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Oct 8, 2008

We Guarantee It

A Government Guarantee Is a Blank Check Written On Your Account

When you guarantee something, you have all of the downside risk of ownership, often without any upside hope of profit. A guarantee is the most dangerous financial action you can take. Ironically, the more that you can pay, the greater is the danger. A guarantee should be specific, limited, and closely watched. All of Wall Street and Main Street know this. Politicians know it too; they pretend that they don't.

The center of the current financial disaster is a runaway government guarantee placed in service of government affilliated corporations Fannie Mae and Freddie Mac, under the direction of Barney Frank, and the cooperation of most of Congress.

A mistake in oversight can cost you plenty.

Credit Parable

(Stage lights brighten from black)

Son:  Hi Dad. I need a credit card for college. I can get a card with a $3,000 limit at 18% interest, and I'll pay off any balance from my part-time work. I expect to occasionally run a $2,000 balance. I figure this will cost me about $150 per year. At $12/month I think the convenience is worth it.

Dad:  You have done your research, and I think this makes sense.

Son:  I want to mention that they will cut the rate to 10% and raise the limit to $5,000 if you will guarantee the card. I'll have all the credit I need in an emergency, and I'll save $67 per year, just for getting your signature. It's free money.

Dad:  OK, I trust you. I'll just sign here ...

(A year later)

Son:  I have a problem. You know that credit card I got a year ago? I owe them $18,000. They are going to make you pay them.

Dad:  What? How can that be? What did you do?

Son:  A few months after I got the card, they raised my credit limit to $20,000. I think they were impressed by your credit rating. They offered me 0% interest for a year, so I moved to an off-campus apartment and bought some furniture. I could not resist taking a spring break to Cancun. Did you know that you can gamble at age 18 in Cancun?

I met a beautiful girl. She is from a wealthy Nigerian family, but needed a loan to complete her first year. Bad luck, she had to leave college and go home. Unfortunately, the college says they didn't get the tuition she owed them, but they do have my credit card number and my signature. Her phone number in Nigeria is not working.

They raised the interest rate to 29% when I was late with a minimum payment, and there were some extra credit fees. With late fees and some stupid stuff with their attorneys, they say I owe them $17,893, and that you have to pay if I don't. Of course, I can't pay them.

I'm sorry Dad, I thought I could clear this all up, and I really didn't know what to do. So, there it is.

Dad:  This is impossible. I only guaranteed a $5,000 limit, and you were going to be careful. They aren't getting more than $5,000 from me, and you are going to work that off.

Son:  They told me that raising the $5,000 limit was just an extension of the contract terms, and that I had 60 days to object, but I didn't see the harm. Also, it seems that you guaranteed "the card" and not "the limit". Anyway, it might take a lawyer to fight their claim. They said that we would have to pay more of their attorney's fees if we fight and lose. Your credit rating is also at stake.

Dad:  (Head in hands, wheezing sounds) What a disaster.

(Lights fade to black)

Created by Congress

The parable suggests what the Congress did with Fannie Mae and Freddie Mac, the government Sponsored Enterprises (GSE's) that Congress set up to encourage lending for home ownership.

Congress maintained close oversight of what Fannie and Freddie (FanFred) were doing, and approved of it. Congress created OFHEO (The Office of Federal Housing Enterprise Oversight) especially to regulate FanFred. The much larger and more visible SEC (Securities and Exchange Commission) was available, but Congress wanted its own regulator.

OFHEO knew month by month that by December 2007 FanFred had bought and held 18% ($219 billion) of all subprime mortgage bonds (the most risky) created in 2006 and 2007. By June 2008, Fannie owned in addition $307 billion of questionable Alt-A mortages, 11.5% of its total of $2,670 billion of mortgages owned.

FanFred borrowed money from private institutions in order to buy and hold this "subprime paper" and more usual mortgages. Fannie and Freddie together owned and guaranteed mortgage bonds representing $5,400 billion in home mortages ($5.4 trillion). In comparison, the borrowed debt of the US is separately $5.5 trillion. Institutions loaned to FanFred whatever it wanted, because FanFred had the implied guarantee of the US Government.

Risky Lending

An Alt-A mortgage is rated as an intermediate risk, between standard prime "A" mortgages and "subprime" mortgages. It may be granted to someone with low credit scores and serious late payments, without recent defaults or bankruptcy. Compared to a prime loan, it allows for no verification of stated income and assets ("no-doc loan"), higher debt for the stated income (payments at a higher fraction of income), less money down ("high LTV Loan to Value ratio"), and for less desireable properties.

A "subprime" mortgage is rated as high risk. It is granted to someone who cannot qualify for Alt-A, maybe to someone with recent defaults and bankruptcy.

The small market for Alt-A loans increased hugely because FanFred became a buyer. The subprime mortgage was created by government mandates on banks through the the CRA housing bill, and the volume of subprime loans expanded mostly because FanFred became a buyer, as dictated by Congress. FanFred did not buy all of the risky loans, but it supported the market for such loans and made them acceptable over time to other institutions. So, mortgage losses have not been limited to FanFred.

FanFred set the standards for the mortgage market. Mortgage lenders made risky loans to people with poor credit ratings, according to the standards for the loans FanFred would buy. FanFred's decreasing credit standards of course produced decreasing credit standards by retail mortgage lenders. FanFred knowingly took on all of the risk when they bought these loans.

Don't Stop

No one stopped FanFred from making these bad investments. The Congress (House and Senate) intentionally ignored clear warnings over many years. The House Financial Services Committee (overseeing banking and financial services) did not object, and actually encouraged more lending to subprime borrowers. Barney Frank (D. MA) has served as ranking (most senior) Democratic member on this committee since at least 1991 Called the House Banking Committee in 1991, it had oversight over Fannie Mae.
  Events in 1991: Frank pushed the Banking Committee to loosen regulations on mortgages for two- and three-family homes.
  Fannie hired Herb Moses as Assistant Director for Product Initiatives where he helped develop many of Fannie Mae’s lending programs for affordable housing and home improvement.
  Moses had lived with the openly gay Frank since 1987.
, and has chaired the committee since 2007 in the Democratic majority.

Barney Frank was Fannie Mae's Patron Saint, blocking attempts at limiting and reforming FanFred at least since 1992, denying that there were any problems, and even today demanding that any restructured company continue buying subprime loans.

FanFred's management was corrupt. In May 2006, OFHEO levied a $400 million fine against Fannie (as a corporation) for intentionally reporting $10.6 billion in false profits. According to USA Today "OFHEO holds Fannie Mae CEO Franklin Raines and former CFO Timothy Howard as principally responsible for manipulating the company's earnings from 1998-2004 while reaping tens of millions of dollars in pay and bonuses."

In April 2008, the NY Times reported that Raines and two other top executives would together pay $31.4 million in fines for their actions in 1998-2004. There is no mention of anyone going to jail.

Republicans did nothing for 12 years as the majority party. Democrats have done nothing in the past two years as the majority. There was never a majority of legislators, of whatever political party, in favor of stopping FanFred from using its guarantee to recklessly borrow money and buy risky loans.

Plausible Deniability

Politicians benefitted from FanFred in many ways. Their voters received loans, they received votes, FanFred made campaign contributions, and many of the political elite worked for FanFred at high salaries.

Most Democrats, in particular Rep. Barney Frank, said that FanFred aided poorer voters as part of enlightened social policy. Most Republicans did the same, and many did not criticise FanFred, afraid of being labeled heartless penny-pinchers who didn't want to help the poor. FanFred bought political support by contributing $200 million in the last 10 years toward lobbying and political contributions.

A long list of politically connected, mostly Democratic directors, senior management, and consultants made FanFred a vehicle for political patronage and personal profit. See Slate.com - Sep 2008 Fannie Mae and the Vast Bipartisan Conspiracy: A list of villains in boldface.

It is amazing that the government offered no written, legal guarantee of FanFred's mortgage bonds and debt. Large institutions relied on an implicit government guarantee Fannie Mae’s awfully big advantages
  At the link [edited]:  Fannie Mae is a government-sponsored enterprise. The financial markets concluded that the government will provide full faith and credit for Fannie’s debt. So, Fannie Mae maintains a AAA credit rating.
  The government has never said it would guarantee Fannie and Freddie’s portfolios, and Fannie denies any guarantee in its offerings. But everybody, and I mean everybody, believes that the government would support Fannie and Freddie, and they don't press the government to say anything.
AMG:  See also the other advantages that Fannie and Freddie had over any private company.
, and they were proved right by recent bailouts.

Institutions and credit rating companies such as Standard & Poor's (S&P) see almost no risk of default by FanFred and other GSE's, because GSE's are created by Congress, promote public policy (what politicians want), and are huge enterprises. This view has been supported by at least 30 years of government intervention to give government agencies and GSE's a guarantee in fact, if not in law.

Strangely, the GSE's and the government emphasize that there is no legal obligation for the government to pay their debts if the GSE's or agencies default.

Here is Barney Frank at a hearing in September 2003 about a Republican (George Bush) administration proposal to increase the regulation of FanFred and other GSEs:

[edited] I will consider the legislation, but the GSE's Fannie Mae and Freddie Mac are not in any kind of a crisis. An accounting problem has led appropriately to people being dismissed. At this point there is no threat to the Treasury.

This is an example of self-fulfilling prophecy. Some critics see a problem, that the Federal government must bail out people who might lose money. But, I do not believe that we have any such obligation.

I support the role that Fannie Mae and Freddie Mac play in housing, but investors should not look to me or the Federal Government for a nickel. If investors take some comfort and want to lend them a little money at lower interest rates, because they like their affiliations, then housing will benefit. But there is no guarantee, there is no explicit guarantee, there is no implicit guarantee, there is no wink-and-nod guarantee. Invest, and you are on your own.

We have a system that has worked very well to help housing. The high cost of housing is one of the great social bombs of this country. I would rank it second to the inadequacy of our health delivery system as a problem.

Fannie Mae and Freddie Mac have helped make housing more affordable, both through leveraging the mortgage market, and their mission to focus on affordable housing. In return, this Congress has given them some of the arrangements which are of some benefit to them.

I believe that we (the Federal Government) have probably done too little to push them to meet the goals of affordable housing and to set reasonable goals.

I worry frankly that there is a tension here. The more people exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see.

We see entities that are fundamentally sound financially and will withstand some of the disastrous scenarios. And even if there were a problem, the Federal Government doesn't bail them out. But the more pressure there is, then the less I think we see in terms of affordable housing.

The Congress approved $200 billion ($200,000 million) to pay off FanFred's losses, and it may cost $300 billion. This was before, and in addition to, last week's $850 billion "bailout" bill recently enacted ($700 billion plus $150 billion added on by the Senate for pet projects and earmarks). When the government pays, this actually means taxpayers will pay, both in direct dollars and in even larger losses in opportunity and jobs. For 110 million households, the spending or loss of $500 billion is $4,500 each.

In my view, this is a giant case of Plausible Deniability. That is the tactic of benefitting from a situation, but claiming that you didn't know, weren't responsible, or even spoke against it. The attitude is "You can't prove that I knew". It is politics as usual.

Barney Frank has not repeated his position in the current crisis, that the government will not and should not pay off the debts of FanFred.

He wants FanFred to continue in its mission. He and Sen. Chris Dodd among others support restoring FanFred to health and then returning them to the way they were before they went into conservatorship, but with safeguards to prevent another crisis.

The Bush admistration favors the breakup of FanFred after this crisis has passed. New, private companies would compete in the market for loans, and they would not have the support of the government.

FanFred was in some ways a hidden project. There were no budget items. Politicians claimed that there was no guarantee, no cost to the government, and nothing extra to legislate. There was no need to publicly examine what would happen if FanFred lost money and defaulted. OFHEO warned the House Financial Services Committee about growing risk. Chairman Barney Frank dismissed this as a matter of opinion.

In the language of Washington, FanFred was "off budget", until it exploded onto the taxpayer's budget with massive losses and a disruption of the US and world financial system.

More Rules

Now, the losses are discovered, and the cry goes out by Democrats that the fault was a lack of regulation by the Republican President George Bush.

In my view, the majority of Congress knew the risks in FanFred and willfully ignored those risks, while whispering "so far, so good". Most politicians saw the problems, and accepted possible losses as the cost of doing business, eventually to be paid for by "rich" people through progressive tax increases. No harm done according to their philosophy. Other politicians did not want to be labeled "unfeeling" or "anti-poor", and couldn't point to losses until they occurred.

The economist Thomas Sowell has written that almost nothing in life can be reduced to a set of rules. The beauty of a free market is that people can use their full abilities, knowledge, and experience as needed to produce a productive result or avoid loss, while risking only their own money. This is called good judgment, and it can't be completely expressed as a set of rules.

The fatal weakness of government and bureaucracy is that it is limited to a set of rules. When the rules don't work and loss results, a bureaucracy blames lack of regulation, and wants even more rules and more money. There is no public solution. We can't risk having a government that is not bound by rules.

The failure and huge cost of FanFred goes beyond inadequate rules. Politicians actively suppressed regulation of a business that they created, supervised, and grew into a monster using government connections. These same politicians are now blaming the lack of regulation in a "free market".

Congress guaranteed the debt of FanFred so that it could borrow unlimited funds from lending instutions, without review by those instutions, and without the borrowings appearing on-budget as an obligation of the Government.

Congress ran FanFred into the ground, plucking presents along the way. Congress set up FanFred,  took full responsibility by unofficially guaranteeing repayment of its debts,  removed it from private market discipline,  funded it through massive private borrowing outside of Government budget accounts,  commanded it to do risky business outside usual standards,  restricted its regulation to a special office set up by Congress (OFHEO),  and then ignored that regulator.

This scheme continued until the losses were enormous and had to be accepted publicly. Congressmen and Senators now complain that it was greed and lack of regulation by all of those other people that caused massive losses, especially the other people in the other political party.

If Fannie and Freddie were truly private companies in the free market, no one would have lent them enough money to damage the US and world economies. The mortgage loans were too risky, and no one would have trusted them.

New Guarantees

The Price of 12 House Votes
10/03/08 - WSJ.com Editorial

[edited] The White House and Congress are raising bank deposit insurance to $250,000 per account (up from $100,000) to pick up 12 House votes in favor of the $850 billion emergency credit legislation. The political bet is that this will please the community bank lobby, which in turn will persuade a dozen House Members to change their vote to Yes.

[ Note that this guarantee and subsidy is a political payoff to banks, so that they will throw support and money at congressmen, to convince them to support the credit legislation (or bailout bill). It seems that the minority is arguing with money rather than principle. As usual, it worked. ]

Apparently, the way to persuade Members who claim to oppose a "bailout" is to increase the cost of that bailout. The same Members who denounce bankers taking reckless risks are delighted about a measure that will encourage bankers to take more such risks. Your Congress at work.

The long-term danger is more risky lending. We've seen it before. In March 1980, Congress increased deposit insurance from $40,000 up to $100,000. This encouraged struggling Savings and Loan banks [Government licensed, inspected, and insured local and regional banks] to pay higher rates to attract more deposits, and use them to make risky loans.

Those loans went bust a decade later, and taxpayers had to pay $150 billion [$235 billion in 2007 dollars] to cover the losses and repay the deposits. That hard lesson is one reason the $100,000 limit hasn't been increased until now.

Maybe by coincidence, $40,000 in 1980 was worth about $100,000 today, and so $100,000 back then was worth $250,000 today. Congress has made the same adjustment to deposit insurance today that it did in 1980, inviting the same behavior, risk, and result.

Deposit insurance is a government guarantee of private banks. Our politicians think that such guarantees are worth it and have little cost or risk, or they just don't care. The FDIC (Federal Deposit Insurance Corporation) is supposed to act like an insurance company, but it is out of money, as reported at Seeking Alpha.

[edited]  11/26/10 - The FDIC insures total deposits of $5,400 billion [calc] Calculated as $379 B /.07 from the link. in 7,830 banks and savings associations, up to $250,000 per account.

As of 09/30/2010, the FDIC had a negative balance of $8 billion [borrowed from the Treasury], despite adding $7.2 billion during the quarter. In the next 4 years, the FDIC expects to pay out $52 billion for hundreds of bank failures due to losses on commercial real estate.

The FDIC is supposed to collect fees from insured banks to pay for any losses (to pay back the depositors) if this or that bank fails. The FDIC has not collected enough to cover current bank failures, and looks forward to needing at least $52 billion more.

Raising the insured limit to $250,000 has made things worse, because depositors are encouraged to put more money into bank deposits, at the higher interest rates the banks are likely to offer. They will not care about how much risk the bank has acquired as an investment institution.

Like Fannie and Freddie, like Savings and Loans in 1980, this increased government guarantee is a subsidy to the banks. It provides the banks with more money to lend, supplied by depositors who "don't have to worry". It poses "systemic risk", the risk that the worst banks will offer the highest interest, acquire large deposits, and lose their bets on risky loans.


Starting with a government guarantee, only government regulation stands in the way of disaster. This is the same regulation that has failed in the past and present, regulation based on rules and modified by powerful politicians, lobbying, and campaign contributions. Depositors have less risk to their deposits, but a greater hidden risk to their 401K accounts and the availability of jobs, when the next bubble bursts and is bailed out by the government (by the taxpayers).

Government guarantees have great value and invite unlimited risk. The guarantee is made by government on behalf of taxpayers. The cost of these guarantees is not limited to the amount that government spends or borrows, it is as great as all of the promises that politicians make or allow their Fannie's and Freddie's to make. The guarantee will be paid by you, in taxes or lost jobs, when the bill is due.

Many politicians make unlimited promises. They need to be regulated by being fired, before a declining economy fires you and takes your investments and retirement account.


McCain Talks to the Senate
On 5/25/05 Sen. John McCain spoke to the Senate about his bill, The Federal Housing Enterprise Regulatory Reform Act of Jan 2005.

[edited]  Fannie Mae reported quarterly profit growth over the past few years. OFHEO regulates Fannie Mae and reported that this growth was an “illusion deliberately and systematically created” by the company’s senior management, resulting in a $10.6 billion accounting scandal.

Fannie Mae employees intentionally manipulated earnings targets to generate bonuses for senior executives. Franklin Raines was Fannie Mae’s chief executive officer. Over half of his compensation during 1998-2003 came from meeting these targets. This echoes the deeply troubling $5 billion profit restatement at Freddie Mac.

Fannie Mae lobbied Congress in an attempt to interfere with the regulator's examination of the company's accounting problems. The OFHEO report comes some weeks after Freddie Mac paid a record $3.8 million fine to the Federal Election Commission, and restated lobbying disclosure reports from 2004-2005.

This report confirms that the GSEs need to be reformed without delay. If Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Faannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole.

McCain's letter about Fannie and Freddie

On 05/05/06, Sen. John McCain wrote a letter to Senate Majority Leader William H. Frist and Chairman of the Senate Banking Committee Richard C. Shelby. Nineteen Republican senators co-signed. No Democratic senator signed. Sen. Obama did not sign.

Republicans held a majority in both the House and Senate, and George W. Bush was president. McCain wanted to resrict Fannie and Freddie, but there was no majority for stopping them.

(Democrats would win majorities in both the House and Senate in the Nov 2006 elections.)

McCain [edited excerpts]: We are concerned that that Fannie Mae and Freddie Mac pose an enormous risk to the housing market, the overall financial system, and the economy as a whole. We want effective regulatory legislation this year for the Government Sponsored Enterprises (GSEs) in housing finance. If not enacted this year, American taxpayers will continue to be exposed.

Therefore, we offer to you our support in bringing the Federal Housing Enterprise Regulatory Reform Act (S. 190) to the floor and allowing the Senate to debate the merits of this bill. It has passed the Senate Banking Committee.

These GSE's are mammoth financial institutions with almost $1.5 Trillion of debt outstanding. Deficits, entitlements, pensions, and flood insurance are fiscal challenges facing us today. Congress must ask itself who would actually pay this debt if Fannie or Freddie could not?

Fannie, Freddie Subprime Spree May Add to Bailout (Update 2)
09/22/08 - By Jody Shenn via Bloomberg

[edited] Freddie Mac had been gorging on subprime and Alt-A debt, buying the safest classes of the [riskiest] mortgage loan pools. Freddie bought 13% ($158 billion), and Fannie bought 5% [$61 billion] of all these securities created in 2006 and 2007, according to its regulator and the newsletter "Inside MBS & ABS".

These purchases supported the boom in lending that led to frozen credit markets, more than $514 billion in bank losses, and the collapse of two of the biggest securities firms. The amount of subprime losses may determine whether the $200 billion authorized to U.S. Treasury Secretary Henry Paulson is enough. William Poole said that Paulson may have to spend $300 billion. Mr. Poole is a former president of the Federal Reserve Bank of St. Louis.

[ Fannie and Freddie have guaranteed payments on $5.4 trillion ($5,400 billion, $5,400 thousand million dollars) in mortgage bonds and its own corporate debt. ]

How the Democrats Created the Financial Crisis
09/23/08 - at Bloomberg by Kevin Hassett

[edited] Alan Greenspan told Congress in 2005 that it was urgent to act: if Fannie and Freddie "continue to grow, to have low capital, and to engage in the dynamic hedging of their portfolios (to avoid the risk in changing interest rates), they potentially create growing systemic risk. We are placing the total financial system of the future at a substantial risk."

For the first time, the Senate Banking Committee passed a serious reform bill. The bill gave a regulator power to require Fannie and Freddie to eliminate their investments in risky assets. [The bill went from the committee to consideration by the Senate.]

The market for risky mortgage bonds would likely not have existed without Fannie and Freddie keeping the market liquid by buying up excess supply. These subprime bonds buried many of our oldest institutions in losses [when Fannie and Freddie stopped buying them].

The bill did not become law. Democrats opposed it on a party-line vote in the committee, making this a partisan issue. Republicans were tied in knots by the tight Democratic opposition, and couldn't get the Senate to vote on the matter.

How Government Stoked the Mania
10/03/08 - WSJ by Russell Roberts (via EconLog)

[edited] Housing prices would never have risen so high without multiple Washington mistakes.

Congress designed Fannie and Freddie to serve both investors and the political class. Congress and the White House subsidized low-income housing by demanding that Fannie, Freddie, and local banks do more to increase home ownership among poor people. It was a political free lunch, avoiding an allocation of budget dollars.

The Department of Housing and Urban Development (HUD) told Fannie and Freddie that 42% of their mortgage financing in 1996 had to go to borrowers in their area with below median income. The target was 50% in 2000, and 52% in 2005.

The Community Reinvestment Act of 1977 (CRA) did the same thing with traditional banks. It encouraged banks to serve two masters, their own profit and the so-called common good. The CRA was "strengthened" in 1995, causing an increase of 80% in the number of bank loans going to low- and moderate-income families.

Fannie and Freddie were part of the CRA story. Bear Stearns did the first securitization of CRA loans in 1997, a $384 million offering guaranteed by Freddie. Bear Stearns issued $1.9 billion of CRA mortgage bonds backed by Fannie or Freddie in the next 10 months. Fannie Mae securitized $394 billion in CRA loans in 2000-2002, with $20 billion going to buy mortgage bonds from others.

[ "Securitized" means collecting mortgages together into "pools" and selling "mortgage bonds" that pay principal and interest according to what the homeowners pay on their mortgages. ]

Politicians pressured banks to serve poor borrowers and poor regions of the country despite risk. They could push for increases in home ownership and urban development without having to commit budget dollars. Another political free lunch.

Fannie Mae's Patron Saint
09/09/08 - WSJ.com Editorial

[edited] Taxpayers are now on the hook for as much as $200 billion to rescue Fannie Mae and Freddie Mac. To know why, look no further than House baron Barney Frank's rapid response to this bailout. The Treasury wanted the companies to reduce their ownership of high-risk mortgage-backed securities (MBS) starting in 2010. Mr. Frank said "Good luck on that," and that it would never happen.

That is the Fannie Mae problem in profile. Mr. Frank wants you to pick up the tab for its failures, while he vows to block a reform that might prevent the disaster from happening again. At least he is consistent. His record is close to perfect as a stalwart opponent of reforming the two companies, going as far back as 1992.

In January 2007, Mr. Frank noted one reason he liked Fannie and Freddie; they were subject to his political direction. He contrasted Fan and Fred to private-sector mortgage financers. "I can ask Fannie Mae and Freddie Mac to show forbearance" in a housing crisis. Mr. Frank believed they would do his bidding because Fannie and Freddie are political creatures.

Mr. Frank attempted to prove exactly this when housing prices began to decline. He encouraged the companies to guarantee more "affordable" mortgages, thus encouraging their disastrous purchases of subprime and Alt-A loans. He increased the conforming-loan limits, to allow buying larger mortgages. And he pressured regulators to reduce capital requirements [money in reserve]. The larger losses are being paid by taxpayers.

The biggest payoff for Mr. Frank is the "affordable housing" trust fund he required as one political price for supporting the recent Fannie reform bill. This fund siphons off up to $500 million per year of Fannie's and Freddie's profits, which he and other politicians can direct to their favorite interests.

This is why Mr. Frank won't tolerate cutting the companies' MBS holdings. Those portfolios were a main source of profits before the housing crash, and he figures they will be again after this crisis. This time, his fund will get part of the loot.

Shouting Fannie! in a Crowded Congress:
Advice from the man who foresaw the GSE collapse.

10/14/08 - WSJ by William McGurn

[edited] Richard Baker is the Louisiana Republican who spent nearly a decade in Congress crying out that Fannie Mae and Freddie Mac were ticking bombs. He is now CEO of a lobbying firm for the hedge fund industry. He is somewhat bemused to hear people say they are shocked, shocked to learn that someone had predicted it all. Mr. Baker said "Everyone writes as though there were just one hearing or one piece of legislation. I think I must have had eight bills and maybe 40 hearings going back to 1996."

Fannie Mae and Freddie Mac had the worst of both public and private accountability. They lacked the congressional oversight that would have come from an explicit and acknowledged taxpayer guarantee. And, the privileged position given by the implicit guarantee removed market discipline that applies to other private enterprises.

Mr. Baker said that it wasn't the unregulated part of the financial markets that got us here. It was the regulated part.

For example, the lack of a government guarantee in the hedge fund industry means folks do a lot more investigation before they part with their money.

Today this sounds wise and obvious; but back then he was opposed. Fan and Fred's executives threatened to sue him when he made public their outrageous compensation. A fellow congressman accused him of a "lynching" when he questioned Franklin Raines, the now disgraced former head of Fannie Mae. He was dismissed as a crank when he suggested Fan and Fred's [mortgage bonds] were not solid. He couldn't find a single co-sponsor on one of his early reform proposals.

The Very Poor Pelosi-Obama-Reid Economy
10/18/08 - Pajamas Media Blog by Tom Blumer
(via Instapundit) [edited]

Barack Obama and others have an equal-results-regardless-of-merit mindset.

You see, thanks to blockbuster research done by Ragnar Danneskjold at the Jawa Report, we know that Obama was a plaintiff in a lawsuit against banking behemoth Citibank in 1994, ultimately settled out of court in 1998. In essence, the suit demanded that the bank approve an equal percentage of minority and non-minority mortgage loan applicants. Danneskjold writes: “The net result of this sort of litigation was, of course, that banks like Citibank started approving more subprime loans in the 1990s.”

Lawsuits like this fueled the explosive growth of these high-risk loans to minority borrowers who could not qualify for conventional mortgage financing. Government-sponsored enterprises Fannie Mae and Freddie Mac (a.k.a. Fanron and Fredron) also responded to these legal pressures by lowering credit score thresholds for subprime and conventional loan approvals.

The high default and foreclosure rates that followed ultimately led to the crackups at Fan and Fred. Those failures in turn contributed to liquidity problems in the banking system that were apparently so serious that Congress rammed through a $700 billion bank “bailout” package. Despite such supposedly corrective measures, equity markets have steeply dived.

All of this likely makes Barack Obama the first U.S. presidential candidate in history to cause an economic downturn even before the general election has been held.

After experiencing barely one quarter of the Pelosi-Obama-Reid Economy, can it really be that the American people want four more years of this?

Credit Rating Agencies Misled Investors

Barack Wrote a Letter About Fannie and Freddie
10/29/08 - WSJ Opinion

The main topic is that politicians write vague letters complaining about things, then later point to those as proof that they were early in predicting any crisis. But, letters are nothing. Public statements, action, and votes are everything.

Part of this article explains a piece of the financial meltdown puzzle. A "Credit Default Swap" is an insurance policy that pays if a company can't make payments on its debts. It is the industrial version of mortgage insurance, which pays back your bank if you can't make the payments on your home loan. A financial institution guarantees a repayment when it sells a Swap.

For example, a Bank has some doubts about loaning money to X-Corp. The Bank wants Hedge to pay back the loan if X-Corp fails. So, the Bank loans the money to X-Corp at 12% interest, and pays 6% interest to Hedge to buy a Swap. The Bank keeps 6% interest as a result, and feels safer knowing that either X-Corp or Hedge will pay back the loan. The Bank pays Hedge to take most of the risk.

[edited] Many sellers of Swaps (insurers of corporate credit) made horrendous judgments in assessing the likelihood of defaults. They were encouraged to make these poor judgments by government-approved credit-rating agencies, who evaluated and approved mortgage-backed securities (bundles of home loans).

Banks bought AAA rated (rock-solid) mortgage securities. The ratings were given by government-approved agencies. Other institutions (say insurers like AIG) relied on those AAA ratings, and insured those banks by selling Swaps, which seemed to be a safe, conservative risk. The actual risk of those mortgage securities was far higher.

Much of the subprime disaster could have been avoided if the credit rating agencies had never agreed to put a AAA rating on collateralized debt obligations - CDO's.

CDO's are constructed from pieces of other mortgage bonds, in complex ways that almost no one understood. Most investors around the world had never heard of a CDO before the housing boom, but they knew what AAA meant. They relied on the credit rating agencies to understand CDO's and tell them that they were safe. The government's chosen credit raters had said for years that this label applied to conservative investments that were highly unlikely to default.


Conflicts and the Credit Crunch
09/07/07 - WSJ.com Opinion by Arthur Levitt Jr., former chairman of the US Securities and Exchange Commission

The credit rating agencies such as Standard & Poors, Moody, and Fitch are specially authorized by government regulators to give their opinions about the riskiness of bonds and debt. This gives these few companies almost all of the credit rating business, excluding healthy competition that might challenge their judgment and practices.

[edited] Originally, investors bought a subscription from credit rating agencies to get information to support investment decisions. This business model changed in the 1970's. The issuers of securities paid the agencies for assigning ratings.

This conflict of interest deepened with the rise of complex structured financial products. The credit ratings agencies offered the issuer (the company selling the bonds) help in constructing the product to obtain a high rating, and then went on to assign that rating.

This has become a lucrative business for the ratings agencies in the past few years. Structured finance deals accounted for 40% of Moody's total revenue last year. This raises doubts about the objectivity of ratings that are critical to the proper functioning of the market.


The Moody's Blues
02/15/08 - WSJ.com Opinion

[edited] Investors struggled to understand complex new securities during the credit boom. So, they relied on the credit-rating agencies, mainly Standard & Poor's, Moody's, and Fitch. These firms labeled the new securities with the ratings already applied to corporate bonds.

But, the new securities had almost nothing in common with corporate bonds. Joseph Mason is a professor of finance at Drexel University. He examined Collateralized Debt Obligations (CDOs) having a Baa (medium risk) rating from Moody's. He found they were more than 10 times as likely to default (10 times the risk) as corporate bonds of the same rating. Moody's argues that the figure is closer to eight times, but you get the idea.

Are the ratings agencies always the last to know, or just the last to acknowledge a problem? The agencies say that they rely on facts presented by issuers, and that they are not responsible for conducting their own factual review. When S&P and Moody's rate a pool of mortgage loans, they don't examine any of the individual mortgages. S&P said "We are not auditors; we are not accounting firms."

So, the information about the assets underlying these bonds comes from the company selling the bonds, and the credit rating agency never verifies any of it. Investors might wonder what exactly does the rating agency provide? An opinion.


Write the Rating Agencies Out of Our Law
01/02/09 - Online.WSJ by Robert Rosenkranz

[edited] [ There are only a few government certified rating agencies, including S&P, Standard & Poors, and Fitch. ] Their ratings on bonds determine the amount of money (capital) that a bank needs to set aside by regulation for expected losses.

Ratings have a profound influence on how financial institutions invest their assets. Regulations make the rating agencies the de facto allocators of capital. Every participant in the financial system has a strong incentive to group assets in ways that maximize their rating, not their fundamental soundness.

[ Large capital requirements (more money set aside) means owning fewer bonds and making less money on the coupon payments. ]

The $6 trillion structured finance business serves mostly to improve ratings. Subprime mortgages and all manner of other risky loans would deserve a "junk" rating if taken alone, and require high capital reserves.

The structured finance people bundled these assets and sliced the bundles into "tranches" [groups according to order of repayment]. The rating agencies gave AAA ratings to 85% of the tranches by value, and gave "investment grade" to another 14%, thus turning lead into gold through ratings alchemy.

This created enormous demand for risky mortgages packaged into bonds. Mortgages were given to countless house purchasers of poor credit risk, which in turn drove dramatic increases in prices. The housing bubble has now burst, and average house prices in America are down 20% to 25% from the peak. This led to the current financial crisis, based on huge losses from the "rock solid" bonds.

A "tranche" is similar to a first and second mortgage on a home. The first mortgage has priority, and is repaid first in any default. Any remaining money goes to repay the second mortgage.

Tranches (French for "slices") are obligations created from a bundle of home mortgages or other loans. All of the mortgage payments collected from the bundle are allocated to repay the first tranche as required, then the second and remaining tranches until the money runs out.

The first tranche is likely to be repaid even if many loans default. The last tranche is likely to be worthless if more than a few loans default. Many risky tranches were given AAA or "investment grade" ratings, far above the actual risk as now understood.

+ + +
A comment about the above article
by Craig Bardo - 01/02/09 at EconLog.EconLib
--> Capital Requirements and Bond Ratings

[edited, restated] The failure of the ratings agencies has had consequences that are out of proportion. It should not be dismissed as a simple regulatory mistake.

I represented bond issuers and designed entire programs based on getting better ratings as well as better tax treatment for non profit issuers. Why did the ratings agencies get the mortgage securities so wrong and not the debt of hospitals, colleges, and universities I represented? Why did purchasers do better buying lower-rated health and university bonds than the higher-rated mortgage bonds?

The answer lies in political pressure. My issuers had very little power over the rating agencies. But, the federal government effectively provided the charter for the ratings agency, and the federal government tacitly backed the bonds being rated. Even the most seasoned, hardened analyst working for the ratings agency would have a hard time stating that those bonds were not worth the paper used to print the offering document.

The ratings agencies obviously treated the federal government involvement as a credit enhancement. They looked past the credit worthiness of Fannie Mae and Freddie Mac, and treated their securities as a full faith and credit obligation of the federal government.

Investors would make better decisions if we didn't have the current ratings and regulatory schemes. The government was a direct participant in the current crisis.

Craig Bardo's comment illuminates an important question. The financial crisis is world-wide. Banks bought housing bonds from Fannie Mae and Freddie Mac that were implicitly guaranteed by the U.S. government. The failure of those bonds has caused losses to the federal government, but not to those bond holders, because the government is meeting that guarantee. The larger banking crisis is not about the losses on Fannie Mae and Freddie Mac bonds. (Of course, we should still be unhappy about those losses to the U.S. government and our society.)

The world-wide problem is that banks and other institutions bought huge amounts of mortgage bonds that were issued independently of Fannie and Freddie and not guaranteed in any way by the U.S. Government. Those banks are failing because of the huge losses on those bonds.

Maybe this is what happened:

The ratings agencies gave AAA and investment-grade ratings to MBS bonds (Mortgage Backed Securities) issued by Fannie and Freddie. The bonds were risky, but the implicit guarantee of the government made up for that. The implicit guarantee was a sophisticated (and correct) prediction by most analysts.

There was political pressure to bless the subprime credit expansion, the government policy to expand home ownership. The ratings agencies found a rationale for blessing the bonds independently of any government guarantee. After all, the government said there was no guarantee.

Subprime MBS bonds issued by investment banks received the same AAA ratings as the bonds issued by Fannie and Freddie. Subprime MBS bonds were built on similar categories of subprime mortgages. The ratings agencies couldn't say that Fannie's bonds were AAA, but that similar bonds issued by others were risky "junk".

Bond buyers came to believe the AAA classification given by the ratings agencies. These agencies had been reliable analysts of the other bonds on the market.

Bond trading departments were making money. They wanted to believe the AAA ratings. They would collect their bonuses long before any problems with the bonds, so they kept any doubt to themselves.

The risk control departments of banks had no formal or regulatory reason to limit trading or ownership of AAA rated bonds.

The government was indeed a direct participant in the current crisis.

The Housing/Financial Crisis - Their Own Words
Our leaders talk about the good and safe purposes of Fannie and Freddie.

Democrats Were Warned of Financial Crisis and Did Nothing.
(YouTube 3:32) A review of actions about Fannie and Freddie.
Watch the whole thing. Barney Frank says Fannie and Freddie are solid. (1:40 - 2:05)

Don't Regulate Fannie and Freddie
(YouTube 8:30) Late 2004 - Democrats fight greater regulation of Fannie Mae and Freddie Mac. "Excerpts from a hearing to investigate Fannie and Freddie's illegal bookkeeping"

Barney Frank - Lack of Regulation by Republicans
(YouTube 1:49) 09/18/08 - Barney Frank speaks on the lack of financial regulation by the Bush administration (:35 - 1:40).

Sponsoring Recklessness at Fannie Mae
11/13/08 - (07/28/08)  The New Yorker by James Surowiecki
(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.

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.

The Bank's Mistake was Trusting the Government
03/13/09 - ChicagoBoyz by Shannon Love

[edited] For leftists, OneUnited should represent the perfect small, minority owned bank. The “socially responsible” Maxine Waters invested in the bank and sat on its board. There is no evidence that it made predatory loans. Yet, it failed.

It failed not due to any short-sighted greedy decisions of the bank’s management, but because the bank’s management and board members, like Waters, trusted that the mortgage-backed securities issued by the government sponsored enterprises (GSEs) Fanny Mae and Freddie Mac were worth the paper they were written on.

OneUnited is a microcosm of the entire financial collapse. Over the past 40 years the GSEs have piled up a vast store of toxic assets created by the attempt to get something for nothing by fooling the market about the risk of residential mortgages. Ratings firms gave the GSEs top ratings because of their implied government guarantee and oversight. Banks like OneUnited bought into the political myth and now they and everyone else are paying for it.

Whitewashing Fannie Mae
12/11/08 - WSJ.com Review and Outlook

[edited] Documents from a recent congressional hearing prove that Fannie Mae and Freddie Mac turbocharged the housing mania with a taxpayer-backed, Congressionally protected business model that has cost America dearly.

Fannie Mae and Freddie Mac have long maintained they were quietly buying 80% fixed-rate 30-year mortgages when they were blindsided by the greedy excesses of subprime lenders.

Memos and emails from 2004-2005 by top management show they took increasing risks to maintain their market share [fraction of all loans they would buy] and meet affordable-housing goals set by HUD, by purchasing risky loans including option-ARMs and interest-only mortgages.

In April 2004, Head of risk management David Andrukonis wrote to his colleagues about "stated income, stated assets" (Liar's) mortgages, "This is not an affordable product, but a product necessary to recapture market share. In 1990 we called this product 'dangerous' and eliminated it from the marketplace."

One Fannie Mae document from March 2005 notes dryly, "We invest almost exclusively in AAA rated securities, but the rating agencies may not be properly assessing the risk." Fannie and Freddie bought them anyway, to maintain their market share and to show people like Democrat Barney Frank that they were promoting affordable housing.

By mid 2008, Fannie and Freddie had bought or guaranteed $1.6 trillion [$1,600 billion] worth of subprime loans. They were central players creating the housing boom and the credit bust. They bought private-label subprime and Alt-A MBS (Mortgage Backed Securities) They helped legitimize and provide liquidity (be willing to buy and sell) for products that they now claim others irresponsibly sold.

Mr. Raines (former CEO of Fannie) testified "It is remarkable that during the period that Fannie Mae substantially increased its exposure to credit risk, its regulator made no visible effort to enforce any limits."

He failed to mention that Fannie and Freddie spent millions on lobbying to ensure that regulators did not get in their way. Freddie spent $11.7 million lobbying in 2006 alone. Fannie and Freddie tried to buy everybody in town, from both political parties, and made themselves immune from regulatory scrutiny.

Stop Covering Up - Kill The CRA
11/28/08 - Investor's Business Daily Editorial
(Via InstaPundit)

[edited] The Community Reinvestment Act is to blame for the financial crisis. It so powerfully serves Democrats' interests that they will do anything to protect it, including revising history.

The CRA coerces banks to make politically correct loans to people who can't afford them. Clinton beefed up the CRA in 1994 and forced banks to subsidize poor communities with close to $1 trillion in high-risk loans and commitments that ignored prudent lending rules. Clinton ordered HUD to set quotas for "affirmative action" lending at the Government Sponsored Enterprises Fannie Mae and Freddie Mac, creating the secondary market [buyers] for subprime loans.

This destroyed credit standards and created the subprime market. Minority home ownership rates had been flat, but began a steep rise in 1995. Home prices soon followed, stoked by easier lending. This promoted the housing bubble that has now burst, causing the worst housing and banking crises since the Great Depression.

Many bank officials complain that they still feel pressured by CRA regulators to make inner-city loans they know are at great risk of default.

Myth:  The CRA could not be at fault, because the overwhelming share of subprime mortgages came from non-bank lenders that were not regulated by the CRA.

Fact:  Nearly 40% of subprime loans in 2004-2007 were made by CRA-covered banks such as Washington Mutual and IndyMac. This doesn't include loans by bank-owned subprime lenders which were in effect covered by the CRA.

Myth:  The CRA did not force anyone to do subprime loans or take excessive risks.

Fact:  Banks made subprime loans to comply with the CRA, encouraged by Clinton's regulators. Subprime loans were rare before Clinton took office. They were more than 9% of mortgage originations when Clinton left office, and are 20% today. Clinton pushed banks to grant mortgages to minorities with poor credit, or risk being branded racist. Rules were weakened to accept welfare and unemployment checks as qualifying income.

Myth:  Greedy investment bankers securitized and sold subprime mortgage bonds. They produced the credit crisis, not government.

Fact:  Clinton's CRA amendments created the subprime market. Wall Street got involved in a big way only after Clinton pressured Fannie and Freddie to assume the risk and guarantee the profit from subprime loans.

Regulations had almost everything to do with this mess. We should be abolishing these regulations, instead of strengthening them to atone for the alleged "sins of capitalism".

FDR and the FDIC
12/02/08 - Cafe Hayek by Russ Roberts

President Franklin D. Roosevelt recognized the danger of a government guarantee in the 1932 proposal for the FDIC, Federal Deposit Insurance on bank accounts. He opposed the bill, but accepted credit for the program after congress passed it.

[edited] Roosevelt:  It would lead to laxity in bank management and carelessness on the part of both banker and depositor. I believe that it would be an impossible drain on the Federal Treasury to make good any such guarantee. For a number of reasons of sound government finance, such plan would be quite dangerous.
Federal Deposit Insurance: A Banking System Built on Sand
June 2010 - The Freeman by Warren C. Gibson

Many aspects of the FDIC and banking.

[edited excerpts]:  Rep. Henry Steagall vigorously pushed deposit insurance. Franklin Roosevelt opposed him.
Roosevelt in March 1933:  The underlying thought behind the word ‘guarantee’ for bank deposits is that you guarantee bad banks as well as good banks. The minute the Government does that, there will be a probable loss. We do not wish to make the United States Government liable for the mistakes of individual banks, and put a premium on unsound banking in the future.

FDR was right. Deposit insurance creates a moral hazard, an incentive to be reckless when misdeeds are covered by someone else. Bank managers tend to make riskier loans than they would without insurance, and depositors don’t worry about the lending practices of the banks they use.

Many people, including me, buy bank certificates of deposit through online brokers, perhaps not learning the name of the bank that received the money. The magic letters FDIC are all we look for.

Though the FDIC lacks market incentives, it is awash in political incentives. Congress voted in 2008 to increase deposit coverage from $100,000 to $250,000 with little or no discussion of the costs. This “temporary” increase will likely become permanent.

Members of Congress are motivated by the campaign contributions of bankers and others. They may not know or care about the long-term consequences.

Deadweight Loss of Taxes

It isn't common knowledge just how much wealthy people already pay, and how much tax is wasted by increased spending on everything. Ironically, raising taxes on anyone will lower the production of the US, and so will lower the number of jobs.

There are two myths that make people eager to raise taxes, if it doesn't affect them personally.

  • Taxes are a nice transfer. $1 from him means $1 for me or my friends.
  • Government spending stimulates jobs. Good for the economy.

From   Tax Avoidance And The Deadweight Loss Of The Income Tax
2000 by Martin S. Feldstein, the George F. Baker Professor of Economics at Harvard University and former President of the US National Bureau of Economic Research.

[edited]  Traditional analyses of the income tax greatly underestimate deadweight losses by ignoring its effect on compensation and consumption [jobs]. The full deadweight loss is easily calculated. Estimates imply a deadweight loss of as much as 30% of revenue. The deadweight loss caused by increasing tax rates may exceed $2 per $1 of revenue increase.

I will restate this. Government activities and transfer payments had better be useful to the society, because economic output has already been lowered by 30% of the taxes currently collected. Output will be further lowered by $2 for each $1 of any additional taxes collected. This means that $2 worth of production (jobs) will be destroyed for every additional $1 collected through increased taxes.

This is a severe loss, because there is no "stimulus" from that "extra" $1 in government spending. That $1 would have been invested or spent anyway. Taxes only move goods around from some people to other people, at great expense.

To transfer $1 to a needy voter, or bail out a public loss, the government will take $1 from a richer person, eliminating $2 in production of goods and services, also called jobs. By the same analysis, $1 of decreased tax results in $2 in new production and jobs. This effect is not "trickle down" from spending. The $1 in reduced tax supports some amount of increased investment that in turn supports $2 in new jobs.

At   The Myth of the Economic Multiplier   I consider why it seems there should be a stimulus that goes beyond each dollar of spending, and why this is wrong. Government spending is a banquet, not a stimulus.

Also see my post   Public Tax Meeting   about proposed tax policy, to raise taxes on the wealthy 5% and give a rebate check to the 95%.

1 comment :

Unknown said...

Well written article. Assuming your numbers are right (they look plausible) you have done an excellent job of explaining the basis of the current economic crisis. The problem with the MSM is that they just don't go deep enough to explain things well. They skim the surface and report things infused with their political bias which in the end creates more confusion.

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