September 9, 2008
By the time you read this, the crisis with Fannie and Freddie will be at least a few weeks old but, since we taxpayers are now the guarantors of last resort for a whole bunch of questionable loans, it is important to understand the situation.
Fannie Mae and Freddie Mac are two quasi-governmental agencies that buy real estate loans that meet certain criteria, on what is known as the "secondary market". Your lender makes you a loan to buy a house and immediately gets the money back courtesy of Fannie or Freddie, who buys it and sells it off to a 4th party (the first 3 being you, the lender, and Fannie/Freddie). The lender thus has more money to loan the next guy, and absolves himself of the risk attendant to that now-sold loan.
One big reason interest rates have remained so low for so long is that, as a side benefit of that process, many of these loans were packaged and sold in the stock markets worldwide as "mortgage backed securities", providing access to pools of capital not previously available. The buyers of these securities, I am sure, made assumptions about the integrity of the process that, as all can see now, were not valid.
The process is fraught with holes and misunderstanding, which I have gotten into elsewhere and won't now, suffice to say that recent events in the mortgage markets amply demonstrate the structural problems with it. I can't help adding that, very contributory to this problem was the fact that Congress in the early 2000's ordered Fannie and Freddie to loosen their criteria for buying loans so that "retail lenders" would be willing to make real estate loans to "the less advantaged" which, as we discovered last Spring, is a euphemism for "unqualified buyers". Like most forms of Affirmative Action (remember the attempt to engineer gender-balanced fire departments?), this one had a price to pay down the road.
One of the more egregious forms of self-deception employed to justify making loans was to qualify buyers at what is known as a "teaser rate" -- an artificially low rate that only lasts for 3 to 12 months, at which time the interest rate "indexes", meaning it rises to the actual market rate. So this last Spring the "sub-prime crisis" came to a head when enough homeowners who had been given those loans couldn't make the payments after their loans indexed, and they went into default. The new owners of those loans (remember, they were sold perhaps 3 or 4 times, and the new owner was many steps removed from the original borrower) a) lost interest in buying any more loans as a large portion of their portfolio was now "non-performing", and b) began foreclosure procedures against the homeowners who were now not paying. The sudden lack of secondary buyers for the loans meant that most lenders a) had a ton of money tied up in recently-made loans they suddenly couldn't sell, and therefore b) they couldn't make new loans. The few that were were charging usurious rates to compensate them for the risk and cash tied up. When that happened, buyers couldn't get loans and properties stopped selling. The sellers who had a compelling reason to sell then reduced their prices until a buyer was found, which then set the market at that new lower level.
The can was then kicked down the road last Spring when the Fed ordered Fannie Mae and Freddie Mac to purchase all that suddenly unsaleable paper in order to relieve the logjam. As I said at the time (and this was about April), hold onto your wallets because the next crisis is going to be with Fannie and Freddie. If those loans are unsaleable, they're unsaleable whether being offered by such as Countrywide or Fannie/Freddie. If there are no ultimate buyers, there aren't. But Ah Grasshoppah: one buyer left and guess what happen next: Since the Federal Government (that's you and me, baby) is the ultimate guarantor of Fannie Mae and Freddie Mac, guess who now owns those loans. For those of you who thought the Federal budget deficit was bad before, get ready. This is but one example of how a once-free economy is destroyed.
I am tempted here to swerve into a macro-economic discussion channeling Adam Smith and Karl Marx. Suffice to say for now that Marx's observation that "capitalism contains the seeds of its own destruction" was correct, in that as capitalism fulfills its promised prosperity, those living under it become less willing to endure the economic ups and downs that are a necessary part of capitalism, and demand that the government "smooth them out". Each time this happens, the downturn thus avoided accrues somewhere else, as the natural economic balance is thrown out of whack by such interventions. At some point the aggregate of those accrued downturns becomes too much to paint over once again. Additionally, the economy surrenders some of its "freedom" to new "regulations" which, in the heat of the moment seem eminently logical (and in the current situation, absolutely necessary) but which, over time, create and tangle of laws, red tape, and ultimate governmental bureaucratic takeover, which have the eventual effect of stifling the free economy that created the prosperity that caused the demand for them in the first place. Europe is long-down this same road, which, with it's cousin High Taxes (after all, if the government is the rescuer of last resort, all this rescuing has to be paid for), is why it is stuck with stagnant economic growth, little economic opportunity, and little innovation.
It isn't clear to me that this evolution is avoidable, as is probably clear from the above. Those who advocate somehow returning to an unregulated system (the libertarians) suffer, in my humble opinion, from a naivete about what life under such a system would be like; after all, the current "system" began that way. On the other hand, those calling for more regulation are, again in my still humble opinion, either pandering for votes in this political season, and/or don't grasp the price of regulation. Whatever the case, we have once more painted ourselves into an economic corner, from which it appears that only more government intervention and control can provide exit.