Barney Frank has been all over the airwaves this week with a clear and—we never thought we’d say this—perfectly sound message about Fannie Mae and Freddie Mac: “They should be abolished.”

Considering that Frank has been one of the principal backers and beneficiaries of the so-called government-sponsored enterprises, this is indeed good news.

Doesn’t Frank also join Ron Paul in calling for an audit of the Fed? What’s going on?

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.

What is especially noteworthy is the process through which the American public has been desensitized to the explicit expansion of state power in eight short years. It is a virtue that humans adapt quickly to new environments, but this strength can be turned into a weakness by clever politicians.

The housing boom and bust was a product of interventionist monetary policy, namely Alan Greenspan’s decision to slash interest rates after the dot-com crash. The crash in real-estate prices has in turn led to large defaults on mortgage payments, inflicting billions in losses for investment banks and other large institutions that had bet heavily on mortgage-backed assets. The heavily regulated financial sector was vulnerable to these unexpected events. What should have been a large hit to real estate and a few institutional investors has now spread and is currently threatening the global financial system itself. (We should keep this episode in mind whenever someone claims that the free market is too unstable and requires wise government oversight to promote stability.)

Villains and Saints

A panicked citizenry looks about for villains and saints, and the government is only too happy to dispense the labels. The villains are predatory lenders, short-selling speculators, and “do nothing” officeholders and regulators allegedly blinded by their laissez-faire faith, while the heroes (naturally) are the populist politicians who promise to clean up the greed and irresponsibility of the nefarious financial industry. If citizens would just suspend their abstract aversion to nationalization of large sectors of the economy, the government could keep them safe from further economic harm.

The Federal National Mortgage Association—FNMA or Fannie Mae—was founded as an agency of the federal government as part of the New Deal in 1938. Its function was to create a secondary market for mortgages, meaning that Fannie Mae, rather than originating loans to homebuyers, would buy mortgages (and their expected payment streams) from community banks and thrifts. In 1968 Fannie Mae was transformed into a private-sector company with shareholders, and its official connection with the government was transferred to the Government National Mortgage Association (GNMA or Ginnie Mae). The Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered in 1970 as another government-sponsored enterprise in the secondary mortgage market; it too is owned by shareholders.

The ostensible purpose of Fannie and Freddie is to promote homeownership. The two GSEs buy mortgages and bundle them into mortgage-backed securities, which are sophisticated derivatives that slice and dice the incoming monthly mortgage payments such that outside investors can (in theory) limit the risk of their real-estate investments. By providing a huge and liquid secondary market for mortgages, Fannie and Freddie make it more lucrative for others to originate mortgages. Make no mistake about it: The official mission of Fannie and Freddie is to cause banks to lend to applicants who would be rejected in the absence of government meddling. This point needs to be stressed as analysts wonder, “Why did banks make so many bad loans?”

All of this raises an obvious question. How exactly do Fannie and Freddie achieve their goal of promoting more mortgage origination than would have occurred in a free market? The answer is that these GSEs enjoyed implicit—and now explicit—government backing. Until quite recently, the official position of the federal government has been that Fannie and Freddie were private companies, earning private profits to be distributed to private shareholders. No taxpayer money stood behind them. However, investors suspected the GSEs were too big and too symbolic to be allowed to fail. Consequently, investors were willing to lend money to Fannie and Freddie—by buying bonds issued by these two GSEs—at lower interest rates than these same investors would have charged a truly private firm that performed Fannie’s and Freddie’s operations. Because their bonds were presumably guaranteed by the “full faith and credit” of the U.S. government—meaning the IRS and printing press—Fannie and Freddie were able to gain a huge share of their market; they directly owned or guaranteed roughly $6 trillion in mortgages. To repeat an earlier observation: The vulnerability of the overall system to a few giant firms is itself a product of intervention in these markets. If the government suddenly promised that it would use tax dollars to make creditors whole if Apple defaulted on its bonds, then we would expect it to become more “profitable,” cut prices, and gain market share from Microsoft.

It is worth pointing out that plenty of insiders got rich during the good times. Former Fannie chairman Franklin Raines earned some $90 million in compensation from 1998 to 2003. Even during the “bad times,” things weren’t so tough for the people running the two politically connected firms. As part of its takeover, the government ousted CEOs Daniel Mudd (Fannie) and Richard Syron (Freddie), yet they are entitled to compensation packages that could be worth up to a combined $24 million.

A Culture of Recklessness

Besides the implicit backing of their debt, the GSEs also enjoyed less regulation than their purely private counterparts. This bred a culture of recklessness and short-term thinking. To hit targets and trigger bonus payments to top executives, Fannie Mae manipulated its earnings over the period 1998–2004. Yet even when it was “caught,” Fannie was only fined $400 million in what was an $11 billion accounting scandal. Furthermore, one suspects that the full $400 million penalty did not fall entirely on the executives who defrauded their own investors, meaning the gamble was well worth it from their narrow point of view. Students of political economy know that regardless of the official motivation for a new government agency or program, once it is up and running, politicians, bureaucrats, and corrupt businesspeople will find ways to enrich themselves at taxpayer expense.

What is particularly insidious about government debt guarantees and rescue loans—whether the implicit backing given to Fannie and Freddie for decades or the explicit guarantee given to the Mexican government during its own credit crisis in 1995—is that they can often seem costless. Indeed, the U.S. Treasury actually made money on its “bailout” of Mexico because the Mexican government didn’t default on the bonds it had sold to investors around the world. In similar fashion, it didn’t cost the government anything for its implicit protection of the GSEs when housing prices were booming in the mid-2000s.

All of this changed, however, once house prices began sharply falling. Speculative buyers and those who had planned to refinance out of ARMs were now caught with mortgage payments they couldn’t afford, and so they began walking away. The stream of monthly payments into the bundled securities created by Fannie and Freddie was now drying up, and so the giants began losing money because as part of their normal operations they had guaranteed some of these payments. From the fourth quarter of 2007 through the second quarter of 2008, the two reported combined losses of $11.7 billion. Now the cost of the government’s backing would be evident.

Parsing Paulson

It will be instructive to parse the actual announcement of the Fannie and Freddie seizure. Right out of the chute, Paulson explained:

Note that the Congress didn’t send a bill to President Bush asking to nationalize the two corporations. On the contrary, it merely gave the relevant agencies the legal permission to take such actions if deemed “necessary.” This latter strategy is far harder to contain, because who could possibly object to giving the executive branch options? That seems to be a different issue from the question of which options were good ones. Thus members of Congress can truthfully say that they merely voted in the interest of preparedness for a takeover. The president and his minions can take the blame or praise for the specific exercise of the powers so delegated.

Paulson went on to say:

Since this difficult period for the GSEs began, I have clearly stated three critical objectives: providing stability to financial markets, supporting the availability of mortgage finance, and protecting taxpayers—both by minimizing the near-term costs to the taxpayer and by setting policymakers on a course to resolve the systemic risk created by the inherent conflict in the GSE structure.

The problem here is that the “critical objectives” are incompatible. When Paulson talks of “supporting the availability of mortgage finance,” this means making mortgages more available than they would be in a purely free market. To achieve that objective, then, the government must expose taxpayers, and the skewed incentives will necessarily distort the financial markets. Again, there is no way around this. If the government induces lenders to make loans that they originally thought were too risky, then the government has obviously made the overall system more volatile.

After Paulson’s opening remarks, he turned the podium over to James Lockhart, director of the new regulator, the Federal Housing Finance Agency. Lockhart explained that the GSE structure was inherently flawed because private shareholders pocketed gains while the taxpayers were ultimately on the hook for massive losses. Even so, Lockhart further explained that as part of the takeover, Fannie and Freddie would expand their portfolios of mortgage-backed securities before reducing them steadily starting in 2010. As usual with government, when something isn’t working, the solution is to make the problem grow—call it a “surge” in mortgage portfolios. No doubt future administrations will continually revisit whether conditions “on the ground” warrant a reduction in the monstrous agencies.

Lockhart also revealed that in exchange for its guarantee, the Treasury received senior preferred equity shares and warrants (similar to call options) that entitle the Treasury to purchase up to 79.9 percent of the common stock of the two companies under certain conditions. (To the best of my knowledge, those “certain conditions” were not revealed to the public—it’s not merely that reporters have omitted the precise details out of laziness.)

It is significant to point out that the preferred and arguably even the common shareholders were robbed in this procedure. The Treasury’s “senior preferred equity shares” bump the original preferred shareholders down a peg, forcing them to absorb losses before the Treasury takes a hit. On the other hand, if things turn around and Fannie and Freddie stocks recover, then the Treasury would find it profitable to exercise its warrants and thereby dilute the values of the other shareholders. For these reasons, the term seizure is far more accurate than rescue to describe the government’s actions with respect to Fannie and Freddie.

The government cannot create wealth. Although he is very smart and understands financial markets, Henry Paulson cannot centrally plan the mortgage market to improve on the spontaneous outcome of voluntary interactions among millions of professionals in the private sector. The fundamental causes of our current financial crisis were mortgages granted to unqualified applicants, as well as investors making very risky bets on assets derived from these mortgages. The bailout of those who lent to Freddie and Fannie, and the easing of the GSEs’ regulatory limits, will only sow the seeds for a potentially worse crisis down the road.

The Trend Toward State Socialism

Beyond the harmful effects on the real-estate and mortgage markets, the seizures of Fannie and Freddie—as well as the bailout of AIG the following week—reinforce the trend toward outright state socialism. Investors are looking less at fundamentals and more at government announcements. The idea that these moves are encouraging “stability” is ludicrous, as the once-mighty Lehman Brothers was allowed to fail in between the two massive bailouts.

During normal economic times, if the government began seizing firms and disbursing hundreds of billions of dollars to particular institutions, and furthermore if each action were discretionary and impossible to predict even one week in advance, then everyone would recognize these policies as incredibly destabilizing. Yet this destabilizing effect still exists when laid over a backdrop of massive losses, and in fact hurts even more because of the victim’s initial weakness.

Hard as it is to believe, the best course of action would have been for the government to allow these troubled firms to fail. This would be akin to pulling the Band-Aid off quickly, which is temporarily painful but soon forgotten. But with the possibility of federal bailouts and other novel techniques to revive the housing sector, troubled firms have been postponing the inevitable, hoping for a reversal of misfortune. As the financial crisis has now entered its second year, Bernanke and Paulson are pulling off the Band-Aid very slowly indeed.

As government-sponsored entities, Fannie Mae and Freddie Mac allowed their private executives to profit greatly from implicit taxpayer support over a period of decades. However, now that their excessive risk-taking has finally caught up with them, the GSEs’ shaky balance sheets have been absorbed by the federal government, which at the same time has announced that the two failing giants will take on even more obligations. Besides the further bilking of the taxpayer, the seizure is an ominous sign of just how much power the executive branch has accumulated. The takeover of Fannie and Freddie will do nothing to promote stability in the financial markets in the long run, but it will serve as a precedent for further “necessary” expansions of government control of the economy.

They were created—intentionally—to distort the housing and mortgage markets. That is, 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 wealth and income 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 required 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. (Rent-seeking here refers to the quest for politically derived as opposed to market-derived profits.) Dressed up as promotion of the American Dream through homeownership, the planners used the 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 and immediately pass them on to others. Pooling lots of mortgages together, the GSEs create mortgage-backed securities (MBS) and either sell them or (more frequently) keep them, assuming the risk of default. In fact Freddie and Fannie created the secondary mortgage market that has come in for criticism since the subprime problem developed.

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 real private companies, permitting them to do things on a scale larger than would have occurred in a free market. The advantages include tax exemption, government loans, an implicit bailout promise, and lower capital requirements.

The result was a far more concentrated lending market and hence greater vulnerability to 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 new mortgages are GSE-backed. So the government has just become the country’s major mortgagee.

The GSEs have 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 will begin with a billion-dollar infusion. Then the government will start buying shaky Freddie- or Fannie-backed mortgage securities in the marketplace. A $5 billion purchase will get things going, but up to $200 billion has been promised. It will no doubt be more.

Where will this money come from: taxation, borrowing, or the printing press? What will that do to our economic well-being?

The New York Times is wrong. This is not “an extraordinary federal intervention in private enterprise.” It is the state bailing out statism. Let’s hear no more about the “laissez-faire” Republicans. That myth serves only to protect advocates of state intervention regardless of party.

It is with deep sadness that I note the death in October of our long-time contributing editor Norman Barry after a long illness. Over the years Norman kept Freeman readers informed about free-market and statist developments in Europe and elsewhere, always with optimism about the future of liberty. He was a professor of social and political theory at the University in Buckingham, which, he proudly noted, is the United Kingdom’s only private university. Among his many Freeman articles, my favorite is “Freedom and Morality in the Plays of Tom Stoppard” (August 1999, http://tinyurl.com/6h9s5s). He was a gentleman, a prolific scholar, and a pure pleasure to work with.

A standard argument for the patent system is that without it innovation would shrivel. But what if it’s patents, not their absence, that impede innovation? Michele Boldrin, David Levine, and Alessandro Nuvolari tell the story of the steam engine that couldn’t . . . until the patents expired.

The right to earn a living in one’s own way is increasingly under assault by special interests successfully lobbying for licensing and other protectionist restrictions. Bob Ewing says people are fighting back.

Centralization of power always threatens liberty. So Pierre Bessard is justifiably nervous about the tax “harmonization” taking place in the European Union.

The poet E.E. Cummings alienated himself from his left-wing friends when he wrote a book in 1931 on how the Soviet Union crushed individuality. Bruce Walker has the details.

Our hard-working columnists have delivered once again. Lawrence Reed teaches the politicians about Adam Smith. Thomas Szasz sees the therapeutic state as an escape from and threat to self-responsibility. Burton Folsom examines the record of Andrew Mellon. John Stossel wonders if we need all those stop signs. Walter Williams picks through fuzzy thinking. And Steven Horwitz, encountering the claim that the free market has failed, replies, “It Just Ain’t So!”
Books coming under review this issue are about the welfare state, Milton Friedman, abundance, and three influential economists.

Since it’s December, the issue concludes with the year-end index, prepared by Managing Editor Beth Hoffman.

In this environment, it’s natural that the government—and in particular the presidential candidates—are offering their “solutions.” As we’ll see, most of these proposals would only make things worse. To see why, we first need to understand what went wrong in the housing market.

To put it simply, there was an unsustainable bubble in home prices. From June 2001 to June 2006, the ten-city composite index mentioned above rose a whopping 89 percent. Now an average annualized return of over 13 percent isn’t bad, especially when you can live in the investment or rent it out for income. Consequently, more and more people entered the housing market. Some bought more expensive homes than they otherwise would have, and others even began buying homes purely as investments to “flip” once they had appreciated. As in any market, when prices exploded producers began cranking out more product—homebuilders were very busy, and their stock did very well during this period.

Another important part of the story is the revolution in financing that blossomed at the same time, which both benefited from and exacerbated the housing boom. In a traditional arrangement people in a community deposit funds with the local bank, which pays them a low interest rate in return. Then the bank takes this large pool of individual deposits and grants mortgages to qualified applicants, charging them a higher (but fixed) interest rate to compensate both for the bank’s overhead and the possibility of default. To make sure its loans went to responsible borrowers, and to align everyone’s incentives, the bank would insist on a hefty down payment, often 20 percent of the price of the house.

Yet things didn’t always happen this way during the recent housing boom. Rather than conventional fixed-rate mortgages, eager buyers were granted adjustable-rate mortgages (ARMs) that offered low upfront rates, which would then reset down the road. This allowed people to buy much more expensive homes, because they could handle the monthly payment at the “teaser” rate. Many buyers figured they could either flip the house before the ARM reset, or they could refinance at that time into a fixed mortgage.

Besides ARMs, other unorthodox practices occurred. People might be granted interest-only mortgages, where the borrower treads water with each payment, or even “negative amortization” ones, where the principal owed to the bank actually grows over time. Naturally, people signing up for all of these low-pain mortgages didn’t have money for a down payment, and here too the banks were very obliging. Before discussing the innovations on the mortgage-holder side of the market, I should stress that the above patterns aren’t as crazy as they now appear in retrospect. If home prices had continued their double-digit rates of appreciation, these practices all made perfect sense. It was only when the housing market collapsed that the borrowers were caught with their pants down.

On the banking side, here too practices deviated from the old ways. Rather than keeping mortgages on their balance sheets, local banks would sell them off to middlemen, who would ultimately pass them on to the giant investment banks headquartered on Wall Street. These organizations would turn to their “financial engineers” to bundle pools of mortgages into a new entity, broadly classified as a collateralized debt obligation (CDO). Outside investors could then buy bonds issued by the CDO. The flow of monthly mortgage payments into the CDO funded the flow of coupon payments to the bondholders. In the event of defaults, there were pre-determined rules for which CDO bondholders took the hit first. Naturally, the riskier classes (or “tranches”) of CDO bonds offered higher rates of return at the outset.

The growth in popularity of CDOs allowed institutional investors to participate in the booming housing market. Someone managing a pension fund didn’t have to do research on employment and default rates in Sacramento to gain exposure to real estate; all he had to do was buy bonds issued by the relevant CDOs. The high ratings granted by Moody’s and other agencies satisfied contractual and regulatory requirements, and reassured these outside investors that such investments were safe. Sure, any individual borrower could default, but the Ph.D.s at the investment banks had quantified the risks so everybody (apparently) knew exactly what he was buying into.

Of course, the party ended once housing prices peaked, and things turned ugly when prices began falling sharply. Most obvious, homebuilders were caught flat-footed, with more inventory in the pipeline that now had no buyers. But the fall in prices also   devastated those borrowers who had been banking (literally) on the opposite expectation; with negative equity and no buyer, they were stuck with mortgage payments (especially those with resetting ARMs) they couldn’t afford.

As is well known, the housing bust wreaked havoc in the credit markets as well. CDOs involving real estate were suddenly dangerous. The mathematical models that had previously been used to value them were obviously deficient, yet market prices weren’t available because nobody wanted to purchase the securities. Thus beginning in August 2007 and continuing to this day, banks have been reluctant to lend to each other because they couldn’t really trust the solvency of their counter-parties. (A bank asking for a short-term loan might have $1 billion in mortgage-backed securities on its books to pledge as collateral, but how much were those assets really worth?)

Because of banks’ reticence to lend not only to regular people but also to each other, the housing bust led to a much broader credit crunch. The process was a vicious circle. Spooked by the debacle, banks became much more stringent in their standards when evaluating new mortgage applications. This has only intensified the fall in house prices, as willing buyers can’t obtain financing.

How Government Caused the Trouble

Now that we have a better grasp of exactly what happened, the next issue is, “Why?” The typical answer is greed, on the part of investment banks, real-estate brokers, and speculators. But unless someone can explain why financiers and speculators were greedier in the mid-’00s than at other times, this explanation isn’t too helpful.

The free-market economist has learned from many different examples that when individuals and firms systematically make boneheaded decisions that lose them gobs of money, there is usually a government policy driving the madness. And in the housing bust, the pattern holds.

First and most obvious, the Federal Reserve had an easy-money policy to try to rescue the economy from the dot-com crash. In 2001 alone, the federal funds target rate was slashed from 6.50 percent down to 1.75 percent; the target eventually reached an incredibly low 1 percent by June 2003, where the Fed held it for an entire year. Then from June 2004 through June 2006, the target was steadily hiked back up to 5.25 percent. Although the correlation isn’t perfect, when the federal funds rate is cut, other interest rates—including mortgage rates—generally fall with it. Given the close connection between mortgage rates and home prices, even mainstream analysts have blamed the Fed for its role in the housing crisis.

Another obvious government distortion resulted from the actions of the Federal Housing Administration (FHA), which provides insurance for mortgage holders in the event of a default by borrowers. To see the connection between the FHA’s activities and the housing boom, we need only quote from the main page of its website: “Unlike conventional loans that adhere to strict underwriting guidelines, FHA-insured loans require very little cash investment to close a loan. There is more flexibility in calculating household income and payment ratios.”

Implicit Government Guarantees

Freddie Mac and Fannie Mae, major participants in the secondary market for mortgages, also share a portion of the blame. They buy mortgages from originators (banks, thrifts, credit unions, and so on), package them into bundled securities, and then sell the new assets to outside investors. As so-called government-sponsored enterprises, they do not directly receive tax dollars or explicit government assistance. However, many investors believe there is an implicit federal guarantee behind these agencies, and their regulatory requirements are also looser than for their purely private-sector counterparts.

Because of these advantages, when mortgage originators know a loan will be eligible for purchase by Freddie Mac and Fannie Mae, they can charge home buyers lower rates than would otherwise be profitable. Indeed, part of the official mission of these companies is to make the dream of homeownership attainable for millions of low- and moderate-income families. When trying to understand why so many obviously unqualified people were able to obtain financing during the housing boom, we shouldn’t ignore the role of large intermediaries explicitly designed to “soften” the strict requirements of the pure market.

Pressure to loosen underwriting standards was placed on private lenders as well in the name of avoiding discriminatory “redlining.” Stan Liebowitz, an economics professor at the University of Texas at Dallas, has been a critic of such political correctness for over a decade. In a February 5 New York Post op-ed (http://tinyurl.com/2ahdkd), he explains how beginning in the 1980s, activist groups such as ACORN (Association of Community Organizations for Reform Now) agitated against lending practices that yielded fewer approvals for minority and other low-income applicants.

In 1992 the Boston Fed produced an academic study that purportedly verified this bias in lending and distributed a manual for lenders that said the use of “arbitrary or outdated” criteria could be evidence of discrimination. Some of these criteria included income verification and the credit history of the mortgage applicant.

In 1995 the fuzzy-sounding 1970s Community Reinvestment Act (CRA) was strengthened. Henceforth, all banks and thrifts that enjoyed deposit insurance had an affirmative duty to lend throughout the regions in which they accepted deposits, notably including poor neighborhoods. If they received bad marks on this score, they could be subject to direct or indirect sanction, such as having merger plans held up by the Department of Justice. Studies by both the Federal Reserve and Harvard’s Joint Center for Housing Studies found that the CRA achieved its goal—namely, higher rates of homeownership in poorer communities.

Although some defenders of the CRA have pointed out that half the subprime loans were made by institutions outside the law’s purview (http://tinyurl.com/3sjcfj), surely government and activist efforts to shame lenders into loosening standards must play some role in our story. To quote Liebowitz:

Ironically, an enthusiastic Fannie Mae Foundation report singled out one paragon of nondiscriminatory lending, which worked with community activists and followed “the most flexible underwriting criteria permitted.” That lender’s $1 billion commitment to low-income loans in 1992 had grown to $80 billion by 1999 and $600 billion by early 2003.

Who was that virtuous lender? Why—Countrywide, the nation’s largest mortgage lender, recently in the headlines as it hurtled toward bankruptcy.

In an earlier newspaper story extolling the virtues of relaxed underwriting standards, Countrywide’s chief executive bragged that, to approve minority applications that would otherwise be rejected “lenders have had to stretch the rules a bit.” He’s not bragging now.

Finally, there is the matter of the ratings agencies. Had they done their job properly, and given more accurate estimates of the riskiness of the rather exotic CDOs with which many investors were unfamiliar, then the housing boom would not have gained so much momentum. As usual, critics of capitalism attribute their mistakes to simple greed or even corruption.

Yet we have to ask: Don’t agencies such as Moody’s and Standard and Poor’s have an incentive for honest and accurate reports? Aren’t they suffering now for their wildly overoptimistic ratings, the way Countrywide and other lenders have either gone bust or are on the verge of doing so?

The answer is no. State and federal regulations of entities such as banks, insurance companies, and broker-dealers often rely on the creditworthiness of the bonds on the books of these organizations. Naturally the government then has to specify which ratings agencies are legitimate for this purpose; a banker can’t simply get a letter from his brother-in-law declaring his bonds to be “investment grade.” Although space does not permit a full treatment here, suffice it to say that the major ratings agencies are largely shielded from open competition (http://tinyurl.com/5akgq3). Consequently they will not be ruined by the housing bust, and it is no wonder then that they were so reckless with their profitable (at the time) evaluations.

Now that we understand the problem with the housing and credit markets, and how misguided government policies caused or at least greatly exacerbated the mess in the first place, we can quickly evaluate the likely effectiveness of some of the recent and suggested moves to fix things:

Cutting the federal funds rate. From September 2007 through April 2008, the Fed cut its target rate from 5.25 to 2 percent. Not surprisingly, things are still awful in the housing market, and the credit markets are still unsettled. As we’ve seen above, it was arguably Fed rate cuts that caused the housing boom in the first place. At this point, everyone is spooked; newly created dollars won’t flow into housing, but rather some other sector, such as commodities.

Bailouts of firms judged “too big to fail.” The Federal Reserve Bank of New York notoriously assisted with JPMorgan’s rescue of Bear Stearns in March on the grounds that its collapse would have led to widespread panic and further failures. As many critics have argued, such rescue attempts lead to a “moral hazard” that will only further encourage risky practices in the future. For a market to work, we need to rely on the profit-and-loss mechanism. Bear Stearns was heavily invested in mortgage-backed securities (MBS) and should have been left to suffer its fate on the open market. The only way to reward firms that wisely eschew hot items during a boom is to allow their competitors to go bust.

Accepting mortgage-backed securities as collateral for short-term loans. On March 11, the Federal Reserve announced the Term Securities Lending Facility, authorized to lend up to $200 billion of the Fed’s holdings of Treasury securities to primary dealers in 28-day loans. The Fed agreed to accept MBS as collateral for these loans. The move promoted “liquidity” because it is much easier to raise cash in the market with bonds issued by the federal government (Treasuries), rather than securities tied to mortgages at risk of massive defaults.

There are several problems with this arrangement and others like it. First, it obviously puts taxpayers on the line if the primary dealers default and the Fed is stuck with (grossly overvalued) MBS. Second, it intensifies the moral hazard discussed above; it benefits those who hold a large amount of MBS—precisely the investors with poor foresight. Finally, it perversely encourages holders of MBS to keep them off the market, since the Fed will accept them at an unrealistic book value.

To repeat, the problem in the credit markets isn’t simply the massive losses from bad loans. It’s also the uncertainty caused by the large holdings of derivative assets tied to mortgages. Only when institutions bite the bullet and begin selling these assets, presumably at large losses, can realistic market prices be established. Only then will banks be able to assess each other’s creditworthiness, and only then will they begin lending freely to one another. Government efforts to prop up the MBS market perversely stall this shakeout.

Rewriting contracts in favor of the homebuyer. Senator Hillary Clinton has been the most aggressive in this area. In December she called for a 90-day moratorium on certain types of foreclosures, and a five-year moratorium on ARM resets. Although these measures would help some existing homeowners in the short run, they would make it harder for newcomers to obtain financing to purchase a house. After all, the reason a bank is willing to lend out such large sums to a young couple is that the loan is secured; the bank can take possession of the house if the couple defaults. As far as ARM resets, it obviously doesn’t help the beleaguered holders of MBS to be told that the government has codified their fears of nonperformance.

A federal “loan substitution” program. In a March 7 op-ed in the Wall Street Journal (http://tinyurl.com/2zo6nm), economist Martin Feldstein proposed that the federal government pay off 20 percent of the mortgages of homeowners who opt into the program. They would repay the government over 15 years at the rate earned by two-year Treasurys (1.6 percent when Feldstein was writing). The point of the plan would be to encourage homeowners—especially those with negative equity—to continue making their monthly mortgage payments, rather than walk away.

Feldstein said the plan would be financed “by issuing new two-year debt until the loans are fully repaid, thus eliminating any net cost to the government.” It is rather shocking that Feldstein, chairman of the Council of Economic Advisers under President Reagan, didn’t consider that some of the participants in the plan might default on their debt to the government. As usual, the taxpayer would ultimately foot the bill for this massive handout to the mortgage industry.

Enhanced regulation. Almost every “serious” commentator on the housing crisis, including the allegedly laissez-faire Treasury Secretary Henry Paulson, has called for enhanced government oversight of the financial sector. It is ironic that in February the constraints on Freddie Mac and Fannie Mae were considerably loosened to allow them greater leeway in buying mortgages—and this just as the companies were reporting losses in the billions of dollars in the fourth quarter alone of 2007.

Where Do We Go from Here?

There are two distinct approaches the government can take to discourage institutions from engaging in reckless financial transactions. One is to let them do whatever they want (subject to prohibitions on outright fraud and theft) and let them go bankrupt if they screw up. The other is to hold their hands every step of the way, bailing them out of trouble but also second-guessing every decision they make.

In light of the complex and quickly moving financial system, as well as the politicians’ own dismal record on matters of honest bookkeeping, I think the first approach is far more sensible.

Unfortunately, even some nominal friends of markets have argued the housing crisis is too serious to ignore. If the government sits back waiting for prices to hit bottom, we are told, there will be unacceptable ripple effects throughout the rest of the economy. Yet as we have seen, most of the proposed interventions would make the housing crisis worse; any alleged ripples would turn into tidal wives. Beyond that observation, we should also remember that prices really do serve a function in a market economy. The politicians have already caused real damage, and people need market prices to know how to make the best of a bad situation. Propping up home prices at unrealistic levels will simply waste tax dollars and hamper the correction.

Our current housing and credit crises are quite serious—perhaps the worst since the Great Depression. As usual, the free market is not to blame; numerous government policies caused or exacerbated the situation. The host of “solutions” being implemented or  recommended will only make matters worse.