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.