Government-Caused Calamity (2008 Oct)

by Barry A. LieblingAs the value of mortgage backed securities collapsed the United States realized a tremendous economic trauma in September 2008. Some of the largest investment banks went out of business, were acquired by other institutions, or converted themselves to commercial banks. The stock market plunged precipitously, and the two largest mortgage-related institutions Fannie Mae and Freddie Mac were taken over completely by the federal government.

As expected a chorus of interventionist pundits proclaimed that the crisis is yet another catastrophe that is the result of greed, capitalist ideology, markets that are not supervised by responsible government officials, and a severe lack of regulation – which free market advocates stubbornly and foolishly resist.

Bear in mind that the definition of a free market is one in which all assets are privately owned and managed, and the sole responsibility of government is to prevent force and fraud. Of course, the United States has always had a mixed economy – where some elements are free and others are directed by government action. The crucial issue here is the extent to which the current trouble is attributable to people acting within a free market or is caused by government intervention.

Consider the genesis of the two behemoths in this drama. Both Fannie Mae and Freddie Mac had the status of a Government Sponsored Enterprise (GSE) – created by the federal government, beholden to it, but “owned” by private investors. Each had the mission of making housing more affordable by providing financial institutions with more cash. Banks and mortgage companies would originate mortgages and, instead of keeping them, sell the mortgages to Fannie or Freddie. The money the originator received was supposed to be used to originate more mortgages. Next Fannie and Freddie would bundle groups of mortgages together and sell mortgage-backed securities – at a profit – that represented ownership in these bundles.

Of course, before Fannie and Freddie came into existence there was nothing to stop a private company from purchasing mortgages, grouping them into bundles, and selling shares in the aggregated investment. But in a free market the demand among investors for mortgages was low.

Thus, many mortgage originators were pleased that Government Sponsored Enterprises took actions that do not occur in a free market – purchasing their mortgages at higher prices and at greater volumes than private investors would be willing to do. It is a certainty that once the government assumes this role the potential for trouble is vast.

And this is the key to understanding everything that follows. With Fannie and Freddie becoming the most significant players in the mortgage business the entire domain was subject to government intervention. Financial institutions, builders, investors, home-buyers – all had to make decisions in an environment saturated with government power. Whatever happens where Fannie and Freddie dominate is largely the result of interventionism – not the workings of a free market. When the government is a strong agent in the world of business it is not neutral. Instead, it pressures people to comply with the wishes of politicians.

Why did investors, both institutional and individual, purchase securities from Fannie and Freddie? The yields were not exceptionally high, but the fact that Fannie and Freddie were government-sponsored convinced many that they were extremely safe. If anything were to go wrong with a GSE mortgage-backed security, surely the government will make good on it. Many investors felt no need for scrutiny. Notice that securities created by private companies – in a genuine free market – do not enjoy this status.

Both mortgage giants have been around for a long time – Fannie since 1938 and Freddie since 1970. Why did the calamity occur now? Is it fair to blame “unfettered capitalism” and “selfish greed” or are there government actions that are behind the disaster?

For much of their existence Fannie and Freddie had a reputation for being conservative – only purchasing mortgages that met very strict standards – for example the home buyer had to document a history of employment, a minimum income, a good credit history. Lower quality mortgages were not good enough for Fannie and Freddie, which signaled to banks that if they originated risky mortgages they would be stuck with them. This did not encourage banks to make loans recklessly.

In the 1990s and 2000s the political wind shifted. Powerful members of congress called upon Fannie and Freddie to make housing more affordable to under-served, lower income people who did not necessarily have excellent credit ratings. The result is that Fannie and Freddie changed the criteria they used for buying mortgages from banks. Executives in banks knew that they could originate “sub-prime mortgages” – loans to people who were less likely to pay the money back. The downside exposure was minimized since once the mortgage was sold it was not the bank’s problem.

Adding governmental fuel to the fire was the Community Reinvestment Act – started in 1977 and strengthened in 1995 – which applied to commercial banks. In essence the law – designed to deliver benefits to the poor – prohibited banks from “discriminating against” people in their service area who were less affluent. The effect was that banks complied with the directive by relaxing their loan standards and originated mortgages that were riskier – giving mortgages to borrowers who otherwise would not have obtained them.

So for the last several years Fannie and Freddie have been cranking out and selling an increased number of low-quality mortgage backed securities. And many investors, which includes financial institutions, did not worry since the government is implicitly behind them. When the real estate bubble burst and property values declined Fannie and Freddie crashed, and institutions that are heavily invested in mortgage backed securities are on the brink of ruin.

Clearly, this is a story of government interventionism leading to mischief. It cannot be interpreted as a failure of regulation. The visible hand-prints of government meddling are everywhere. Those who would attempt to pin the blame on free enterprise cannot be taken seriously.

How will the crisis be resolved? As of this writing Treasury Secretary Henry Paulson has suggested a monumentally expensive federal bail out for financial institutions that are holding low quality mortgage backed securities. A government enterprise will buy their “bad mortgages” at higher prices and at greater volumes than they would obtain if they were selling to private businesses. Does this sound familiar?

*** See other entries at AlertMindPublishing.com in “Monthly Columns.” ***

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