Fannie, Freddie, and a Primer in Finance

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One way to make someone’s eyes glaze over is to explain the various relationships in financial matters. Discussions of swaps, equity, options, short-selling and the like quickly become technical and esoteric, and most people instantly tune out what is being said.

Unfortunately, this situation convinces people that finance is complicated and cannot be understood — and so it must be left to the "experts" who are assumed to know better. Thus, the average person — the taxpayer who will be left on the hook — does not really understand why entities like "Freddie Mac" and "Fannie Mae" are in trouble, and why their "bailouts" are a disaster. They only know that the people who are supposed to be "in charge" of these things are declaring success.

First, what are "Fannie Mae" and "Freddie Mac"? They are entities created by the federal government to make mortgage loans and to guarantee those loans. "Fannie Mae" is an acronym for the Federal National Mortgage Association, which was created by the Franklin Roosevelt administration in 1938 to help further home ownership. "Freddie Mac" is the Federal Home Loan Mortgage Corporation, created by the Nixon administration in 1970 as a "competitor" for the FNMA. Both entities ultimately were "privatized," but nonetheless have operated with the obviously implicit guarantee from the federal government that it would protect them against losses.

In a free market, there would be nothing like these entities, or if something like them existed, there would be no guarantee that losses would be covered by taxpayers, which has created an obvious moral hazard. They exist because the government decided to follow a policy during the Great Depression to encourage home ownership beyond free market levels, which also meant that the entities that would have to finance such endeavors would have to come from the government.

Now, there is nothing wrong with home ownership, as it is an extension of private property rights. However, it should be emphasized that not everyone should be a candidate for home ownership, as owning a home means that the opportunity cost for moving increases greatly.

I will use my family and me as an example. We own a home and about an acre of property in the mountains of western Maryland, and my place of employment is located about five miles away, so it is relatively convenient to where I work. As long as I have my current employment and as long as I can continue to make the payments (and pay the property taxes), we can remain in this house.

However, if an attractive employment opportunity were to come elsewhere, the opportunity cost of moving would be substantially greater than if we were renting. First, we would have to sell the house, and in the current market, selling it at a price that would permit us even to cover what we paid a year ago might be difficult. Second, if we were to move without the house being sold, we would have to continue making payments and pay for a new place, which almost surely would negate any gains from the new employment. What seems like an asset to us right now would become a huge liability in such a situation, so it is clear that home ownership right now truly limits our choices.

The government’s insistence on individual family ownership of homes has a distorting effect upon the housing market, as it invariably creates rental shortages and then perpetuates the very problem. Let me explain. Because the government has created a financial system that encourages (or demands) people buy homes instead of renting them, there is a dearth of single-family housing or other rental housing that would meet the needs of individuals and families.

That situation drives up the price of rentals to the point where buying a home, at least in the short run, seems like the better alternative, as far more homes are available for purchase than for rent. Thus, the incentives that government policies create also continue to widen the gap between what a free market would create and what the government seeks to impose. (One can see that situation clearly in California, as the rash of foreclosures mean that lots of families that have lost their homes now are competing in the rental markets, which drives up rents, but that at the same time, thousands of houses sit empty waiting to be sold.)

The government did not create this market at the point of a gun; instead, it set up a series of financial rewards and punishments. Interest paid on home mortgages is tax deductible, while rent is not, but the series of incentives goes much deeper and extends well beyond the individual homeowner.

How does the financial system work to create the huge numbers of home loans? Why, in a world of scarcity (and that includes the amount of loanable funds available for capital development) would so much of the financial system be directed toward home ownership?

In a free market, capital is directed toward those ends that pay the highest returns, as well as toward investments that pay a good return, but also have better prospects for those loans actually being repaid. Repayment would come because the investments to which the loans were directed are profitable, that is, they bring entrepreneurial rewards that are higher than the sum of the prices paid to the owners of the factors of production.

When done correctly, finance is a wonderful thing, for it permits large numbers of people to pool their resources in order to provide money to entrepreneurs and to firms in order to pay for new projects, purchase of new capital, and for entrepreneurial ventures. An economy cannot grow without it.

However, with finance comes risk. Not all ventures can be successful, and there are times when even with the best of intentions, borrowers find that they cannot repay the loans in a timely manner — or even at all. In a free market, the projected risk would play a role in the determination of the interest rate, as risk and uncertainty are a function of time, and interest rates ultimately are determined by the time preferences of lenders and borrowers.

Free markets have mechanisms to deal with these kinds of issues, including insurance, rating systems, and the like, and the end result is that capital tends to move toward the ends that best reflect the risks and rewards. Such a system would include provisions for people to borrow money for home ownership, but the patterns would not be as pervasive as what we see presently in the United States.

Thus, to encourage more home ownership than would exist in a free market, the government has had to resort to financial manipulation, and that is where the FNMA and the FHLMC come in. Backed originally by government capital, these entities have gone into the secondary markets, purchased loans made by banks and savings and loan institutions at their present value, and then have taken those loans and "bundled" them into what are called mortgage securities.

Lending institutions can put loans (debt) on their balance sheets because those who have borrowed the money have promised to repay it with interest in the future. In a world in which people who have taken out home mortgages have demonstrated the ability to repay those loans in a timely manner, the debt instrument created thus has a market value.

The important role that the FNMA and FHLMC have played has been the fact that they have been a ready market for these debt instruments, which has encouraged lending institutions to make more of such loans than they would otherwise. (I will skip the discussion of the government role in propping up banks and savings and loan institutions, as that would take another series of articles. Suffice it to say that they are not free market institutions, at least in the manner that Austrian economists view free markets.)

The effect here is twofold. First, it encourages more home ownership than would exist in a free market, which distorts the free market in housing. Second, it means that capital that would have gone to more highly-favored uses in a free market now is directed to less-profitable uses. Therefore, the emphasis on home ownership would seem to have a perverse effect upon our economy by diverting scarce capital away from those projects that would bring even more economic growth.

When one combines this situation with the fact that hostile governments have been stifling economic opportunities through taxation, regulation, and property seizures, the situation becomes even more perverse, something that became apparent during the past decade. Investment opportunities in the United States have been declining in large part because of government hostility, and that creates an inwardly destructive effect.

First, less investment means people have fewer opportunities to better their lives, so they turn to government for help. Second, governments that are empowered in these situations tend to be extremely hostile toward private enterprise and, therefore, tend to drive even more business enterprises away.

Third, investors then look for other means to gain a return on their money, and that is where the government-backed housing securities come in. Because such securities traditionally have been seen as relatively "safe" because of the government guarantees, they became attractive places to put money.

As this industry grew, brokerage houses on Wall Street began to use them as collateral for about everything, and these securities were used to prop up other funds or became a financial mainstay. Combine this situation with the Bush administration’s "ownership society" goals and the belief that home ownership is an "opportunity" that should not be denied to anyone, regardless of their ability to pay, the outcome was inevitable.

While more and more loanable funds were diverted toward mortgages, the increased demand for housing forced up home prices, and ultimately they went up to levels which average buyers could not afford with conventional mortgages. Unfortunately, the lending industry — prodded by the Federal Reserve System and the mortgage industry — created new loan packages to entice people to borrow huge sums of money. Things like "interest-only" mortgages, adjustable-rate mortgages (ARMs), and the like were hawked to would-be homebuyers, who were assured by the mortgage companies that their properties would appreciate quickly and then they could re-negotiate their loans, using their newfound equity to lower their payments.

This entire scheme was on a collision course with reality. The proliferation of mortgage securities ultimately drove down their value, and the constant search to find potential marginal home buyers with marginal means or credit has kept this market alive, but it was a devil’s bargain, as the newcomers into the market were the ones who were least likely to be able to make timely payments.

Austrians can recognize the pattern of malinvestment here, even if most other people cannot. This is not a situation into which the government can ride, guarantee the securities, save homeowners from foreclosure, and generally save the day. Instead, by propping up this sick industry, the government not only extends the malinvestments (and, thus, retarding the recovery), but also does it by creating even more new money, which only encourages people to run to the last game in town: commodities futures.

Most people cannot recognize the relationship between the government’s bailout attempts and the increases in commodity prices, including prices for oil and gasoline. True to form, the political classes, which ultimately are responsible for this mess, blame the speculators and the oil companies, and the mainstream news media provides the amen chorus.

The party really is over. We are going to be facing hard times no matter what the government does. If it continues to prop up the sick markets, it only delays the inevitable and then will make the economic downturn even worse. This country cannot avoid the financial and economic day of reckoning, but if the political classes and their allies continue to push events in the direction we now are seeing, what would have been a steep but brief recession will turn out to be an economic calamity that will drag everyone down with it.

July 18, 2008

William L. Anderson, Ph.D. [send him mail], teaches economics at Frostburg State University in Maryland, and is an adjunct scholar of the Ludwig von Mises Institute. He also is a consultant with American Economic Services.

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