The Housing Bubble and the Limits of Human Knowledge
By Alex J. Pollock Friday, March 1, 2013
Fannie Mae and Freddie Mac lost an aggregate $246 billion during the shriveling of the great American housing bubble. They lost all the profits they had made since 1971 plus another $140 billion — quite a performance. The government rushed in to rescue Fannie and Freddie’s creditors with $187 billion of taxpayers’ money, to bring their capital up to zero: this means that ordinary Americans are being taxed so that foreign and domestic bondholders get back every penny they lent Fannie and Freddie.
The reality of the government guaranty of the debt of these “government-sponsored enterprises” (GSE) has thereby been unambiguously demonstrated. Senior government officials previously denied that the government was on the hook for Fannie and Freddie (presumably thinking that their denial would never be tested by events — a bad theory).
What financial shape were Fannie and Freddie in as the crisis proceeded? How bad would the effects of the shriveling bubble be? How much can you trust the word of government officials? How much about the financial future can central bankers or anybody know? Consider the lessons of the following 10 quotations:
1. About whether Fannie and Freddie’s debt was backed by the government: “There is no guarantee. There’s no explicit guarantee. There’s no implicit guarantee. There’s no wink-and-nod guarantee. Invest and you’re on your own.” — Barney Frank, senior Democratic congressman, notable Fannie supporter, later chairman of the House Financial Services Committee
It would be difficult to imagine a statement more wrong.
2. “We do not believe there is any government guarantee, and we go out of our way to say there is not a government guarantee.” — John Snow, Republican and secretary of the Treasury
Saying it did not make it so, unfortunately.
3. “The facts are that Fannie and Freddie are in sound situations.” — Christopher Dodd, senior Democratic senator, prominent Fannie supporter, chairman of the Senate Banking Committee
Pronounced two months before Fannie and Freddie collapsed.
4. “We have no plans to insert money into either of those two institutions [Fannie and Freddie].” — Henry Paulson, Republican and secretary of the Treasury
Stated one month before the Treasury started inserting money into Fannie and Freddie.
Ordinary Americans are being taxed so that foreign and domestic bondholders get back every penny they lent Fannie and Freddie.
5. “Home prices could recede. A sharp decline, the consequences of a bursting bubble, however, seems most unlikely.” — Alan Greenspan, chairman of the Federal Reserve Board
The common wisdom of the bubble years. At the time of this statement in 2003, the Fed was in the process of dramatically reducing short-term interest rates and stimulating house-price increases.
6. “Global economic risks [have] declined.” — International Monetary Fund
Observed four months before the international financial panic started in August 2007.
7. “More than 99 percent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.” — Federal Deposit Insurance Corporation
This statement was made in the second quarter of 2006, at the peak of the housing bubble. More than 400 such institutions later failed and others were bailed out in the ensuing bust. The FDIC failed its own required capital ratio, reporting negative net worth.
8. “The risk to the government from a potential default on GSE [Fannie and Freddie] debt is effectively zero.” — Joseph Stiglitz, Nobel Prize–winning economist, Peter Orszag, a future White House budget director, and Jonathan Orszag
Conclusion after considering “millions of potential future scenarios” — but obviously not the scenario which then actually happened.
9. "'Not only didn’t we see it coming,' but once the crisis started, central bankers 'had trouble' understanding what was happening." — Remarks by Donald Kohn, vice chairman of the Federal Reserve Board
A candid statement of the truth.
10. Finally: “Libenter homines id quod volunt credunt.” That is: “People easily believe that which they want to believe.” — Julius Caesar
Nothing has changed in this respect since Caesar’s day, and his dictum applies to government officials, central bankers, economists, and experts — just as it does to you and me.
Alex J. Pollock is a resident fellow at the American Enterprise Institute.
FURTHER READING: Pollock also writes “Entrepreneurs, Risk Managers, and Uncertainty,” “Central Bank Dreams, Monetary Realities,” and “Which Depositors Should Suffer Losses When a Bank Fails?” Peter Wallison says “Don't Be Fooled about Low Rates and the Housing Bubble.” Edward Pinto asks “How Could FHA Have Contributed to the Housing Bust?” The American Enterprise Institute chronicles “6 Government Failures of Fannie Mae.”
Image by Dianna Ingram / Bergman Group