Whose fault is it that Freddie and Fannie are on the ropes?

An obvious question given the mess that Fannie Mae and Freddie Mac are now in is, Whose fault is it that Freddie and Fannie are on the ropes? At Cafe Hayek Russ Roberts's answer to the question is

I actually think this is an emergent mess that evolved out of no one's design. An alliance of bootleggers and baptists that created something that was no one's intention but that served many people well until it fell apart. It's a study in flawed incentives and institutional design. The lesson is that government agencies work best when we know what they're doing and there is some measure of accountability, even if it's only political.

Roberts then offers a little fable on the subject,

Once upon a time, Fannie and Freddie were partners in a business. Well, it wasn’t exactly a business. It was almost a charity. Not quite. It was sort of a government agency. Or maybe it was all three together. When Fannie and Freddie talked to investors, they acted like a business. When they talked to the government regulators, they acted like a government agency.

And when they talked to the American people, they acted like a charity. A charity whose goal was to help more people own a home.

Who could be against that?

But it’s hard to be three things all at the same time. So maybe it’s not surprising that Fannie and Freddie ultimately ended up suffering from multiple personality disorder. Which were they? A business? A charity? A part of the government? No wonder people were confused.

One day, Henry, who worked for Uncle Sam, woke up and discovered that Fannie and Freddie didn’t have enough money to keep the promises they had made. Henry was one of the last ones to find out. A lot of people had been saying for years that Fannie and Freddie were living beyond their means. Now the bills had finally come due. Who was going to get stuck with the bill?

Everybody wanted to blame someone else. Some blamed Fannie and Freddie. But it wasn’t really their fault, they explained. Uncle Sam told us to act like a charity. So we helped a lot of people get houses who wouldn’t have had them otherwise. And our investors told us to make money. We tried to do both. And we’ve succeeded. Unfortunately, our books don’t balance.

When Uncle Sam got mad at Freddie and Fannie for making promises they couldn’t keep, Freddie and Fannie just shrugged. Hey, they said. You said you’d always take care of us. I know you winked when you said it. But can you really blame us for living large? When you have a rich uncle, nephews and nieces with credit cards are known to have a spending problem.

The lesson is clear for Uncle Sam. Fannie and Freddie need new rules, rules so different that we may as well change their names and call them Florence and Floyd.

We also should remember, there really isn’t a rich uncle. There’s just you and me. If we’re going to pay for the misdeeds of Florence and Floyd, let’s make them government agencies with accountability. Or disband Freddie and Fannie and let the people who take the risks risk their own money instead of yours and mine.

Eamonn Butler at the Adam Smith Institute blog offers his answer,

Not 'markets' but US government financial regulations were the principal cause of the credit crisis. I've written here before about the 'anti-redlining' laws: regulations to stop lenders refusing loans to people who happened to live in a poor part of town. That gave millions of poor people access to home loans – but at the expense of the institutions taking on riskier customers.

Now the loans have gone bad, the housing market is ailing, and the institutions are in pain. So the government steps in and takes over control of the mortgage lenders Fannie Mae and Freddie Mac.

Once Freddie and Fannie had about three-quarters of the mortgage market. But then the Fed decided that they should be classified more like hedge funds. But of course they then didn't meet the hedge fund accounting regulations... Put into the penalty box, they lost their top management and weren't able to ply their trade – just at the time when, thanks to plummeting interest rates, everyone else was re-financing their book to advantage.

All sorts of new products popped up on lenders' balance sheets – derivatives and other instruments with high yields, large leverage and riskier, narrower spreads. A mix of assets that the rating agencies didn't know how to rate. So trouble was stacking up but few people quite realized it. Fannie and Freddie were eclipsed, their mortgage share slid drastically.

On the 'anti-redlining' laws Butler has previously pointed out that for all the discussion there has been about the sub-prime mortgage market, few people have noted the simple fact that the US government actually compels banks to make loans to poor people in poor neighbourhoods – regardless of whether those loans are prudent and are ever likely to be repaid. Butler goes on to explain

It started with the Community Reinvestment Act of 1977, which aimed to support community groups, but in 1995 the Act was extended and beefed up, giving regulators far more powers to punish banks who refused to lend to people in poor urban neighbourhoods – so-called ‘redlining’ – because they considered the risks too high in those particular areas.

Congress's idea, obviously, was to extend to poorer people the same rights and enjoyment of home ownership that the middle-class majority possessed. But in fact it precipitated the banks into giving loans to some rather shaky people. Quite simply, they feared retribution by the regulators if they did not.

As a result, sub-prime loans mushroomed in the late 1990s. Not too bad for as long as the US economy was booming. But booms inevitably burn out and then the banks started to realize the magnitude of their dodgy contracts. And now, the whole world is being sucked into this crisis, and ordinary, prudent bank customers find themselves and their money frighteningly exposed.