Search This Blog

Wednesday, November 04, 2009

Imagine that - creating a distraction

Bruce McQuain at Q and O points to an Arnold Kling post
I think there is something even more sinister going on. I interpret the pay czar in terms of Murray Edelman's symbolic uses of politics. The idea is to focus on a symbol of the cause of taxpayer losses--bonuses of the executives of bailed out firms--in order to distract attention from the substance. The substantive issue is the extent to which the losses were caused by political actions and the extent to which they are concentrated at Freddie Mac and Fannie Mae.

The further into this crisis we go, the greater the share of subprime loans and mortgage losses are turning out to be located at Freddie and Fannie. Even one year ago, if you had asked me, I would have told you to expect at least 2/3 of the losses to be at companies like Citi and Bear, with less than 1/3 at Freddie and Fannie. It now looks quite different. Conservatively, 3/4 of taxpayers losses will be at Freddie and Fannie. Perhaps as much as 90 percent of taxpayer losses will be there.

Given the large role of Freddie and Fannie, it makes sense for politicians to create as large a diversion as possible. Hence, the brouhaha over bonuses at bailed-out banks.

Incidentally, the debate over the "public option" in health reform also can be viewed as an exercise in symbolic politics and diversion. The point is to divert attention away from the bankruptcy of Medicare.

The aggressive government push for expanded home ownership and affordable housing in the form of easy credit made a huge contribution to the mess:

Since the early 1990s, the government has been attempting to expand home ownership in full disregard of the prudent lending principles that had previously governed the U.S. mortgage market..

Thus, almost two-thirds of all the bad mortgages in our financial system, many of which are now defaulting at unprecedented rates, were bought by government agencies or required by government regulations.

More F&F reform is needed:
All the debate of the last several weeks on changes to the financial regulatory system has omitted any discussion over reforming the entities at the center of the housing bubble and financial meltdown: Fannie Mae and Freddie Mac.

Total losses from the bailout of Fannie and Freddie are likely to exceed $250 billion — as much as the cost to the taxpayer of all bank failures in American history combined.

Note: F & F bailout loss estimates now exceed $350 billion.

Fannie and Freddie infected capital markets and spread through every sector of the banking system. Before the bursting of the housing bubble, holdings of government-sponsored enterprise (GSE) securities — bonds and mortgage-backed securities as well as preferred stock — constituted more than 150% of core capital for insured banks.

It was not only the commercial banking system that was stuffed with toxic GSE holdings; it was also many of the investment banks. More than 50% of Maiden Lane One, the toxic assets that the Federal Reserve guaranteed in order to persuade JPMorgan to buy Bear Stearns, are GSE securities.

Additionally, more than 40% of money market mutual fund holdings were in the form of GSE securities.

At the height of the bubble, Fannie and Freddie purchased more than 40% of the private-label subprime mortgage-backed securities. Between the two of them, they were the largest single source of liquidity for the subprime market.

Interestingly enough, the very vintages of subprime loans that performed the worst — 2006 and 2007 — were the years in which Fannie and Freddie entered the market in force.

With their massive leverage, Fannie and Freddie were levered more than 100-to-1 — a disaster waiting to happen.

Why then were foreign investors so willing to trust their money to Fannie and Freddie? Quite simply, they were assured by U.S. Treasury officials that their losses would be covered.

Ultimately, Fannie and Freddie were not bailed out in order to save our housing market; they were bailed out in order to protect the Chinese Central Bank from taking losses. Without the implicit federal guarantee of Fannie and Freddie, trillions of dollars of global capital flow would not have been funneled into the U.S. subprime mortgage market.

Some might argue that the problem with Fannie and Freddie was fixed with last year's regulatory reform bill. That bill created a new regulator, one with increased supervisory powers, including the ability to wind down a GSE, and independence from the congressional appropriations process, letting the regulator raise additional funding.

Nothing could be further from the truth. As one of the drafters and negotiators for that bill while on the staff of the Senate Banking Committee, I can say that there was a shared awareness by all parties that the bill was insufficient to prevent the failure of Fannie and Freddie.

It was not the best bill that could be crafted. It was the best bill that could pass, given the continued strength of Fannie and Freddie apologists in Congress.

Most of the worst economic and financial crises in American history have involved real estate. Such is likely to be the case in the future. Reform of Fannie and Freddie is imperative so that American taxpayers will not be on the hook for hundreds of billions of dollars for the next real estate bubble.

There were many contributions by private players but there were also other very large contributions from governmental players.

1 comment:

Hey Skipper said...

It is all the knock-on effects of the CRA.

In order for the CRA to produce any meaningful effect whatever, three things were required:

-- eliminating risk pricing of mortgages

-- providing liquidity by creating a secondary market (i.e., mortgage backed securities).

-- bundling mortgages to dilute the risk of the subprimes over the entire bundle.

Who better to do all that then the FFMs?