) created a system where there is little incentive for the broker to make a good loan. However, this could not have happened without the 3 areas i stated. As i said, they were not sufficant conditions, but were necessary ones.
And you miss the point about subsidizing riskly behavior compared to guard rails. The whole essence of banking is managing risk. Risk is priced via interest rates. Because there was an implicit backing on these securities, fannie and freddie could sell these high yielding notes makign them a ton of money without the appropriate pricing of risk. Likewise there was an over buying of these notes by invstors. So what does this do? It floods an excess of money (available because of overly loose moneatry policy) into the housing market through securitization. This lowered the real cost of housing because loans were cheaper, which in ruun caused the run up in prices. Faced with high real prices once the fed started tightening, now the only way lower income borrowers could afford loans, especially now strongly incentivised through the community reinvestment act, subprime became a new product that met this requirment.
So in short,the process goes as such… 1. The FED grows the money supply too large, so lots of excess capital floating around. 2. government dirrectly subsidizes risk via freddie/ fannie causing this capital to be overly allocated to housing because the real cost of that investment is not taken account in the market. 3. this overflow of investment causes housing prices to explode. 4. as the FED tightens and the real housing costs go up again, subprime is created as the only real way to still offer products. It wasnt created by but was strongly incentivised by the community reinvestment act. Thats the process. It required a perfect storm of the three factors coming together.
MB
First, I need to apologize to my commenters – this comment window is really annoying, isn’t it? I need to try (again) to fix it.
~
Ah. I didn’t even think of that. Makes much more sense, though.
I’m quite okay with that. In fact, I *encourage* that kind of regulation. Redlining sucks. I know. I’ve been there.
I have this >< much sympathy for the banks, here. If they hadn't engaged in such obviously discriminatory practices in the past (the discrimination having nothing to do with creditworthiness), they'd not have to deal with this. And even at this point, I can't imagine that the CRA actually had much in the way of teeth. Banks have better lobbyists than the Rainbow Coalition ever will.
Well, this is the meat of the matter, isn’t it? Lets take, as a given, that borrowers are idiots and that gov’t regulation is flawed. Who had all of the choices here? Who had the information they needed to make good decisions? The mortgage industry and its repackagers, that’s who. And yet what I’m hearing is some sort of “hey, I can’t help myself, that’s what I am!” excuse for the overreaching, fraud, and general failure.
I don’t think I’m missing the point at all. Adopting your reasoning, the banks are drivers that really had no reason to pay attention to the road, because they knew that in the worst case scenario, the guardrails would keep them from going into the ditch. So drive on!
Are you trying to revive monetarism? Serious question. Because as best I can tell, that’s been utterly discredited. (I could be wrong. But I don’t think so.)
It’s that first sentence that kind of blows the rest of it out of the water, I think. Sure, I’m more than willing to say that the regulation was imperfect (tho’ I’m not at all willing to hang it on the CRA). But to assign that the lion’s share of the blame for the massive amount of poor performance and bad faith by private actors? Nuh uh. Not by a long shot.