Lessons from Fannie Mae

I came across an article from 2003 in which Fannie Mae boasted about spending trillions to provide mortgages to millions of people who could not obtain mortgages under standard lending criteria. We later came to learn that many of these individuals could not afford, or more precisely could not manage the mortgages that were granted to them based on social rather than market logic. Seven years and $110.6 billion dollars later, it is all too clear that Fannie Mae's & Freddie Mac's abandonment of sound economic principles was a major factor in the creation and destruction of history's largest financial bubble.

The only way that Fannie Mae could ensure equal outcomes (rather than equal opportunities) for targeted groups was to lower lending standards and predictably much higher default rates ensued. Paradoxically and predictably, the artificially increased demand via massive government subsidies made housing even less affordable, i.e. inflated prices.

Of course it seems heartless and even illogical to let market forces, rather than planning inspired by noble principles like "fairness, equity & affordability" determine the volume and allocation of mortgages (or other goods and services). This is especially true when a system of (somewhat) free choice produces inequitable outcomes. But, the inescapable logic of the markets are: if individuals and institutions are unwilling to risk their own capital on someone or something, they're probably not the best bets.
Of course progressives like Barny Frank were ardent idealists when it came to allocating public funds to expand the availability of mortgages to home seekers with sub-par credit. But, I am betting that he would have behaved as a "heartless capitalist" if he was asked to risk his own capital. The same goes for subsidies to "green companies." Of course I very much want to see renewable energy resources replace fossil fuels, but I am skeptical of placing public funds in companies that private investors are leery of investing in. They are basically saying that given their knowledge of the practices and products of that particular company, they do not foresee it becoming profitable. Of course there are narrow, short term investors who will not invest in ventures that do not generate immediate returns, but there are also a surprising number of investors oriented towards long term profits. And if those investors caught wind of a green company with real potential for future profit, quicker than you can say "buy low," they would begin investing their private capital in that company.
In itself the profit of a company or an investor does not represent a social good, however it does reflect the feasibility and desirability of a good or service. Apple Computers became wildly profitable only when it began producing products that were desirable (meet a real need) and feasible (affordable enough to facilitate wide spread use among consumers). Like computer and internet firms before it, green companies will only take off once they develop technologies that make the use of their products affordable relative to other options.

No amount of subsidies can make a product or service take off until market realitities allows them to organically do so. Paradoxically, subsidies may actually reduce incentives for a company to innovate and create feasible and desirable products. Why should they? Their financial well being is more contingent upon the good will of politicians than the value of their goods and services. And subsidies often serve as a mechanism to maintain the dominance of established players in a market rather than allow for new, more innovative companies to enter and compete in that market.

In no way do I believe that markets are perfect or always rational, but with few exceptions they are better allocators of capital and labor than politicians are. While markets and politicians are both prone to errors, markets are self correcting entities, whereas politics is the art of amassing wealth and power until voters discover the extent of your errors.

Fannie Mae passes halfway point in $2 trillion American Dream Commitment

March 18 , 2003

On the third anniversary of its "American Dream Commitment(R)," Fannie Mae and its lender partners already have fulfilled over half of its ten-year pledge to provide $2 trillion in home financing for 18 million historically underserved families, Fannie Mae Chairman and CEO Franklin D. Raines announced today.

To date, Fannie Mae has provided more than $1.3 trillion for nearly 12 million targeted families, completing two-thirds of the American Dream Commitment in about 30 percent of the time, and leading the market in serving minorities and the nation's affordable housing needs.

Joining with representatives from 11 leading mortgage lenders and Fannie Mae partners, Raines applauded the mortgage finance industry for its extraordinary efforts to reach and serve "emerging markets" of historically underserved families and communities, deliver Fannie Mae's $2 trillion in targeted capital, and extend the benefits of the nation's housing boom.

Lender partners participating in today's announcement include: Bank of America; Bank One Corporation; Charter One Bank; Countrywide Financial Corporation; Doral Financial Corporation; First Horizon Home Loan Corporation; Fleet Boston Bank; Huntington Mortgage Company; Irwin Mortgage; J.P. Morgan Chase & Co.; and Standard Mortgage Corporation.

"Together, America's top lenders and Fannie Mae have made terrific progress in bringing the nation's housing boom to overlooked Americans and addressing the gaps in housing opportunity," Raines said. "Fannie Mae applauds our lender partners for helping us surpass the halfway mark in our $2 trillion commitment to underserved families so quickly. Together, we lead the market in serving Americans of color and modest means."

Fannie Mae launched the American Dream Commitment in March 2000 to narrow homeownership gaps, increase the availability of affordable rental housing, and strengthen communities.

The plan included $420 billion to provide minority home financing and in 2002 Fannie Mae boosted that pledge to $700 billion in an effort to help advance the Bush Administration's minority homeownership proposals.

The Commitment consists of a six-point plan: Mortgage Consumer Rights Agenda; National Minority Homeownership Initiative; Opportunity for All Strategy; America's Living Communities Plan; eHomeownership; and Affordable Rental Housing Leadership Initiative.

Highlights of Fannie Mae's 2002 American Dream Commitment report include:

Fannie Mae provided over $1.3 trillion for nearly 12 million families since 2000, including:

•$670 billion for almost 5.5 million families in 2002
•$67 billion for households headed by women
•$190 billion for families in city neighborhoods
Fannie Mae met its voluntary commitment to lead the market in serving minority Americans. Last year, the company provided $136 billion for almost 1 million minority families, which:

•served 213,000 African-American families with $24 billion in financing;
•served 394,000 Hispanic families with $51 billion in financing;
•served 2,488 Native Americans living on tribal and trust lands with more than $217 million in financing;
•served 375,000 other minorities with $61 billion in financing; and
•led to Fannie Mae partnering with lenders and community groups to finance $8.2 billion through our efforts to facilitate Community Reinvestment Act-targeted business.
In addition, Fannie Mae met or exceeded HUD affordable goals for the 9th consecutive year, with almost 52 percent of business serving low- and moderate-income families; almost 33 percent serving underserved areas; and over 21 percent serving very low-income families.

Fannie Mae reported progress in protecting consumers' rights in mortgage finance. The company launched an initiative with lender partners in 19 communities last year to help victims of predatory lending refinance into safer, cheaper loans.

"Fannie Mae is a national leader in the fight against predatory lending and has established a powerful corporate anti-predatory lending policy," said Raines. "The company believes that rejecting loans with predatory features, supporting the adoption of a strong, federal anti-predatory lending law, and providing good capital through good lenders to drive out the bad will ensure that borrowers aren't victimized by unscrupulous predatory lending practices."

Further progress was also reported in The National Minority Homeownership Initiative and the Opportunity for All Strategy.

"Over the next decade, minorities and immigrants are expected to fuel the growth in the mortgage market, making up more than 60 percent of first-time home buyers," said Raines. "We are committed to working with lenders, mortgage brokers, nonprofit housing partners, and others to address the unique financing needs of these emerging home buyers."

The company continues to develop the eHomeownership and Home Counselor Online™ solutions and is committed to an e-commerce environment to drive down the cost of mortgage credit and increase the availability and accessibility of home loan financing to home buyers. Since it first went live in 2001 on www.efanniemae.com, more than 1,100 housing counselors have registered to use the application.

Source: Fannie Mae

Moral Hazards & Perverse Incentives

One economic concept that's played such a prominent role in our current economic debacle is: Moral Hazards. According to Wikipedia:

"Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its doings, and therefore has a tendency to act less carefully than it alternately would, leaving another party to hold some responsibility for the consequences of those actions."

For example, we can be certain that if Fannie Mae and Freddie Mac were not implicitly guaranteed by the government, they would not have been reckless in issuing sub-prime mortgages. And of course the multi-billion dollar bailouts that the Obama Administration is providing their corporate cronies will not encourage the recipients to engage in more sound economic behavior.

Another concept is perverse Incentives, which is defined as an incentive that has an unintended and undesirable effect, that is against the interest of the incentive marker.

These economic phenomena figures prominently in socialized medicine.

We can argue the merits of providing health care for the truly impoverished, but beyond that we enter the murky territory of moral hazards. By expanding the Medicaid eligibility from 185% to 400% of the poverty level, Blagojevich allowed families earning up to $80,000 to partake in socialized medicine. With some exceptions, the majority of families with this income level could adjust their spending and saving patterns to allow for the purchase of private health insurance. This may mean making tough choices, like opting for a smaller home, a more modest wardrobe and eliminating eating out. But once the option of socialized medicine is presented, their incentives to economize and make tough decisions are essentially eliminated. Many families who would have otherwise purchased their own insurance will opt for government assistance, which is a major factor in the expansion of Medicaid users in Illinois by 62.86% (between 2000 - 2008).

One lesser mentioned, but equally important aspect of moral hazards are the reduction of incentives for personal, professional and economic improvement. To start off with, many private insurance firms will offer lower rates (positive incentives) to those who don't smoke, watch their weight and avoid needless procedures. In contrast, socialized medicine rarely if ever offers such incentives, which predictably lowers incentives for healthy, economical behavior.

In regards to professional development, I can provides countless examples of people who were unhappy with their economic circumstances and decided to invest their time and money in developing new skills in order to pursue more profitable career paths. In the course of improving their productivity they also help create a more dynamic, productive economy. But, with the growth of a cradle-to-grave nanny state, that care for the unproductive and penalizes the productive (via higher taxes and regulation), there are simply less incentives for personal and professional improvement. In fact, Medicaid provides very powerful perverse incentives against professional improvement. For example, in Illinois a family earning $75,000 would lose thousands and thousands of dollars in Medicaid benefits if they raised their earnings to $80,500.

Does this mean that the state should not attend to the health and welfare of the most vulnerable citizens? Of course not. It merely means that we must be extremely cautious of engendering moral hazards that reduce incentives for economically positive behavior and perverse incentives that increase economically and socially destructive behavior.

Crazy Talk from a Wacky Radical!

Here is some crazy talk that wacky radical Ron Paul (excerpts from his speech before a senate hearing on Fannie Mae and Freddie Mac) dating from September 2003:

Today, I will introduce the Free Housing Market Enhancement Act, which removes government subsidies from the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the National Home Loan Bank Board.

This explicit promise by the Treasury to bail out GSEs in times of economic difficulty helps the GSEs attract investors who are willing to settle for lower yields than they would demand in the absence of the subsidy. Thus, the line of credit distorts the allocation of capital.

More importantly, the line of credit is a promise on behalf of the government to engage in a huge unconstitutional and immoral income transfer from working Americans to holders of GSE debt.

The connection between the GSEs and the government helps isolate the GSE management from market discipline. This isolation from market discipline is the root cause of the recent reports of mismanagement occurring at Fannie and Freddie. After all, if Fannie and Freddie were not underwritten by the federal government, investors would demand Fannie and Freddie provide assurance that they follow accepted management and accounting practices.

Ironically, by transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market. This is because the special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans.

Despite the long-term damage to the economy inflicted by the government's interference in the housing market, the government's policy of diverting capital to other uses creates a short-term boom in housing. Like all artificially-created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.

Perhaps the Federal Reserve can stave off the day of reckoning by purchasing GSE debt and pumping liquidity into the housing market, but this cannot hold off the inevitable drop in the housing market forever. In fact, postponing the necessary, but painful market corrections will only deepen the inevitable fall. The more people invested in the market, the greater the effects across the economy when the bubble bursts.

No less an authority than Federal Reserve Chairman Alan Greenspan has expressed concern that government subsidies provided to GSEs make investors underestimate the risk of investing in Fannie Mae and Freddie Mac.

Mr. Chairman, I would like to once again thank the Financial Services Committee for holding this hearing. I would also like to thank Secretaries Snow and Martinez for their presence here today. I hope today's hearing sheds light on how special privileges granted to GSEs distort the housing market and endanger American taxpayers. Congress should act to remove taxpayer support from the housing GSEs before the bubble bursts and taxpayers are once again forced to bail out investors who were misled by foolish government interference in the market. I therefore hope this committee will soon stand up for American taxpayers and investors by acting on my Free Housing Market Enhancement Act.

For the full transcript from Dr. Paul's speech:

http://www.lewrockwell.com/paul/paul128.html

Barney Frank: This Week's Winner of the Jimmy Carter Prize

This week's recipient of the Jimmy Carter Prize For the Advancement of Douchebaggery is Congressman Barney Frank. As a ranking member and now chairman of the house financial services committee, Mr. Frank spent years defending Fannie Mae and Freddie Mac against efforts to impose greater oversight and regulation and downplaying concerns about the financial soundness of these deeply flawed government organizations. Yet, Mr. Frank has the gall to blame the housing crisis on the "failure of unfettered capitalism" and "de-regulation."

Believe it or not, one of the Bush administration's few moments of clarity and good judgement was it's multiple calls to increase regulation and oversight of Fannie Mae and Freddie Mac.

In 2001 Bush stated that size of mortgage giants Fannie Mae and Freddie Mac is a potential problem because financial troubles in either one of them could cause strong repercussions in financial markets.

In fall of 2003 the Bush administration pushed congress to create a new federal agency to regulate and supervise the Fannie Mae and Freddie Mac. John Snow Treasury Secretary stated "we need a strong, world class regulatory agency to oversee the prudential operations of the GSE (government sponsored enterprise) and the safety and the safety and the soundness of their financial activities."

As a ranking member of house financial services committee, Congressman Barney Frank vigorously blocked efforts at greater oversight and regulation stating:

"These two entities – Fannie Mae and Freddie Mac – are not facing any kind of financial crisis. The more people exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses, which I do not see, I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios, but the more pressure there is on these companies, the less we will see in terms of affordable housing.”

In 2005 the Bush administration once against pushed for greater oversight of Fannie Mae and Freddie Mac. With Bush's full support, Alan Greenspan stated:

"Enabling these institutions to increase in size - and they will once the crisis in their judgement passes - we are placing the total financial system of the future at a substantial risk. If we fail to strengthen GSC regulation we increase the possibility of insolvency and crisis."

This bill was voted against by Congressman Frank and his democratic allies. Of course we can be certain that this has nothing to do with the campaign contributions that Frank ($40,100), Christopher Dodd ($133,900), Barack Obama ($105,849) and Hillary Clinton ($75,500) from Fannie Mae and Freddie Mac. That's certainly a lot of change that we can believe in!

http://www.youtube.com/watch?v=9HQWk1Wp3L4

http://www.opensecrets.org/news/2008/07/top-senate-recipients-of-fanni.html

Nahhhh...

The insurance giant AIG received an additional $30 billion dollars bringing the grand total to 170 billion, yes that's billion with a "b." Could that have anything to do with the campaign contributions made to key members of the Obama administration and the democratic party?

Dodd, Christopher $104,300
Obama, Barack $45,111
Clinton, Hillary $36,831
Biden, Joseph R Jr $19,975

Nahhh....of course not!

Fannie Mae and Freddie Mac received billions from the government. Could that have anything to do with the fact that the two largest recipients of campaign contributions were Christopher Dodd ($165,000) and Barack Obama ($126,349)

Nahhh...of course not!

Cautionary Tale

One key element of intellectual conservatism is understanding the limits that humans have in controlling economic and social phenomena. History is fraught with examples of disasters caused by movements who thought that they could arbitrarily force human beings and social phenomena to conform to their abstract visions. The most dramatic example is seen in socialism, in which leaders pushed for the creation of a "new man" and "new economy" organized around their collectivist vision. Of course the inevitable result was famines, scarcity and gulags.

"Progressive" dogmas are rarely totalitarian, but most are based on the implicit belief that social and economic phenomena can be regulated to arbitrarily conform their visions of "social justice" without costly unintended consequences.

Before my "progressive" readers strike out at strawmen; I will unequivocally state that I am not against all regulation and all state intervention in the economy. I simply urge my readers to consider that each government "cure" is accompanied by a whole new set of economic and social "diseases" that prompt even more government intervention.

A brief glimpse of government intervention in the housing market demonstrates this:

1. To obtain the benefit of increased home ownership the government heavily intervened in the economy through Fannie Mae, Freddie Mac, tax write-offs and programs and policies geared specifically towards "underrepresented populations."

2. In addition the government encouraged loose credit by maintaining the prime interest rate at levels that were below inflation.

3. These actions obtained the intended benefit of expanded home ownership.

4. One of the unintended consequence of increasing the demand for housing was higher housing prices, i.e "unaffordable housing" which limited access to the housing market.

5. The government took advantage of rising home prices by dramatically raising property taxes, which made housing even less "affordable" for many Americans.

6. To counter the problem of "affordable housing" and expand housing among "underrepresented populations," the state encouraged the expansion of housing subsidies in general and government backed sub-prime mortgages in particular.

7. This greatly contributed to the dire financial situation of several banks.

8. Which of course prompted an extensive and very costly intervention in the financial sector, which will have a multitude of unintended consequences, among them an increase in the size of the national debt.

9. This will inevitably lead to higher inflation and / or much higher interest rates.

10. And of course the state will enact a whole new set of programs and policies to address the economic problems created by state intervention and so on and so on...

So, at the end of the day the housing market and most of the economy would have been in much better shape if we had exercised greater caution in our efforts to bend the market to our desires. The fundamental problems are that few voters can connect the economic problems of today with the policies of the past. And even fewer politicians are willing to take responsibility for the economic disasters that they created; it's always easier to "blame the market."

Two Chimps and a Balloon...

Chimp one watched as chimp two carelessly inflates the balloon, yet somehow he will be shocked when it bursts...no pictures better summarizes how most politicians and most of the public watched as we created an unsustainable bubble in the housing market and yet somehow were surprised when it burst.

The Fed kept interest rates below inflation, which created incentives for banks to carelessly issue loans and the public to carelessly accept them.

Fannie Mae and Freddie Mac bought billions in sup-prime loans encouraging banks to issue even more of them.

Clinton and Bush stated that they were actively seeking to increase home ownership in "under-represented communities" and Janet Reno went as far as saying that she would actively prosecute banks that did not comply with their initiative, further fuelling the volume of sub-prime mortgages.

Of course many individuals, banks and brokers foolish behavior fuelled the bubble, but they were certainly encouraged by government created incentives.