Sponsoring Recklessness at Fannie Mae

11/13/08 - (07/28/08)  The New Yorker by James Surowiecki   --> Source
(Via Greg Mankiw)

[edited] Fannie Mae and Freddie Mac have long been required to tell investors that their securities are not guaranteed by the federal government. But, the financial markets have always believed that this demurral was window-dressing, and everyone was right. The Federal Reserve rescued them last week when fears of their collapse threatened a financial crisis. The implicit guarantee became an explicit one.

There is no obvious reason for these Government Sponsored Enterprises (GSE's) to exist in the form they do. The government could directly do Fannie and Freddie's jobs. They were set up to buy and sell mortgages to promote home ownership. Fannie Mae started in 1938 as a government agency with authority to buy mortgages, in the hope that this would expand the supply of credit to homeowners.

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Fannie was privatized in 1968. Freddie was created two years later, private from the start. Accounting was the main reason for the change. Lyndon Johnson was concerned about the large debt of the Vietnam War on the federal budget. Making Fannie Mae private moved its liabilities off the government’s books, without removing the obvious, real liability. It was like what Enron did thirty years later, when it used “special-purpose entities” to move liabilities off its balance sheet.

The implicit guarantee of the government empowered Fannie and Freddie to borrow money more cheaply than their competitors. They used this cheap financing to buy increasing numbers of mortgages [and make outsized profits].

They were able to grow extravagantly because neither the market nor the state checked their growth. Had Fannie and Freddie been ordinary private companies, there would have been a natural limit. Companies with more debt are usually seen as riskier, and that makes investors less willing to invest. On the other hand, had Fannie and Freddie been government agencies, visible budget constraints would have limited the size of their operations.

Congress failed to give regulators sufficient power to rein them in, thanks in part to ardent lobbying [and political contributions] by Fannie and Freddie.

See also We Guarantee It for more about what caused our current financial problems.