This is a topic I first broached in May. The United States has a mortgage problem in that house prices have fallen so much and the financial sector is so leveraged that the U.S. faces systemic banking risk from a vicious circle in the mortgage sector. (I normally might have said ‘negative feedback loop,’ but my good reader dearieme pointed out I was misusing the term)
This circle leads from house price declines to foreclosures to bank losses to bank deleveraging and credit tightening leading to more house price declines and on it goes.
Enter Hank Paulson.
By taking over the Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, Paulson can use the two companies, now under government control, to provide fresh liquidity to the mortgage market.
Roots of mortgage nationalization in depression
You see, that is why Fannie Mae, and later Freddie Mac, were created in the first place. On Fannie’s website, it says:
Fannie Mae was created in 1938, under President Franklin D. Roosevelt, at a time when millions of families could not become homeowners, or risked losing their homes, for lack of a consistent supply of mortgage funds across America.
The government established Fannie Mae in order to expand the flow of mortgage funds in all communities, at all times, under all economic conditions, and to help lower the costs to buy a home.
In essence, the Great Depression caused great hardship for Americans because of the destruction of America’s financial system after a wave of bankruptcies in the banking sector. Let’s go back to that painful period of American history.
During the Great Depression, the United States suffered from a similar difficulty of high financial sector debt (see chart below for statistics on debt increase since WWII)coupled with asset losses, eroding banking capital. The result was a loss of confidence in the banking system, causing people to withdraw their deposit money from a number of institutions. These deposit withdrawals created rumor mills that whipped the public into a panic whereby certain banks were deemed so risky that many depositors withdrew funds, so many that the banks were declared insolvent. This is the definition of a bank run, and is exactly what happened to Northern Rock in the UK in 2007.
Funny thing though, insolvent banks don’t lend money because they don’t exist. Therefore, the wave of bank runs and bank insolvencies that resulted from those runs reduced available credit in the system. Hence, irrespective of whatever liquidity the Federal Reserve supplied, the economy — starved of credit – was destined to decline. And decline it did, with output falling 46% in nominal terms and unemployment peaking at 25%.
As one could imagine, getting a mortgage in those conditions was pretty difficult. Bank capital was husbanded tightly out of banks’ logical fears of being the subject of the next bank run. Moreover, back then, there were strict interstate banking laws (laws that were only repealed in 1994.) So that meant that a lender was beholden to the local economy — if an area hit the skids, so did its bank, reducing credit availability and further depressing the local economy.
Enter Fannie Mae. Fannie Mae was created as a government agency to eliminate the restriction on mortgage credit availability – exactly the problem we are now experiencing.
Fannie Mae was founded as a government agency in 1938 as part of Franklin Delano Roosevelt‘s New Deal to provide liquidity to the mortgage market. For the next 30 years, Fannie Mae held a virtual monopoly on the secondary mortgage market in the United States.
In 1968, to remove the activity of Fannie Mae from the annual balance sheet of the federal budget, it was converted into a private corporation. Fannie Mae ceased to be the guarantor of government-issued mortgages, and that responsibility was transferred to the new Government National Mortgage Association (Ginnie Mae).
In 1970, Freddie Mac was created, in order to further expand the government’s role in creating a market for mortgage availability.
The FHLMC was created in 1970 to expand the secondary market for mortgages in the US. Along with other GSEs, Freddie Mac buys mortgages on the secondary market, pools them, and sells them as mortgage-backed securities to investors on the open market. This secondary mortgage market increases the supply of money available for mortgages lending and increases the money available for new home purchases.
One might believe for ideological purposes that the government should not be involved in the mortgage market because it distorts investment decisions. I have sympathy for that argument.
However, I also realize that it is times like these that necessitate government’s participation in markets on some level. The U.S. banking system as a whole is clearly undercapitalized and institutions are fearful of becoming the next Bear Stearns or Northern Rock. Therefore, liquidity has evaporated in the money markets and in the mortgage market. As a result, in the mortgage markets, before their conservatorship, Fannie and Freddie were responsible for 3/4 of mortgage lending in the US, up from 50% pre-crisis.
There is little the Federal Reserve could have done to correct this problem. The Fed has already done as much as it can — I would argue more than is prudent — to prevent another Depression-like scenario. It was high time, the U.S. government stepped in to do something. Congress, as useless as ever, did not provide a solution. Therefore, it was up to the executive branch to show some leadership on this issue. And Hank Paulson stepped into the breach.
I do not like many features of his bailout plan because they do not eliminate the moral hazard that was complicit in creating the mess in the first place. His plan is also very political. It protects debt holders like China’s central bank, which holds $400 billion in GSE debt. It protects foreign central banks generally, as they hold $1 1/2 trillion in GSE debt. It protects the likes of Bill Gross, who took a calculated risk in feasting on GSE debt, betting that such a plan was likely to happen. The plan does not wipe out equity capital, nor does it wipe out preferred equity holders entirely. These capital classes should bear all of the initial risk to future capital losses, not U.S. taxpayers.
Moreover, there will be the sticky points of the government running and exiting from Fannie and Freddie. Will politics become an increasing factor in GSE decision-making? How will the GSE’s attract top talent now that the profit motive is gone? How will the government extract itself from the GSEs: will it wind down Fannie and Freddie, hold on to them, or privatize them in part or in full? All of these questions need to be answered.
But Paulson’s plan will be effective on many levels. It will certainly give the mortgage market a boost by lowering mortgage rates and increasing liquidity. This will have the net effect of putting a floor on house price declines in the U.S. and eliminating one of the principal risks to the banking system. And I suspect that the U.S. government will actually increase the GSE’s lending in order to do exactly that. Of course, taxpayers will foot the bill on any lending losses.
So, there you have it. The mortgage problem in America has effectively been nationalized – socialized, if you will. Welcome to the United Socialist States of America. This is certainly not a desirable outcome for the bastion of capitalism that the USA believes itself to be.
But, is there any other solution? Personally, I think not. What do you think?
Unemployment Rate, U.S. Bureau of Labor Statistics
Federal Reserve Flow of Funds, Federal Reserve