The New Scapegoat? Fannie and Freddie

The Republican's weekly strategy meeting resulted in a clear consensus: government coddling of Fannie Mae and Freddie Mack has resulted in the current crisis on Wall Street, and it is the Democrats fault. This sounds good, but quickly fails the reality test. And frankly, there is plenty of blame to go around.

Fannie and Freddie are not responsible for so many Wall Street firms taking massive over-leveraged risks with exotic financial instruments called "Derivatives"; referred to as "weapons of financial mass destruction" by Warren Buffett in his 2002 annual letter to shareholders. It is now clear that financial speculators based risky investments on these incomprehensibly complex securities including Collateralized Mortgage Obligations (CMO), Auction Rate Securities (ARS), and the pseudo-insurance Credit Default Swamps (CDS), without having the ability to accurately value them.

There has been a massive failure of regulation on the "shadow" banking system since Ronald Reagan installed the deregulation philosophy deeply into the Republican Party and body politic of the United States. Created over the last 20-years, a largely unregulated system of "broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders"(1) is now failing due to the lack of structures implemented on the conventional banking system following the Great Depression. Christopher Cox, a committed free-marketer and the chairman of the Securities and Exchange Commission, recently announced that voluntary regulation of the financial industry "does not work", and members of both parties have talked about regulatory systems that were "asleep at the switch".

Prior to the September 2008 bailout, Fannie Mae was a publicly traded, stockholder owned firm, independent of the Federal Government since 1968. Freddie Mac was also a private corporation, although government chartered. These entities participated in the same subprime loaning frenzy that dominated the lending industry: from 2001 through 2007 the subprime portion of the total mortgage portfolio in the United States rose from under 3% to 13.7%(2). During the same period, subprime loans rose from 15% to 48% as a proportion of all new loans being written(3). In the past month, both Wachovia the fourth-largest U.S. bank, and Washington Mutual, the nation's largest savings and loan, have failed due to bad bets on the mortgage market. Clearly, the vast profits being made on the subprime mortgage market led to industry wide extravagance, not limited to Fannie and Freddie.

Right-wing talk radio personalities such as Rush Limbaugh have rushed to place the blame for the financial crisis on Democrats. However, Republicans held majorities in the House and Senate since January of 1995. Democrats did not take control of Congress until January 4, 2007. Therefore, while several prominent Democrats made public statements against increased regulation of Fannie Mae and Freddie Mac proposed by the Bush Administration prior to 2007, it was the majority Republican caucus that failed to pass regulatory reform. And it was Republicans that spearheaded the Gramm-Leach-Bliley Act of 1999, and the Commodities Futures Modernization Act of 2000, that exacerbated the regulatory vacuum. Additionally, the Executive Branch of our government has considerable regulatory power, should it care to use it. No impartial observer would suggest that the Bush Administration had much interest in regulating anything during its time in power.

But, in case you were thinking that it was strictly a Republican idea to deregulate the financial markets, the Clinton era treasury secretaries Robert Rubin and Lawrence Summers were supporters of the regulatory reform bills mentioned previously. And let's look back to the 1998 bail out of Long Term Capital Management (LTCM), a massive failed hedge fund. That disaster should have been a warning that our financial system was spiraling out of control. Things only got worse from there as the market for an alphabet soup of Derivatives, and massive over-leveraging only increased. So who was the president and who was the Chairman of the US Federal Reserve when LTCM failed you ask? Bill Clinton and Alan Greenspan.

There is enough blame to go around. Now, perhaps our government could help solve the problem that both parties helped create.

1 The shadow banking system is unraveling, Nouriel Roubini, September 21 2008, The Financial Times.
2 Sub-prime mortgage market -Some facts and data, Peter Possing Andersen, Danske Bank, March 2007
3 Subprime Mortgage Problems: A Quick Tour Through the Rubble, by Ronald D. Utt, Ph.D., WebMemo #1881, http://www.heritage.org

WORTH REPEATING

I saw the following entry on the web site of the Atlantic (http://marcambinder.theatlantic.com/archives/2008/10/the_fanniefreddie_talking_poin.php), responding to this same issue. I thought it was worth repeating here:

FWIW [for what it's worth], I'm a registered Republican who mostly loathes FNM [Fannie Mae] and FRE [Freddie Mac], and I think this [blaming Fannie Mae and Freddie Mac] is wildly dishonest. No clue if it will be effective, but anyone repeating it is either a grifter or a mark.

1. FNM/FRE market share collapsed during the peak bubble years when the worst loans were being made. Probably not a coincidence.

2. FNM/FRE portfolios have performed vastly better than those of lenders like Ameriquest, Long Beach (WaMu), Aurora (Lehman), Option One (H&R Block), First Franklin (National City and then Merrill Lynch). They could have survived w/o a bailout; they just couldn't have served their stated purpose without one.

3. GSE defenders always argued that, in their absence, the private lenders would run amok in the good times and flee the market in bad times. Given that total GSE market share was over 80 percent in the first calendar quarter, it is hard to dispute that any more. (GSE critics were correct in arguing that running a book that big with such little capital would inevitably result in a gov't backstop.)

Posted by dbblg | October 8, 2008 1:28 PM