« The NY Times goes in search of a good root beer | Main | Cross price elasticity »
July 15, 2008
Best sentences I have read today about Fannie and Freddie
From Arnold Kling:
Anyone could see that the GSE dominance of the mortgage market was unhealthy. But the political process was unable to get the job done. What the central planners tend to forget is that political failure is even more entrenched than market failure.
Maybe the taxpayers will have to pay today or maybe in some future tomorrow but the benefits of the GSEs are intimately tied to the costs - there is no such thing as a free lunch. The lunch may look free for a long time - as in the classic peso problem - but what that means is that when the bill comes due it will be big.
Better will be to simply remove these guarantees; if it pushes mortgage rates up 25-50 bp, that would simply be recognition of a subsidy that has long since lost its usefulness.
King also points to Gerald O'Driscoll:
We must also realize that, whatever the deficiencies of the mortgage market in Depression-era America, that era is over. There is no "market failure" in housing finance today, except the one created by government-backed institutions dominating housing finance. Money flows where it is rewarded. Home mortgages are plain vanilla financial instruments, perhaps partly due to Fannie and Freddie. So by all means, let us thank them for their service as we bid them adieu in their present form.
Taken together, these sentiments sum it up nicely. The GSEs served a purpose. As the credit market developed, that purpose became somewhat less relevant than it once was. Yet, because of the implicit (now made explicit) government backing, they were able to offer what looked like a free lunch. As long as things remained stable, they helped shave a few basis points off of mortgage rates by absorbing some of the risk. If they only held loans of the highest quality (creditworthy customers, 20% down payments, etc), we wouldn't be having this conversation. But if those were the only loans that they held, the irrelevance of the GSEs would be more apparent and would have been vulnerable to being legislated out of existence.
So, given that people respond to incentives (and that includes people in government agencies [i.e. regulators and Congress]), it was entirely natural that the GSEs would bite off a little more than they could chew. They traded on their name and their implicit government backing, promising a little bit of a free lunch. But when things turned sour, we saw that the lunch was not free.
We live and we learn (though some people do not get the message the first time). Fannie and Freddie are too big to be allowed to fail. They need access to that lifeline that for too long we pretended wasn't ever going to be needed. Allow them to unwind this in an orderly way rather then letting it all unravel at once.
But then, for goodness sake, learn from this mistake. There is no reason for the GSEs to ever again be as large as they were.
UPDATE: Clarified the sentence about government agencies responding to incentives. I was referring to the fact that the regulators and Congress had no incentive to get tough with the GSEs and the GSEs then in response naturally expanded their reach.
Posted by William Polley at July 15, 2008 12:46 PM
Trackback Pings
TrackBack URL for this entry:
http://www.williampolley.com/cgi-bin/mt-tb.cgi/1031
Comments
Again, Fannie and Fredie were private entities acting exactly like profit maximizing capitalist should act. When they were public entities acting
to achieve other goals they did not seem to have these problems.
So why are individual institutions acting exactly like the profit maximizing firms they are should represent a failure of government. It looks like a failure of capitalism to me.
As far back as we have records capitalist institutions, and especially financial institutions acted exactly like Fannie and
Freedie acted.
I'm sorry, I do not follow your line of reasoning that a capitalist institution acting exactly like a capitalist institution should represents a failure of government. It looks like a market failure to me.
Posted by: spencer at July 15, 2008 4:32 PM
Do you deny that the implicit government backing of Fannie and Freddie knocked 25 to 50 basis points off of the mortgage rate as some have suggested?
Is that not a subsidy for which the bill is just now coming due?
Fannie and Freddie were private companies, that is true. The government agencies I was referring to (I should have been more clear) were the regulators and Congress. Did anyone believe that the government would simply allow the GSEs to fail? Of course not. And that is the true root of the problem.
Fannie and Freddie were able to operate in that market in a way that was not available to other institutions that did not have the implicit government guarantee. Congress should have reigned them in. But Congress had no real economic incentive to do so (as long as everything was status quo) and every political incentive not to do so (because Congress likes to look like they are promoting home ownership).
And I call that government failure.
Posted by: William Polley at July 15, 2008 5:23 PM
One more thing, spencer...
You said, "When they were public entities acting
to achieve other goals they did not seem to have these problems."
True. One of the advantages of government is that it can pursue other objectives besides profit. There are times when that is appropriate.
It gets problematic when a government entity gets spun off into the private sector while still retaining the aura of government backing (or worse, regulatory forbearance).
If government creates an agency to tackle a specific market failure, and then when that market failure has been largely rectified turns the agency loose to pursue its own objectives while maintaining an uneven playing field in its favor... is the resulting failure the fault of the market or of government?
Government created them, then created the environment that enabled them to get into trouble. Then government looked the other way. Hard to deny that.
But spencer, you know that I'm not an anti-government radical. In fact, I do believe that there are still market imperfections in housing (though much less then in the Great Depression, obviously). I think that one could still justify a role for a scaled down Fannie and Freddie with more government oversight than has been the case in recent years.
Honestly, the GSEs have never been a hot topic on this blog nor any passionate interest of mine. However, from time to time over the years (each time there were calls to get Congress to tighten the screws a little) I remember thinking to myself that the whole thing seemed a little "out-of-whack", to use a non-technical term.
Out-of-whack in the sense that anyone could see that the government was taking on the extra risk (because again, I would have said years ago that if the GSEs ever ran into trouble the government would make sure they don't fail and cause a systemic collapse). Now, as long as everyone understands and acknowledges that, then we all understand that the taxpayer is on the hook for that risk. If that's the way you want it, fine. But I think that some people were in denial--thinking that they would never get into trouble and that this was a free lunch.
But TANSTAAFL!
Posted by: William Polley at July 15, 2008 6:21 PM
How ironic to suggest private lending has displaced the need for them when they are now doing 130% of the mortgage market. Perhaps it is the time private lending has past, since apparently it indeed has.
Posted by: Lord at July 15, 2008 10:15 PM
My favorite statement was Mike Moffat's
Economists are seeing exactly what they want to see in the current situation.
Posted by: Lord at July 15, 2008 10:18 PM
Unless we're going to change the definition of market capitalism (and that appears to be exactly what the Administration is doing), we should keep this fundamental principle in mind: when a financial institution (or any other economic agent) gets "too big to fail" - it's too big.
Posted by: Uncle Jeffy at July 17, 2008 1:55 PM