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Fragile by Design

Friday, July 25, 2008

If we could start from scratch, we would not create a mortgage finance system dominated by an enormous duopoly.

This summer’s episode of the crisis in housing finance featured Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs). While it was often said that Fannie and Freddie were “too big to fail,” the real reason the government rescued the two mortgage giants is that their portfolios are too difficult to liquidate. Unlike Bear Stearns, the investment bank that collapsed suddenly earlier this year, Fannie and Freddie cannot be merged into other firms.

The GSE bailout exposed the fragility of our mortgage finance system. Years of government intervention have made the mortgage market heavily dependent on the GSEs. (As Treasury Secretary Hank Paulson has noted, in the first quarter of 2008 they funded 70 percent of all mortgage originations.) By the same token, the government policies that fostered this excessive concentration also made the GSEs highly susceptible to the sort of “run on the bank” that took place earlier this month.

Top-Down Design vs. Emergent Order

Fragility is a common characteristic of centrally-planned systems. Designed to withstand historical shocks, they can fail catastrophically when faced with a new experience. The classic example is the Maginot Line, which was well-suited to the historical experience of World War I but unsuccessful when confronted with the Nazi blitzkrieg.

The opposite of a centrally-planned system is an emergent order, or what economist Friedrich Hayek termed a “spontaneous order.” A classic example would be the English language. No one designed the English language; it emerged and adapted over time. Language does not work well when it is designed top-down, as the failed example of Esperanto illustrates. Common law, which is built up over the years by precedent, is another example of an emergent order.

If I want to look up “public choice theory” in a reference work on the Internet, I could go to the Concise Encyclopedia of Economics (CEE), where I would find an article by Jane S. Shaw. The CEE is the product of top-down design. The topics and authors were selected by an editor, who gave the author a deadline and was responsible for final approval of the content of her article. 

Alternatively, I could look up “public choice theory” in Wikipedia, where I would find an article contributed by one or more authors. Although contributors may correct one another, there is no editor overseeing the article on this topic or even ensuring that the topic is covered at all. Wikipedia is an example of an emergent order.

As these two online encyclopedias illustrate, the same problem can be solved either by top-down design or by an emergent order. In this case, for solving the problem of providing information on “public choice theory,” both approaches work fairly well.

Mortgages and Consumer Credit

America’s financial markets reflect a mixture of the emergent order of markets and the top-down design of government regulation and provision. Credit cards and other forms of consumer lending have been left more to the market. Mortgage finance has been provided more heavily by government.

Both consumer credit and mortgage finance are subject to errors and abuses. Borrowers may take on more debt than they can handle. Lenders can attempt to take advantage of borrowers. Conversely, lenders may deny credit to applicants who, if given the opportunity to borrow, would repay loans on schedule.

Lending institutions also face risks in these markets. Due to unforeseen circumstances, the rate of defaults may exceed what was anticipated, so that a loan portfolio suffers losses.

According to their regulator, Fannie Mae and Freddie Mac have sufficient capital. According to former St. Louis Federal Reserve Bank president William Poole, they are insolvent. One can justify either perspective.

Consumer lending has grown fairly steadily over the past several decades. While there have been recessions in which lenders experienced high default rates and curtailed their activity, there has been no catastrophic failure in consumer lending.

In contrast, mortgage finance has suffered a number of serious failures. In the inflationary 1970s, the heavily-regulated thrift industry proved unequal to the task of meeting the demand for mortgage credit. In 1970, Freddie Mac was created in order to help the thrift industry move funds from surplus states in the East to rapid-growth states like California. 

All through the 1970s the thrifts were hit by “disintermediation.” Savers took money out of the savings and loans, where interest rates were held down by regulatory ceilings, and instead used other means to invest in interest-bearing securities. As the thrifts grew steadily weaker, Fannie Mae and Freddie Mac expanded their activities.

By the early 1980s, the thrift industry had collapsed, leaving the field wide open for Fannie and Freddie. The GSEs now enjoyed unique status in the mortgage lending arena in terms of low capital requirements and other regulatory advantages. Their share of all mortgage debt outstanding soared from less than 10 percent in 1980 to more than 30 percent in 1990. It reached a peak of just over 50 percent in 2003. 

By then, there were only two segments of the mortgage market that Fannie and Freddie did not dominate. One was the “jumbo” market, for loan amounts far above the typical home price. The GSEs are excluded from this market by law, with the loan limits changing each year to adjust for general price increases. The loan limit currently would be $417,000, except that Congress earlier this year raised the limit on an emergency basis to $729,750. The thinking behind the emergency legislation was that GSE support might be needed in the jumbo market.

Fishing in Subprime Waters

In addition to not being allowed to purchase “jumbo” mortgages, the GSEs are only supposed to purchase mortgages that are of “investment quality,” meaning not the sort of high-risk mortgages known as “subprime.” From 2004 through 2006, when most of the growth in mortgage originations was in the subprime segment, Fannie and Freddie were not able to maintain their market shares. However, notwithstanding their charter rules, they did participate in the subprime market, buying hundreds of billions of dollars in securities backed by subprime loans as well as funding other subprime loans under the guise of meeting the needs of “affordable housing.”

In 2007, the regulator of Fannie and Freddie authorized faster growth in their portfolios, in order to allow them to participate in the rescue of subprime loan borrowers. This further encouraged the GSEs to fish in subprime waters.

Like Tinkerbelle

The more we ask politicians to provide perfect insulation from financial risk, the more fragile the system will become. That is the real lesson of the Fannie and Freddie saga.

According to their regulator, Fannie and Freddie have sufficient capital. According to former St. Louis Federal Reserve Bank president William Poole, they are insolvent. One can justify either perspective.

Until recently, the GSEs were able to borrow at low interest rates, due to a perception that their debt instruments were almost as free from risk as U.S. Treasury securities. As long as they can continue to borrow at those rates, and as long as the losses they experience from mortgage defaults do not significantly exceed current forecasts, they should not run out of capital.

On the other hand, investors had begun to worry about potential problems at the GSEs, and the market interest rates on their securities had begun to rise. If the GSEs could no longer borrow at attractive rates or raise new capital, they would have to sell securities to meet cash needs. Because no one else enjoys the funding advantages that the GSEs do, any sale of securities would have to take place at prices that are below the values at which the GSEs carry the securities on their books. Because their securities are not marketable at their book values, William Poole is correct to say that the GSEs are technically insolvent.

When another financial firm gets in trouble, as happened with Bear Stearns earlier this year, a merger is feasible. Because the value of the assets of Fannie and Freddie depends so crucially on their unique borrowing advantages, a merger is not an option. That fact underlines the fragility of a mortgage finance system that relies so heavily on the GSEs.

In practice, the GSEs are like Tinkerbelle, the fairy in the Peter Pan story. If everyone believes in them, they are alive and probably sound. However, once people lose faith in them, they are insolvent. A loss of faith is the one risk against which they are not protected, unless one counts as protection the potential for a taxpayer-funded bailout.

In fact, the faith that is required in this case is somewhat peculiar. On the one hand, investors must have faith that the GSEs will be profitable, which in return requires faith that Congress will allow them to pursue private gains. On the other hand, political leaders need to have faith that the GSEs are carrying out a mission that will be appreciated by their constituents, yet they must also limit taxpayer exposure. Congressman Barney Frank (D-MA) recently quipped that Fannie or Freddie will need to consult regulators “before it can even pay its water bill for the toilet.”

Why Have GSEs At All?

For many years, experts have questioned whether the GSEs are necessary. In 1999, then-Treasury Secretary Lawrence Summers criticized what he called the “systemic risk” posed by the GSEs. They do reduce mortgage rates, although by how much is subject to dispute

What the GSEs do is channel more capital into mortgage markets, resulting in lower interest rates paid by homebuyers. This in turn raises the demand for housing. By the same token, this means that less capital is available for other uses. 

As long as one believes that housing is a form of investment that should be favored, steering capital away from other uses and into housing may seem worthwhile. But in recent years, too much capital went into that sector and created a bubble. 

Just as the GSEs appear to have outlived their usefulness, their perilous financial condition requires support from taxpayers as well as the time and attention of top government officials. The main goal of politicians and regulators is to preserve Fannie and Freddie in their current form. The two chief alternatives—1) to let them fail; 2) to nationalize them—seem unpalatable. 

If we could start from scratch, we would not design a mortgage finance system dominated by an enormous duopoly. We would be much better off with a system in which capital requirements and other regulations faced by financial firms were based on the characteristics of their loan portfolios. 

A level regulatory playing field seems like a natural way to allow banks and other financial firms to increase their participation in mortgage lending and to reduce our reliance on the GSEs. However, there seems to be little or no movement in this direction on the part of public officials. 

This illustrates another aspect of centralized systems created by design: they are almost impossible to change. Neither advance warnings nor actual crises are sufficient to spur major reforms. 

In contrast, in the messy emergent order of markets, individual enterprises fail but the market keeps going. Frequent but non-catastrophic failure is characteristic of the “creative destruction” process. 

The recent bust in home prices was a shock both to the private sector and to the GSEs. The private sector did most of the risky lending, and private investors took most of the losses, but the process of dealing with failed private firms has worked fairly well. The GSEs, which played less of a role in subprime lending, are more like Humpty Dumpty: putting them back together may not be possible. 

Financial markets will always be subject to miscalculations and mistakes. However, the more we ask politicians to provide perfect insulation from financial risk, the more fragile the system will become. That is the real lesson we should take from the Fannie and Freddie saga. 

Arnold Kling is an economist living in Silver Spring, Maryland.

Image by The Bergman Group/ Darren Wamboldt.

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