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  • The Real Problem With Fannie and Freddie

    The Washington Post has a fine editorial on the current financial crisis first noting:

    As financial panic spread across the globe and governments scrambled to contain the damage, reality seemed to announce the doom of U.S.-style free markets and President Bush’s ideology. But this is wrong in two ways. The deregulation of U.S. financial markets did not reflect only the narrow ideology of a particular party or administration. And the problem with the U.S. economy, more than lack of regulation, has been government’s failure to control systemic risks that government itself helped to create. We are not witnessing a crisis of the free market but a crisis of distorted markets.

    But the Post still does not yet really grasp how fundamental Fannie and Freddie were to the market meltdown. Later in the editorial they write:

    Homeownership is a worthy goal. But when government favors a particular economic activity, however validly, it must seek countervailing control to ensure the sustainable use of public resources. This is why banks must meet capital requirements in return for federal deposit insurance. Congress did not apply this sound principle to Fannie Mae and Freddie Mac; they were allowed to engage in profitable but increasingly risky activities with an implicit government guarantee. The result was that taxpayers had to assume more than $5 trillion of their obligations.

    The problem with Fannie and Freddie was not limited to to their paltry capital requirements. The problem with Fannie and Freddie was that, because of political pressure, they encouraged and subsidized the loosening of lending standards and then covered up the increased risk they were injecting into the system by putting the government’s stamp of approval on the garbage securities they were putting into the market.

    For decades Countrywide Financial was a largely unsuccessful firm that was only re-listed on the New York Stock Exchange in 1985. But between 1985 and 2003 Countrywide delivered investors a 23,000% return, exceeding the returns of Washington Mutual, Wal-Mart, and Warren Buffett’s Berkshire Hathaway. How did they do it? This 2000 report by the Fannie Mae Foundation provides a clue:

    Countrywide tends to follow the most flexible underwriting criteria permitted under GSE and FHA guidelines. Because Fannie Mae and Freddie Mac tend to give their best lenders access to the most flexible underwriting criteria, Countrywide benefits from its status as one of the largest originators of mortgage loans and one of the largest participants in the GSE programs. …

    When necessary—in cases where applicants have no established credit history, for example—Countrywide uses nontraditional credit, a practice now accepted by the GSEs.

    In other words, Fannie and Freddie favored lenders like Countrywide that had irresponsible lending practices. In fact, Fannie Mae was Countrywide’s biggest customer. Thanks to its loose lending practices and backing of Fannie Mae, Countrywide became the largest mortgage lender in the country. In 2006, it financed 20% of all mortgages in the United States — 45% of which were subprime.

    Countrywide has since lost $33 billion on mortgages, a tab that you the taxpayer are picking up. These are important facts to remember the next time a politician tries to sell you on the idea of government intervention in the market.

    Posted in Economics [slideshow_deploy]

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