Monday, September 08, 2008

Quite a stink...

I suppose this was inevitable for the past 70 years. When FDR first created the FNMA, more commonly known as Fannie Mae, we should have all noted that eventually Uncle Sam would have to pick up the tab. Or, to be more accurate, the US taxpayer would have to pick up the tab.

Here is the simplified version of what happened. First, some basics. Banks are the ones who lend people money to buy homes. This obviously requires a lot of money up front so there is a limit to what an individual bank can do and thus a limit to how many people can own a home. In addition to this, it’s difficult for a bank to offer a guaranteed interest rate for 30 years because interest rates change, and since banks depend on “income” that pays out a certain interest rate there is the danger that a bank will have to pay out more than they take in. So, to guard against this, the 30 year interest rate would have to be rather high if they offer that at all. Again, this translates into fewer mortgages. Enter Fannie Mae and her little brother Freddie Mac, established to help generate more mortgages and more home ownership.

These two companies purchase mortgages from banks in order to free up the banks to offer more mortgages, and maintain relatively low interest rates. Fan and Fred then bundle the mortgages and sell them to investors. Investors make money on interest and dividends, Fan and Fred make money on interest, the banks are able to lend more money and Joe Public is able to buy more houses…the overall economy benefits. Everyone wins, right? Wrong.

The problem is when Joe Public can’t afford to pay his house note.

This problem is magnified when Fan and Fred grow to enormous proportions and end up owning half of the country’s $12 trillion in mortgages. It is magnified even more when the housing market slumps so much that 10% of these mortgages are late or are already in the process of foreclosure. Suddenly, investors aren’t quite as interested in buying shares and bonds of the two companies. Money becomes tight. The demand for housing drops, and home prices fall. A crisis looms.

Of course, it doesn’t help when the government does things to “help” people own a home, things like loosening credit standards in order to help people buy houses they can’t afford. Now, that wasn’t the actual intent, but that’s what happened. Good intentions, bad outcome. It also doesn’t help when these companies are considered private, but come with an “implicit” guarantee of federal backup. In other words, if things are mismanaged then they have a rich Uncle Sam standing by to bail them out. And mismanage they did, often in the form of adjustable rate loans that made it easier for people to buy out-of-reach homes without understanding - or paying heed to - the potential for disaster down the road.

So Fan and Fred were set up to provide money quicker and easier for home ownership. The loose credit standards allowed more people to purchase homes. The demand for homes increased, and home prices followed. This led to riskier mortgages for people who were even less qualified from a basic credit standing. Thus, we found ourselves in a housing bubble. Simply put, people bought homes they couldn’t afford with the help of very questionable lending standards and lenders who were eager to improve their bottom line, knowing the gov’t was there just in case. Eventually, the in-over-their-head homeowner can’t pay the note. Eventually, the bubble burst. And guess who was left holding the bill?

The Bush administration had no choice in whether or not to bail these companies out. If Fan and Fred failed, the impact would have been disastrous. No one argues that. But I do argue two points. The first is whether the government has any business doing this kind of business. The second is why on earth do we not have stricter standards, more oversight and more transparency when the government does decide to practice business. It seems like that would be an advantage of public involvement in these endeavors. However, that’s not the reality and all of Washington shares the blame for it.

This problem was not created by the Bush administration, although they certainly didn’t help matters. Clinton’s treasury secretary warned of a looming crisis long before Bush took over, but nothing was done. And Congress failed to impose transparency and standards on these companies, the argument being Fan and Fred were private companies that the government has no business meddling with. That argument holds except for the fact that we as taxpayers are the ones guaranteeing the business these people do. So the way I see it Bush, Clinton and all of Congress are to blame here, and I’ll throw in every presidential administration and Congress dating back to FDR. This public/private business model doesn’t work. When things are going great, only the investors win. I don’t recall getting any dividends or profit sharing. Yet when things go bad look who has to pay up!

Not only that, but the simple presence of Uncle Sam’s safety net allows CEOs and others to practice a riskier style of business that they otherwise wouldn’t get away with in the private sector. The potential for corruption is mind-boggling. And now that the government has bailed them out of this mess, the potential for an even bigger bubble to develop in the future is evident unless something is done. Exactly what, I don’t know.

But I do know that the next administration will inherit quite a stink bomb and will have to figure out what to do with it. In my mind, it’s an either/or situation. Either make it completely public, but with full oversight and accountability, reasonable low-risk standards and public sharing of profits, or make it fully private and let the market do its thing. Either way, it’s a $6 trillion mess that lawmakers from both parties repeatedly fumbled and in doing so jeopardized our entire economy.


Mike said...

Excellent analysis. However, as a former mortgage broker, I need to point out a factor you forgot to mention.

Yes, lenders wanted to make more money. Obviously. But that's not the whole story as to why the lending guidelines were relaxed to absurd levels. "The Government" is on the hook there, too.

In the Clinton-led nineties, lenders were told that they *had to* loan money to the poor because not doing so was discriminatory. Liberals won't ever concede this point, but there is actually a pretty good link between being poor and making poor financial decisions. So, Big Brother says, in effect, that lenders must loan money to people who have a history of bad financial decisions, or else. The lenders gladly went along with the rouse, laughing all the way to the bank. They're culpable in all of this, but so is the government who told them to ignore centuries of data about money lending and default.

John Washburn said...

Excellent point, Mike. I was not aware of this, thanks for bringing it to light.

Anonymous said...


Sorry, but blaming Clinton of this one is a dog that won't hunt except that he did sign into law the statute that repealed certain ptrovisions of the the Glass-Steadman Act. That would be the Garmm-Leach-Bliley Act (No other than Phil Gramm economic adviser to John McCain).

In essence, the Gramm-Leach-Bliliey Act gutted the provisions of the Glass-Staedman Act that prohibited commercial banks from acting like investment banks.

Check out the stick figure explanation of the subprime mortgage mess that has been circulating for months on the internet.

Castigate the poor all you want. I agree that people w/o money are more likely to make bad decisions about money than people w/ money. But none of the people who defaulted on their mortgages would have been in that position had predatory mortgage brokers not acted as middlemen for lending institutions willing to loan money to bad credit risks.

John likes to talk about individual responsibility. How about the individual responsibility of mortgage brokers who arranged loans to people who they knew could not pay them? What about the institutional responsibility of the banks that funded the loans? I won't go upstream from there but there is plenty of fault upstream also.

"Hey John. Let me take your life savings and loan it to a person who I know can't pay the loan or who I do not even check to see if he can pay the loan."

"Loop. No thanks."



Anonymous said...

If the Gov protects the poor from predatory lenders instead of forcing those lenders to grant loans to the poor (as it would be unconstitutional) then there would be less of a mess.