http://money.cnn.com/2008/09/07/news/companies/fannie_freddie/index.htm?postversion=2008090711

curious how this looks outside of the fed

I don’t know what to make of it, primarily because this is my first real exposure to the Fannie and Freddie thing. It looks somewhat reasonable if F&F are as important to the economy as the article claims.

Your analysis?

It would appear to me to be a sensible course of action, given the gravity of the situation. That said, it’s pretty damned shitty that the economy is doing what its doing to put these firms in this position to begin with, and the person or people responsible for that (I’m looking at you, Bush Administration) ought to be brought up on charges.

Before I get yelled at for blaming everything on Bush – I wouldn’t mind seeing some of the executives at the banks who thought the way they were selling mortgages was at all sustainable take some heat, too.

I’m mostly curious what people think independent of any special knowledge of the system. That said, here’s a primer.

I should say that my knowledge is not by any means exceptional (even after spending a few weeks preparing a briefing on FNMA/FLHMC balance sheets), but the key economic concepts here are:

-> Too Big to Fail

and the closely related

-> Moral Hazard

I don’t want to give you exceptionally precise definitions (because I’m not sure exactly what they would be) but the broad concepts are:

-> (TBTF) The failure of some exceptionally large companies would cause financial markets to seize up and collapse, and the government will be forced to bail out these large companies in the event of failure in order to prevent a financial meltdown. This meltdown would be really bad according to my second-favorite economist, Tyler Cowen:

http://www.marginalrevolution.com/marginalrevolution/2008/09/could-you-clari.html

-> (Moral Hazard) The presumption that the government would bail the large company out encourages the company to take more risks. Acting in a riskier manner does not increase the cost of failure (because any failure will be borne by the government) but does increase the potential upside. Other examples of moral hazard: a driver with insurance might drive more aggressively, because he will not be on the hook for any damage he causes; a man on a business trip might buy fancier foods than he usually would knowing that his company will compensate him later. These are both analogous to what happened with FNMA and FHLMC.

There is not much debate as to what happened: FNMA and FHLMC were too big to fail; they acted as though the government would rescue them if they fell into hard times (and it seems they were correct). The real trick is to determine how to avoid an immediate market collapse without leading other companies to believe that the government might rescue them in the future. I haven’t read the messy details of the plan yet, but I think I can say that the Paulson and Bernanke are at least aware of the pitfalls, and that I hope they’re acting accordingly.

—

A rule of thumb for evaluating government policy. Ask yourself the following question: “How could I exploit this policy to profit at the expense of the public?” If you can come up with an answer in thirty seconds or less, it’s probably a bad policy idea.

—

Other thoughts.

This was not a problem caused by Bush. The foundations of the modern housing market were in place long before he was elected; and how popular do you think it would have been for him to take steps that would impede the efforts of people to purchase homes? That would have been untenable in 2003 (when something could have been done) and is still, I think, untenable today. FNMA and FHLMC both had formidable lobbyist brigades and were beloved by Democrat and Republican voters alike.

I’m not certain of all ramifications this earthquake will have on the political economy, but as a first thought I think it’s worth reconsidering whether we really want to subsidize home ownership with public money.

I can write more about the nature and size of Fannie and Freddie as well if you’re interested. Here I think I am competent to give at least an overview.

Heh. Was this coherent writing about a technical subject?

Post updated by sam on 2008/09/07 15:48

Yes, and I’ll come back to respond in detail tomorrow… thanks for the synopsis.

http://hnn.us/blogs/entries/53544.html

in re to a conversation Cam and I had – this is a George Mason University economist (they’re super-libertarian there, btw) speculating about an impending US Gov’t default on bonds. It sounds a bit revolutionary (in the ideological sense, “You have nothing to lose but your chains” and all that) but it’s an interesting scenario.

Caveat, I’m not sure I buy any of it. Just posted as a novelty, and if it pans out you heard it from me first.

Yes, I absolutely agree that the Fannie/Freddie situation, much like the Bear Stearns situation, sends a strong message about what our government thinks about corporate responsibility v society’s responsibility (e.g.: “don’t worry about it boys – that’s why people pay taxes.”).

I lay blame at Bush’s feet because were the economy not tanking because of shitty decisions he and his administration have made (War in Iraq, economic policy favoring oil and gas companies and the resultant soaring energy costs, etc.) I suspect people wouldn’t be as pinched, and fewer would be defaulting on their mortgages. Yeah, it’s absolutely not solely his/their fault – and there’s plenty of blame to go around. Admittedly, he’s an easy target. That doesn’t mean, at least as far as I’m concerned, it isn’t worth pointing the finger in his direction, too. :-)

What is of particular interest to me is the culpability of the commercial banks (WaMu, Wells Fargo, Bank of America, Citi, etc.) in all of this. Someone somewhere had to know all those adjustable rate mortgages floating out there weren’t sustainable, right? My understanding is admittedly limited, but shouldn’t common sense dictate it’s a bad idea to crank up the interest rates on mortgages right when the general public is most strapped? Can you speak to this, Sam?

Rumor has it that WaMu might be facing collapse before the year’s out. What sort of consequences do you see to something like that?

Rumor has it that WaMu might be facing collapse before the year’s out. What sort of consequences do you see to something like that?

A bunch of crying cows?

As for the rest of this, I have no idea what to think. I mean, they’re doing it for a reason, and I guess I always assumed the reason was to mitigate the damage to our economy that the collapse of these financial giants would create. But on the other hand, it’s like, did anybody see the first season of Lost, where John Locke is talking about how he could help the caterpillar out of the cocoon, but if he did the resulting moth would be too weak to survive? Yeah, it seems to me by not letting the free market bludgeon the shit out of bad practices we’re just making it worse for ourselves in the long run.

I’m not certain of all ramifications this earthquake will have on the political economy, but as a first thought I think it’s worth reconsidering whether we really want to subsidize home ownership with public money.

When I learned in high school that home ownership was so incredibly subsidized by the government I knew it seemed wrong. Social construction at its most blatant, if you ask me. What is wrong with renting? Or owning a condo?

When I learned in high school that home ownership was so incredibly subsidized by the government I knew it seemed wrong.

There are some arguments in favor of subsidies for housing. For example::

- Homeowners build equity rather than losing money to rent;

- Owning increases a person’s stake in the quality of their neighborhood, and leads them to make decisions that positively affect their neighbors (or at least that do not negatively affect them)

- (Speculation) but it probably increases marriage stability (harder to break up if there’s a larger shared financial responsibility – marriage as an institution is all about finance)

On the other hand, I think that we’re probably vastly over-shooting the optimal level of ownership. I can’t offer you any quantitative evidence of this claim at the moment beyond the costs of policies that have led to this outcome. But those costs are pretty tremendous.

Yes, I absolutely agree that the Fannie/Freddie situation, much like the Bear Stearns situation, sends a strong message about what our government thinks about corporate responsibility v society’s responsibility (e.g.: “don’t worry about it boys – that’s why people pay taxes.”).

I promise that’s not the message the government is trying to send. There are many cases where the government irresponsibly aides firms: licensing requirements, trade barriers, subsidies, and more. However, in this case politicians are not reaping positive press coverage (how do you put a positive spin on “We’re on the hook for $100B”?) and are losing the opportunity to throw money at other programs. As for FNMA and FHLMC (hence `the GSEs’, Government Sponsored Enterprises) – their shareholders are going to take a bath and their CEOs are getting fired. Lose-lose.

There is a systematic downside to the failure of the GSEs, and I think Tyler Cowen and his commenters hash it out nicely in the post I linked to above.

What is of particular interest to me is the culpability of the commercial banks (WaMu, Wells Fargo, Bank of America, Citi, etc.) in all of this. Someone somewhere had to know all those adjustable rate mortgages floating out there weren’t sustainable, right? My understanding is admittedly limited, but shouldn’t common sense dictate it’s a bad idea to crank up the interest rates on mortgages right when the general public is most strapped? Can you speak to this, Sam?

This will be a bit technical – bear with me.

Starting in about 2003 investment instruments called mortgage-backed securities (MBSs) became popular. How they worked: I make fifty mortgage loans; as a result I have rights to the money people make to repay those loans. You’re an investor and decide that these income streams are an attractive investment. I sell you the right to collect loan payments. This collection privilege is what people were buying and selling. MBSs (and similar instruments all called collateralized debt obligations, CDOs) had the advantage of providing a good return while also offering collateral (the house).

The problem is that holders of MBSs had no idea whether the homeowners were capable of making payments or not. Consequently mortgage lenders had incentive to make irresponsible mortgages loans because they could sell them as MBSs at the same rate they sold sound mortgage loans. One particularly toxic arrangement worked like so: I will make you a loan; you will pay a low interest rate for three (or five) years, and then pay a high interest rate. You can see the problem three to five years down the line (that is, today and the next four years).

The point of all of this is to say: lenders are not arbitrarily increasing interest rates on mortgages (which would be illegal). In fact, all of these rates were determined more-or-less in advance, and people are failing to make payments in large part because their payments are jumping rapidly (in some cases more than doubling). Obviously a weak economy does not help the situation.

One last paragraph. Financial institutions were stupid; lenders were irresponsible; people taking loans were stupid and irresponsible in equal measure. There’s a lot of blame to go round and consumers deserve a big chunk of it. I think I ought to emphasize this angle because it’s often ignored by reporters howling about predatory lenders and Wall Street big shots.

Rumor has it that WaMu might be facing collapse before the year’s out. What sort of consequences do you see to something like that?

This would be very, very bad. Fire and brimstone coming down from the skies. Rivers and seas boiling. Forty years of darkness. Earthquakes, volcanoes… The dead rising from the grave. Human sacrifice, dogs and cats living together… mass hysteria!

No but really. It’d be a Grade A Clusterfuck.

After reading a bit more about the Fannie and Freddie thing, my thoughts (and bear with me here, since I’m not especially knowledgeable in this area):

It seems that Fannie and Freddie were both put into place to serve a function that was, in general, a public service to the American lower and middle classes, even though Fannie became a private entity at the same time Freddie was created (also as a private entity).

Because of this somewhat unique origin and purpose, I have less of a problem with the government using public funds to bail them out—especially considering that the costs of not doing so would likely be borne directly by the general public anyway. Since it seems that Fannie/Freddie failing would be a dollar-destroying, market-killing clusterfuck, we’re paying for it one way or another, right? I’d honestly rather have it handled proactively, and this seems to be a reasonable solution (from my limited understanding of all of this). As much as it sucks to use public money to save private interests, I’m more of a “fix the situation” than “argue about how we got here” kind of guy… and it seems that if public money will smooth this over, it’s in our best interest to use it.

Regarding the moral hazard of setting a precedent wherein the government will bail out companies that are deemed “too large to fail” and thus encourage risky behavior… I don’t know. We don’t want companies that are so important to the economy making risky decisions, obviously, but we also don’t want those companies to actually fail if it can be avoided… which risky behavior doesn’t help. Can the government bail out Fannie/Freddie while making it very, very clear that this is a one-time deal that they won’t be doing again? Sort of like saying, “We’re going to fix this fuck-up one time, but if anyone else does it, you’re on your own—consider yourselves warned.”