Monday, June 9, 2014

Too big not to fail: the rise and fall of Fannie Mae

The debate over the role (if any) of the Community Reinvestment Act (CRA) in the sub-prime crisis, and thus the Global Financial Crisis (GFC), often seems to be a stand-in for other issues. In particular, to what extent was either financial meltdown the consequences of government regulation (or the lack thereof).

The answer to the former question is: almost entirely, if by government regulation one includes the full gamut of government interventions and political game-playing. In a market economy, failures of regulation and government intervention always manifest as market outcomes. By the simple expedient of declaring such government interventions and regulations irrelevant or insignificant, said market outcomes can then be pointed to as "proof" of market failure.

But that is ideology blocking analysis. Corporations are pavlovian profit monsters--they will go where profits lead them. They act according to the incentives offered them, within the range of managerial competence. (Hence markets as economic selection processes.)

In the case of the US finance industry, particularly the US housing finance industry, various government interventions profoundly shaped the incentives facing participants in the market, with part of the problem being those being regulated having rather too much influence over how they were regulated.

With no entity playing the political game more relentlessly, narrowly effectively or ultimately self-destructedly than the Federal National Mortgage Association (FNMA) or Fannie Mae. As long-time Wall Street Journal journalist James R. Hagerty sets out in his highly readable history of Fannie Mae, The Fateful History of Fannie Mae: New Deal Birth to Mortgage Crisis Fall.

Supporting housing finance
Fannie Mae started operating in 1938, a late New Deal initiative. While fairly small in its early days, it grew until it became one of the biggest financial institutions in the world. For its first 30 years, it had a monopoly over the US secondary mortgage market. As an Australian reading the book, the idea that housing finance needed government support seems a little bizarre. We have a home-ownership rate slightly above the US's (ex-communist countries generally top the rankings), but did not need to create anything like Fannie Mae or Freddie Mac, or the other US government founded/supported finance entities, to do it.

But such efforts suited some very politically effective interests, such as realtors. The implicit or explicit taxpayer guarantee allowed more funds to be pushed into housing at lower cost. At one point, Hagerty quotes Adam Smith's scepticism about government-sponsored companies:
These companies, though they may, perhaps, have been useful for the first introduction of some branches of commerce, by making at their own expense an experiment which the state might not think it prudent to make, have in the long run proved, universally, either burdensome or useless. 
Fannie Mae provides a dramatic example of Adam having a point. The US$187bn the taxpayer's invested in bailing out Fannie Mae and Freddie Mac may have been more than returned, but their role in fuelling destructive, massively over-leveraged, housing price booms imposed a much greater social cost than that.

Having previously read Fragile by Design, Hagerty's book also put the CRA into a much more useful context, even though it plays a small role in his book. There was a long history of US federal government action to support housing finance. The CRA was a way of extending that pattern of action to urban minorities. The problem with the CRA was not the Act itself, but the way it then came to feed back into, and amplified, already existing patterns, which were also amplifying for other reasons. It was a building block in the edifice that created the sub-prime crisis, no more than that (but also no less).

Hagerty takes us through the history of Fannie Mae, with an enduring feature being attempts to either regulate it more closely, or to fully privatise it, being fought off by Fannie Mae. Fannie Mae wanted to keep its government guarantee (an implicit guarantee, once it became a company with shareholders), because that lowered the cost of its capital, but without tighter prudential regulation, because that would have reduced its ability to leverage off its government guarantee. Fannie Mae's leadership played the political game increasingly effectively, including using such tactics as hiring as many lobbying firms as practicable, so they could not be hired to lobby against it.

To a large degree, Fannie Mae got the regulatory framework it wanted, though part of the trade-off became to expand its support for housing finance. As a result, the prudential rules covering it became increasingly vulnerable to catastrophic failure, if there was a large enough rise in interest rates or fall in house prices. Which, of course, there duly was.

Government guarantees to financial entities require matching prudential regulation if catastrophe is not to be avoided. But Fannie Mae was too politically useful; which it leveraged ruthlessly, to avoid inconvenient prudential regulation to match its government guarantee. Fannie Mae became too good at selling itself as the perfect (off-budget) housing finance problem solver.

As the various housing bubbles across the US started to deflate, a desperate housing industry lobbied hard for Congress to "do something". And there was Fannie Mae and Freddie Mac, available to "do something" off-budget. So, as the housing bubbles deflated, Fannie Mae and Freddie Mac increased their exposure. But this was the end run of a long process of ever-lower standards of lending without compensating increases in prudential requirements.  The necessary corollary to government guarantees if said guarantees were not to make the financial system more vulnerable rather than less.

Pay and ...
And then it all collapsed, wiping out Fannie Mae and Freddie Mac's share values and requiring a $US187bn bailout of the two government-sponsored-enterprises (GSEs). It was as if nothing had been learnt from the Savings & Loans crisis. Which, in effect, it had not.

What Calomiris & Haber call the game of bank bargains has been perennially played in the US to suit narrow interests and not broad ones. As in this case, with the taxpayers left holding the bag (again) as helping the housing industry by "off-budget" measures suddenly went dramatically on-budget.

It is useless to complain that the politics was "corrupted", as if that is the only problem: we have to deal with politics as it is, not as it might be. There is certainly a role for seeking to have better functioning institutions, for informed debate, for exposure. But to change nothing about the political institutions and framings of debate, and then expect the players to reliably and continually act differently, is naive at best.

It was not as if the housing booms themselves were not also significantly responses to regulation. Land rationing was a major driver of where the US housing booms did (or did not) occur. For any asset, if quantity responses are dampened, then price responses become more intense. That is, if supply is constrained (such as by land rationing), then the price of a class of assets (such as land-approved-for-housing) will become more susceptible to demand shocks (both upwards and downwards). Or, in this case, upwards then downwards. Especially if a government guarantee is leveraged into pumping more and cheaper finance into purchasing said asset.

So, local governments were rationing land (driving up house values and property tax revenue), Congress wanted off-budget help to the housing industry and home-owners (both middle class and those aspiring to be so), driving up the funds being pumped into supply-constrained markets, banks wanted to benefit from the too-big-to-fail subsidy, and prudential regulators either did not want to pick unfortunate fights or were overwhelmed by the superior lobbying power of those that they were attempting to regulate. With no-one playing the political game more effectively, or more ultimately disastrously, than Fannie Mae. Which became too politically big not to fail. 

... then repeat
But Fannie Mae and Freddie Mac have been bailed out, not killed off. The too-big-to-fail subsidy is now absolutely established, as are the GSE's government guarantees. Blaming "Wall St" or "easy money", or whatever, means that the game of helping a powerful industry off-budget--in part by not forcing sufficient prudential requirements to match the government guarantees--continues to be played. After all, the imbalance is very much based on providing (positive) externalities to those who usefully notice and passing the costs on to those who do not.

The Savings & Loans Crisis was Mark 1. The Sub-Prime Crisis was Mark 2. The pieces are being set in place to have Mark 3. With "corporate greed" the perennial theatrical villain, so that the real players can continue to play their political games, and taxpayers and home-owners can be set to take the fall, yet again.

But Hagerty's book--clearly based on talking to everyone who matters and reading every report--provides a well-written, clear and informative history of past, present and (sadly) likely future.

[Cross-posted at Skepticlawyer.]


  1. The most amazing thing about this work of scholarly journalism--not actually oxymoronic!--is how much useful information Hagerty has packed into little more than 200 pages.

    It ought to be a classic of Public Choice Economics; how a little known New Deal Agency--that should have gone the way of the WPA or CCC, after the Great Depression ended--grew into one of the two 800lb gorillas of home loan finance in the U.S. (along with its companion Freddie Mac.

    Politicians of both parties used it to get elected, and to make themselves rich; Henry Cisneros, former HUD Sec'y under Bill Clinton made millions as a housing entrepreneur after resigning from govt, to name just one.

    1. Patrick, I suspect it does not fit sufficiently neatly into favoured narratives.

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