The key to understanding the saga of Fannie Mae and Freddie Mac—the recently nationalized twin government-sponsored enterprises (GSEs) that dominate home financing—is this:

They were set up—intentionally—to distort the housing and mortgage markets. Government planners were not content to let voluntary exchange and spontaneous market forces configure those industries unmolested. So—holding the taxpayers hostage—they intervened.

Make no mistake: The collapse of Fannie and Freddie is government social engineering predictably gone bad.

In a free society supply and demand would govern markets. The demand for houses would be determined by people’s preferences and the resources at their disposal. Supply would be determined by relative profit expectations—which is to say, by the demand for housing and the competing demand for the necessary inputs.

A distortion occurs when government planners and rent-seeking corporate allies, under cover of humanitarian social policy, engineer a deviation from natural market outcomes. Dressed up as promotion of the American Dream through home ownership, the planners used political means—ultimately, the threat to imprison uncooperative taxpayers—to channel wealth to the construction, real-estate, and financial industries. The primary instruments of this social engineering were Fannie Mae, created as a government agency during the New Deal and—cough—“privatized” in 1968 to get it off budget, and Freddie Mac, created as a “private” GSE in 1970.

The GSEs don’t make mortgage loans. Rather, using borrowed money, they buy mortgages from original lenders, encouraging banks to make more loans. Pooling lots of mortgages together, the GSEs create mortgage-backed securities (MBS). In fact, Freddie and Fannie created the secondary mortgage market that has come in for criticism since the subprime problem developed.

As economist Arnold Kling writes, “Whether it retains or sells the security, the GSE bears the default risk of the mortgages, which is the source of the recent crisis.”

Freddie’s and Fannie’s activities were designed to channel money to mortgage lenders so that they could loan widely, especially to people who might have been priced out of a fully private mortgage market. The system inevitably lowered lending standards and interest rates.

If these activities had been performed not by GSEs but by real private companies, they would have been subject to market checks. But they were not. They’re not called government-sponsored enterprises for nothing. As such they have special advantages over private companies, permitting them to do things on a scale larger than would have occurred in a free market.

They don’t pay local and state taxes like other companies do, and they can get government loans. Moreover, as Kling puts it, “In both the mortgage insurance business and the portfolio lending business, the GSEs have two important advantages . . . [:] a lower risk premium and lower capital requirements.” In brief, Fan and Fred could borrow money for less than private companies could because “investors believed that the GSEs would not be allowed to fail,” Kling writes. This is the “implicit guarantee.” (With the wink of an eye, the GSEs say their paper is not guaranteed. So why not hold their creditors to the letter of the contract?)

As for the lower capital requirements, Kling writes, “When banks engage in the mortgage insurance business or the portfolio lending business, they are required by their regulators to put more of their shareholders’ funds at risk than the GSEs are. This makes it difficult for banks to compete with GSEs.”

The result was a far more concentrated lending market and hence greater vulnerability to adverse changing conditions. Fan and Fred hold or insure $5.4 trillion in mortgage debt—half the national total—making the taxpayers ultimately responsible now that the GSEs are under federal conservatorship. Three-quarters of mortgages written these days are GSE-backed. So the government has just become the country’s major mortgagee. It’s ironic that after making the GSEs dominant, the government now wants to shrink their role in the mortgage industry beginning in 2010.

Not Greed But Incentives

We can see, then, that the GSEs’ privileged status, which was intended to distort the housing and mortgage markets, did exactly that. The whole shaky structure was vulnerable to a deterioration in home values, to which the GSE system itself contributed. (Other things contributed to the run-up and collapse of home values in particular parts of the country, such as a broad social policy of encouraging banks to lend to un-creditworthy borrowers.) As of September, the GSEs had lost well over $10 billion since the mortgage meltdown occurred, and they were getting close to being unable to borrow enough money to roll over their debt. This and fear of a more general economic meltdown are what prompted the government to step in, exposing the taxpayers dramatically. The bailout was to begin with a billion-dollar infusion. Up to $200 billion has been promised. It will no doubt be more. Of course, the treasury secretary now has the authority to buy $700 billion worth of dubious mortgage-backed securities from struggling banks. Rev up those printing presses.

It’s really an anticlimactic chapter in this story of putrid rent-seeking and political opportunism. The bailout of the GSEs’ creditors creates a new round of the same moral hazard—encouraging recklessness by insuring it—that brought on the calamity in the first place. No one believed it would be the last bailout of those who are “too big to fail.”
The current problems are commonly attributed to greed and irresponsibility. But this won’t do. As Lawrence H. White notes, “Greed is a constant.” Why did the consequences take so long to show up?

There was irresponsibility—but only because the government for decades has pursued a policy of relieving big companies of the responsibility that otherwise would have been imposed by market discipline and competition. Any promise to bail out companies, and any regulatory, tax, or trade policy that raises the barriers to entry for new competitors, sews the seeds of crisis.

Focusing on greed and irresponsibility misses the most basic point: incentives. In a truly free market—when business people know they must face the consequences of their actions—“greed” (whatever that may be) tends to create general benefits. (“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”) In a government-regulated and government-guaranteed environment, “greed” can inflict harm on innocents. Institutions determine whether self-serving action benefits or damages others. Institutions that respect freedom, property, and self-responsibility promote the general welfare. Institutions that forcibly transfer risk to the taxpayers, punish responsibility, and reward irresponsibility promote social and economic catastrophe.

The New York Times was wrong. This was not “an extraordinary federal intervention in private enterprise.” It is the state bailing out statism. As Oliver Hardy might have said, “Well, government, this is another fine mess you’ve gotten us into.” Let’s hear no more about the “laissez-faire” Republicans. That myth serves only to protect advocates of state intervention regardless of party.