Regulating Fannie and Freddie

[Adrian II]

For years now I have advocated what I regard as modern Socialism: harnessing competition in the public interest.

The state should set parameters for markets to ensure truly free and effective competition, i.e. competition based on quality and price, not on (semi)monopolistic price-setting, child labour etcetera. The more essential certain services are to the economy or to non-calculable values of the nation, the more the state should guarantee that they are fairly accessible to everyone. Examples of such services that couldn't or shouldn't function on a cost-benefit basis are policing, telephony or education.

Members who do not share this view will at least share with me the need for regulation. No market could ever function without regulation. It is no surprise that the champion of free markets, the United States, has introduced some of the toughest anticartel laws in the world. But do they work? And if they don't work, then why is that?

In short: what is fair and efficient market regulation, and how do we implement it?

Let's take Fannie and Freddie as example. I would take an example from my own country if everyone on the Org read Dutch, but that isn't the case and there is a lot of English-language info on F & F available which makes discussion much easier. Besides, I am fascinated by the Fannie and Freddie case.

This article breaks down the essential issues nicely.

Whenever the mortgage finance giants, Fannie Mae and Freddie Mac, find themselves in a tough spot — and boy, are they in a tough spot now! — they always seem to find a way to blame their problems on “the mission.”

“We exist to expand affordable housing,” says Fannie Mae on its Web site, and although it also lists its other mission — providing liquidity for the American housing market — it is the former that has long been the companies’ trump card.

That mission of creating affordable housing is the reason that Alan Greenspan, the former Federal Reserve chairman, could testify, year after year, that Fannie and Freddie had become so large, and took so much risk, that they could one day damage the nation’s financial system — only to be utterly ignored by the same members of Congress who otherwise hung on his every word.

The mission is why the two companies were able to run roughshod over their regulator for years, and why the Bush administration was unable to rein them in, even after an accounting scandal.

The mission is why their two chief executives, Daniel Mudd at Fannie and Richard Syron at Freddie, could take home a combined $30 million last year, while presiding over one of the great financial disasters of all time, posting billions of dollars in losses with no end in sight.

The U.S. government has entrusted these two companies with the 'mission' of making affordable housing available to all Americans. This is essentially State Socialism: a (semi)monopolistic company is required by the government to meet policy goals and in return for that it gets all sorts of tax and regulatory breaks from same. The result has been as desastrous as those of State Socialism everywhere in the world. Corruption sets in and the reslt is the opposite of what was envisaged by the policy:

That would be hard enough to swallow if the cause had, in fact, been the companies’ willingness to finance low-interest loans to working-class home buyers. But the real reason was greed. [..] The problem is that while the two companies are still called government-sponsored entities, they are also publicly traded corporations. And for much of the last two decades, they have been hell-bent on growth, the clear goal being to push up their stock prices.

The net result is that the U.S. governmnt is now dependent on these self-created monsters:

[..] given the paralysis in every other sector of the market, the country badly needs Fannie and Freddie to do what they are chartered to do: “wrap” loans so that banks will keep writing mortgages. That’s why Congress recently passed a law that allows Fannie and Freddie to insure mortgages up to nearly $625,500, from the previous limit of $417,000. That’s also why the Treasury is now taking pains to ensure the marketplace that the companies will not go bust, even if it means a government takeover.

My conclusion is that private companies can and should never be burdened with public responsibilities. It is a recipe for fraud, malpractice, policy failure and financial disaster.

So my question is this: How do you regulate a market in the public interest without burdening the parties with public responsibilities? How do you make markets work in the public interest without any of the market parties working in the public interest? I have some thoughts on the matter, but I would rather hear other peoples' views unobstructed by my assumptions.

The author of the article has as idea:

You want to know the truth about “the mission?” The country doesn’t even need Fannie and Freddie to help with affordable housing. Several laws mandate that banks reinvest in the communities in which they operate — and that mandate has come to be defined largely as making loans available for affordable housing. Several executives involved in community-based banking told me that Fannie and Freddie actually refused to buy those mortgages — they weren’t profitable enough. (A spokeswoman for Freddie Mac denies this.)

Are such mandates the answer to my question?

[Hosakawa Tito]

This is a very complicated subject, but the main premise is that people with poor understanding of household budgeting and money management, volatile employment situations, and the unrealistic attitude and desire for instant gratification leads to financial bankruptcy and disaster.

Home ownership is not for everyone. The basic progression used to be that one had to have about 20 percent of the cost as a down payment, and your monthly mortgage payment could be no more than 25 percent of your income. Under these restrictions most families began home ownership in lower priced "starter homes", usually smaller & older fixer-uppers. As they built equity and had children they sold off the starter home for a small profit and bought into a bigger/better one as their family situation required.

Now, it seems, many have gotten away from this. Everyone wants and expects to start out with a McMansion, and can't afford the 20 percent down payment for a $300,000 to $500,000 mortgage, so they put down much less, pay a higher monthly rate...and get in way over their heads.

Banks and mortgage companies are also to blame, primarily out of greed and ignoring the basic principles of intelligent lending practices. Offering adjustable rate mortgages to risky creditors who have to struggle to pay basic living expenses is taking advantage of the financially challenged at it's worst. These financial Machiavellians then bundle the bad loans into "investment packages" that are sold off to other investment groups, banks, mortgage companies, pension investment groups etc... so that the originators of this bad debt make their profit with none of the risk.

The best way to stop this is to mandate that mortgage lenders must hold a large percentage of this high risk debt and not be able to pawn it off. Regulation...yes indeed.

[HoreTore]

So my question is this: How do you regulate a market in the public interest without burdening the parties with public responsibilities? How do you make markets work in the public interest without any of the market parties working in the public interest? I have some thoughts on the matter, but I would rather hear other peoples' views unobstructed by my assumptions.

IMO, you have to separate the issue into two parts. The first part is the usual market thingy, which is completely private. Then there is the second part, which exists to serve those in need for various reasons, and that one have to be completely under government control, and of such a nature that it won't conflict with the private part.

Trying to merge the two into one privately owned but government controlled entity is doomed to fail, as you said and as we have seen the last year.

Sorry for the very brief reply to a big question, but no time for a longer one right now...

[Adrian II]

IMO, you have to separate the issue into two parts. The first part is the usual market thingy, which is completely private.

That's the part I am on about. It can never be completely private, you see.

The 'usual market thingy' is always a carefully constructed institution, ruled by laws set by society and by customs set by the participants themselves. It must be, for without any enforcement of these there would be no market thingy at all. There would be anarchy. This rules and customs thingy is the very principle that allows markets across the world to operate, from Wall Street to the Beijing flea market.

So how exactly do we regulate this market thingy to make it work in the interest of policy goals that society considers necessary or desirable, but without impeding either fairness (i.e. fair competition) or the profit motive of market parties?

My example is clear enough, right? The U.S. government wants affordable housing for people with a minimum income of 'X'. Since the U.S. government does not want to take upon itself the role of mortgage bank, it seeks to regulate financial markets in such a way that mortgage banks wil fulfill this target.

Now this target has obviously not been fulfilled by the U.S. government getting into bed with Fannie (or with Freddie, if you are a Republican) because the result has been fraud, waste, corruption, lack of transparency, or some exotic combination of all of these.

Such wishy washy arrangements just don't work.
To begin with, the favoured companies get preferential treatment, which in itself already impedes healthy competition.
Secondly, these companies are not bound by realistic, measurable targets, but by a vaguely formulated 'mission'.
Thirdly, because they are unduly important both to the government and to the wider financial institutions of the country, these companies get away with incredible lapses of oversight until it is too late to avert disaster.

So that's not the way. 'Regulation' and 'oversight' in themselves are not enough; this has been proven by the F & F deconfiture.

What sort of regulation, and what sort of oversight are needed? This is not just a Socialist issue. Every modern world view from Libertarianism to Catholic Restauration is confronted with it, because every world view presupposes some sort of regulation of economic life, preferably one that works in the interest of their preferred type of society.

P.S. I know this is not going to be a popular thread and most people are probably bored stiff by it. But I would appreciate it if trolling and such were kept to a minimum. So far so good by the way.

[Banquo's Ghost]

So how exactly do we regulate this market thingy to make it work in the interest of policy goals that society considers necessary or desirable, but without impeding either fairness (i.e. fair competition) or the profit motive of market parties?

A challenging thread, indeed.

My own view is that we are regulating the wrong things, in the main. That is to say, I would offer that markets become most disfunctional when two attributes remain unregulated: size and accountability.

A market works best when its processes are transparent to most. Whilst markets will always have the characteristic of the herd, when sufficient knowledgeable traders participate, there will be many views to follow and/or shape the market behaviours.

Nowadays, we have vast and globalised corporations driving all markets. Not only these organisations specifically protected by outdated laws from the consequences of risk, they create monopolies (or small oligopolies) through obfuscation. In simpler terms, they change the rules to suit themselves and confuse others.

The modern drive for privatisation has also created the chimerae oft in charge of essential utilities. These are de facto monopolies - the illusion of choice has been created but in reality, they either operate as cartels or as actual monopolies. This has been done on the basis of a now unchallenged article of faith: private sector good, public sector bad. Both being organisations of people, there is no inherent reason why this should be so. As it suits politicians to have scapegoats, the past thirty years have shown a preference for divesting responsibilites to the private sector - and as the sweetener, a blind eye turned to the consequent profiteering; only sometimes overseen by a toothless regulator. Certainly the public sector in most countries had atrophied to the point of calcification - but surely the solution was to bring appropriate incentives and management to bear, rather than vilify and unload essential services?

Monopolies make a mockery of markets. They rapidly become as lazy and calcified as the publicly owned facilities they were meant to replace. Often, as they approach failure, they cannot be allowed to embrace it, and the taxpayer ends up securing not only the original costs but propping up the profiteering as well. A truly Faustian bargain, but we do so love it.

There is also the crisis of modern conservatism. To me, a conservative is one who values traditional values and the concept of duty. There is also a healthy distrust of government where unneeded, but a recognition of the important role of the state in ensuring all can go about their business. Developing a business requires stability, and an equal opportunity for good ideas to flourish within the rule of law. Unfortunately, my kind of conservatism is long dead. This who style themsleves so these days cling to the singular idea that government is always bad - and the tragic corollary which is therefore, private is always good. Instead of a functioning market, they require only the semblance of a market, unblemished by state intervention. As modern socialism finds itself unable to break free of the desire to intervene in every aspect of the citizen's life, its ascendant shadow strives to intervene not at all.

As noted, markets cannot function without law. Yet incorporation removes (in most countries) a great deal of the burden of law from the compnaies so constituted. Corporations are in law, individuals, but individuals free from prosecution in so many instances because the actual individuals (the human ones) are not, in law, often culpable.

This goes further to the nub of accountability. If one starts a small business, and it fails, one is likely to lose a great deal - including perhaps the house you used to secure the initial loan. Bankruptcy and ruin lurk in one's shadows. This is real risk, with real consequences, and the successful deserve their success. Yet above a certain size - and incorporated - one can risk an unimaginable amount of money, even to ruination of the company, yet leave the scene of destruction with a handsome payout - and invariably a new post running another company.

Clearly something is wrong. Risk does not carry accountability in these rarefied atmospheres, and consequently the market does not work on the men and women employed therein. This has been seen most acutely in the current banking crisis. Financial derivatives - essentially new games of chance concocted by people who hope that no-one else will understand the rules - have grown in such complexity and idiocy that often even their creators lose track of what they are doing. The really clever see far more reward in the stock exchange casinos than in the mundane business of regulation, so whilst even other financiers are struggling to understand what is going on, the poor bumbling non-entities left to regulatory duty are way beyond their depth. Let's not even consider the inadequacy of the functional illiterate that is invariably wasting space as Finance Minister.

Small is beautiful, as a wise fellow* once wrote. We should get rid of the concept of chartered or incorporated status ('twas instigated by Elizabeth I as a method to legitimise piracy by her favourites, and has trod that bountiful path all the days since).

We should utilise law (and international law for a globalised market, which is a whole new subject) to set the stable boundaries for business. We must recognise the essential and noble duty of government to enforce that law (and the enormous contribution that the state makes to ensuring business can flourish, such as EA noted in another thread, i.e. picking up the social costs of their decisions - for which, it should be noted, most corporations repay the state by avoiding the majority of their taxes).

Company bosses should be personally liable for all losses incurred by the company - if this leads to the hoary old complaint that no-one will do the job, then so much the better. Corporations will wither. I can assure such complainers that many small entrepreneurs, always willing to take such risk, will fill the gap and competition and innovation will once again flourish.

Essential services should be taken back into public ownership and the concept of public service as a high calling re-established - through draconian culling of the current incompetents, and implementation of the best of organisational theory - including imposing accountability on public servants.

Fannie Mae and Freddie Mac are exemplars of pretty much every wrong-headed characteristic of business I have excoriated above. No wonder they are crumbling. Yet we will soon forget as the masses are given more shiny things to distract their attention. I would have the responsible politicians and board members stripped of everything they own and made homeless in the same curt manner as those dumb proles they conned; pour encourager les autres, you understand - and we just might see the beginnings of a real functioning market economy.

Spoiler Alert, click show to read: 

E.F. Schumacher, in case anyone is interested in his essay of the same name.

What sort of regulation, and what sort of oversight are needed? This is not just a Socialist issue. Every modern world view from Libertarianism to Catholic Restauration is confronted with it, because every world view presupposes some sort of regulation of economic life, preferably one that works in the interest of their preferred type of society.

Catholic Restauration is a new one, I must admit. Is that the movement where bistros serve bread that one is told earnestly is really something else?

[Adrian II]

We should get rid of the concept of chartered or incorporated status [..]

I have never, ever considered trashing incorporation as an option; I am totally surprised by this political headshot. Allow me to gather my scattered chunks of skull and mushy bits of brain before addressing it; this may take a while, as they say around Bill Gates.

I appreciate the way in which your whole post addresses the core issue. Individual human ambition (often summarily discarded as 'greed') is like a tiger. We can't tame it, we can only try to ride it. Even in political systems (such as Communism) that try to kill it, ambition rears its head nonetheless, only this time in the shape of corruption, bureaucratic infighting and persasive black-marketeering.

This points to another problem that is related to the theme of my post: we can't all be tigers. Someone has to ride the tiger. If we want to regulate markets properly in the sense described earlier, we need regulators and regulating bodies that have a totally different approach from the producers and consumers that make up markets. We need civil servants in the true sense, people who are as ambitious as the rest of humanity, but with different aims. They should be driven by civic values; values which have sadly been eroded by the process of marketization and privatization of public services which you describe.

Civil servants should have a radically different mentality from market parties. Let me give an example. We don't want a policeman to approach a crime scene or a fireman to approach a burning house with this thought foremost in his mind: 'What's in it for me?' Instead, we want them to serve the common good and be ambitious about it, which means that such thoughts should be as far as possible from their minds.

In short: proper regulation requires proper a regulator, a type of civil servant that has been relegated to the dustbin of market capitalism as a 'loser'. How do we rehabilitate him?

Catholic Restauration is a new one, I must admit. Is that the movement where bistros serve bread that one is told earnestly is really something else?

Teh Catholic Restauration for the Irish gentleman.

[HoreTore]

So how exactly do we regulate this market thingy to make it work in the interest of policy goals that society considers necessary or desirable, but without impeding either fairness (i.e. fair competition) or the profit motive of market parties?

My example is clear enough, right? The U.S. government wants affordable housing for people with a minimum income of 'X'. Since the U.S. government does not want to take upon itself the role of mortgage bank, it seeks to regulate financial markets in such a way that mortgage banks wil fulfill this target.

That is my point though. If the government want to achieve certain goals, then it MUST do so itself, it cannot give the responsibility to private companies, for all the reason you have stated...

So the US government wants affordable housing for people with income x, which the "normal" market doesn't give? Then they have to set up their own mortgage bank for that purpose.

[Adrian II]

So the US government wants affordable housing for people with income x, which the "normal" market doesn't give? Then they have to set up their own mortgage bank for that purpose.

You are aware of the history of Fannie and Freddie?

[CrossLOPER]

I have and always will advocate the caveman market.

[HoreTore]

You are aware of the history of Fannie and Freddie?

I have to confess that I'm not...

But I thought they were two privately owned banks, given a special mission by the government in return for tax breaks, etc?

[Vladimir]

Something from Stratfor. Sorry, don't have a link:

Spoiler Alert, click show to read: 

China: Making Due With U.S. Assets
September 12, 2008 | 2036 GMT

PAUL J. RICHARDS/AFP/Getty Images
Freddie Mac headquarters in McLean, Va.Summary China International Capital Corp., an investment bank, estimated Sept. 12 that China’s holdings in U.S. mortgage giants Fannie Mae and Freddie Mac account for a fifth of China’s foreign currency reserves, at approximately $400 billion, according to China Daily on Sept. 12 which cited China International Capital Corp. The immense size of this investment, combined with China’s holdings of other U.S. assets, reveals the persistent lack of diversity in China’s foreign reserve policy. While the Chinese would like to put some of their money in other places, their economic dependence on American consumption means they are essentially stuck making middling returns on U.S. debt.

Analysis
RELATED SPECIAL TOPIC PAGE
U.S.-China Economic Relations
China’s holdings in U.S. debt through mortgage giants Fannie Mae and Freddie Mac amounts to about $400 billion, or one-fifth of China’s total foreign currency reserves, according to a Sept. 12 China Daily report quoting the major investment bank, China International Capital Corp. (CICC). Though estimates differ and the precise value of the Chinese holdings is in constant flux, the roughly 20 percent chunk is proof enough that China stands to suffer big losses from the Fannie and Freddie debacle despite the U.S. Treasury bailout.

After decades of rapid economic growth driven in great part by exports of manufactured goods to American consumers, China has built up the world’s largest foreign currency reserves at approximately $1.8 trillion. The CICC believes that 60 percent of this massive sum, or $1.08 trillion, consists of US dollar assets, though some economists say it is closer to 70 percent — the rest lies mostly in euros and Japanese yen. The $1.08 trillion in dollar assets can be further divided into 50 percent (or about $540 billion) in US treasury bills and 40 percent (about $432 billion) in US agency bonds. The remaining ten percent of China’s state holdings of US securities comprise U.S. corporate debt and equities. The roughly $400 billion that China holds in Fannie and Freddie represents a fall from CICC’s previous estimate of $447 billion in June. But the precise measurement is in continual flux as the relative value of U.S. securities fluctuate, and in the current global economic situation fluctuation can be rather dramatic.

The disproportional presence of American assets in China’s reserves reveals the country’s inability or unwillingness to diversify the range of financial investments it uses to sock away its extra cash — despite the warning signs ahead of the subprime mortgage crisis and credit crunch, commodity inflation and the various other economic woes China now faces.

Beijing has not diversified its reserve holdings away from the dollar because doing so would be incredibly risky. Beijing sees its dollar assets as so numerous that any attempt to offload them in bulk would be dangerous to the country’s financial — and ultimately social and political — stability. Not only would it have trouble selling, say, $100 billion of securities on the spot, but flooding the market would drive the value of its remaining assets down. Moreover, American securities remain Beijing’s best option, despite the currency risk and low returns, because China’s domestic consumption is not developed enough to merit investing at home.

So rather than devalue its own dollar-denominated assets, China will for the most part hang onto them, knowing that only the United States provides a pool of debt big enough to handle the massive reserves that the Chinese continue to accrue through their trade surplus. (Most other serious contenders — Russia, Brazil, Australia, Germany — are running surpluses and do not need to borrow from China.) Furthermore, America is a secure place for China’s money, unlike some of the secondary options.

China can begin to break its dependence on U.S. habits of consumption and debt accumulation and reduce the proportion of U.S. assets in its foreign reserves by buying up non-dollar assets instead. But it will have to do so slowly in order to reduce the negative impact on China’s remaining dollar-denominated assets. Ultimately, until China can generate enough domestic demand to soak up its surplus funds at home, it will have to accept the middling returns of American securities.

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Looks like China is in the same mess we are. Kinda supports my theory that we're cutting off our nose (devaluing the dollar) to spite our face (China).