Tuesday, 9 September 2008

Fannie and Freddie (updated x2)

Greg Mankiw says he has three reactions to the take over of the GSE,
  1. It was likely to happen eventually, so it is better to get on with it, as Treasury did yesterday.
  2. I am saddened whenever any private profit-seeking enterprise gets bailed out, whether it is Chrysler, Long-term Capital Management, Bear Stearns, or the GSEs. Such bailouts sow the seeds of the next financial crisis by fostering expectations of future bailouts and encouraging excessive risk-taking. (And before anyone emails me that the GSE equity holders are not exactly getting a good deal here, let me point out that the debt holders are. In a capitalist system, you want those extending both debt and equity finance to bear the consequences of the risks they undertake. If the taxpayer is chipping in, someone is being insulated from risk.)
  3. The problem is far from over, as the future of these institutions and a large segment of the financial system is still to be determined. The worrisome part is that this future will be determined by a political system that both created the GSEs and failed to provide sufficient oversight, even when many economists suggested reform was needed. To believe that the Congress will do a good job of it would be the triumph of hope over experience.
Number 2 in the list is important. The moral hazard problems that these "bailouts" create could be very expensive in the future. Encouraging excessive risk-taking will not help prevent a future financial crisis.

Philip Booth over at the IEA blog makes the argument that
Many of us have long argued that the welfare state underwrites irresponsible behaviour and crowds out the institutions that could have provided schools, hospitals and social insurances privately. Ultimately, of course, the welfare state leads to the nanny state as the government tries to regulate the undesirable private behaviour that, arguably, is encouraged by the welfare state. The action by the US government yesterday confirms that we now have a welfare state for bankers. The US government has sent a firm signal that irresponsible behaviour in financial markets will be underwritten by US taxpayers. Bankers gain from the upside of their actions and have the downside underwritten, so they will take more risks. The welfare state for bankers also crowds out the development of private mechanisms that could deal in an orderly fashion with difficulties within the banking and financial systems. Worst of all, of course, governments in the future will use the reckless behaviour that will result from all these Federal rescues to regulate the already over-regulated financial system more.
He then argues that Fannie Mae and Freddie Mac were completely unnecessary government creations and that the current bubble was the result of a failure of monetary policy – interest rates held too low for too long. Booth then notes
The government could help in the process of an orderly restructuring of the capital of Fannie Mae and Freddie Mac (whilst providing no financial help) if it is the case that current legal systems are unable to handle that process. But those who have provided capital to the ailing institutions should suffer the losses – not the US taxpayer.
Arnold Kling has a longer piece at the Cato website under the title Freddie Mac and Fannie Mae: An Exit Strategy for the Taxpayer. The executive summary reads,
The Fannie Mae-Freddie Mac crisis may have been the most avoidable financial crisis in history. Economists have long complained that the risks posed by the government-sponsored enterprises were large relative to any social benefits.

We now realize that the overall policy of promoting home ownership was carried to excess. Even taking as given the goal of expanding home ownership, the public policy case for subsidizing mortgage finance was weak. The case for using the GSEs as a vehicle to subsidize mortgage finance was weaker still. The GSE structure serves to privatize profits and socialize losses. And even if one thought that home ownership was worth encouraging, mortgage debt was worth subsidizing, and the GSE structure was viable, allowing the GSEs to assume a dominant role in mortgage finance was a mistake. The larger they grew, the more precarious our financial markets became.

Regulators should contemplate freezing the mortgage purchase activities of the GSEs while at the same time loosening the capital requirements for banks to hold low-risk mortgages. The result would almost surely be an industry much less concentrated than the current duopoly. A housing finance system that does not rely so heavily on Freddie Mac and Fannie Mae will be more robust.

We have to assume that sooner or later some of the institutions involved in mortgage finance will fail. The policy should be to promote a housing finance system where mortgage risk is spread among dozens of institutions. That way, the failure of some firms can be resolved through mergers and orderly restructuring, without exposing the financial system to the sort of catastrophic risk that is represented by Fannie Mae and Freddie Mac.
Meanwhile Russ Roberts argues
One of the most depressing things about the current situation is that people will try and find different ways to "fix" the mortgage market when it was the very attempt to "fix" it that brought us to where we are today. The government should get out of the mortgage market. Let individual institutions arise that intermediate between home owners and sellers. Let those that do it well thrive. Let those that do it badly bear the costs and disappear.
Update: the Free Exchange blog offers thoughts on Fannie/Freddie takeover here and here.

Update 2: Willem Buiter on Better late than never, or two cheers for Hank Paulson


jeremy said...


Do you not think that exactly the same moral hazzard issue arises with Kiwibank?



Paul Walker said...

The short answer is yes. Any business that has an implied government backing gives rise to the possibility of excessive risk-taking. If things go wrong the taxpayer will pick up the bill so why worry?