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May 24, 2009

Fannie Mae and Freddie Mac: How Failed Regulation Caused a Several Hundred Billion Dollar Problem

Fannie Mae and Freddie Mac: How Failed Regulation Caused a Several Hundred Billion Dollar Problem

I know, I am not one to speak much in favor of regulation. However, one of the common misconceptions about conservative capitalists is that they do not favor regulation at all. This is not true, as Common Sense Capitalism believes that regulation is a vital part of a well-run capitalist society. This is, however, when it is not being abused to pass a government mandate (fuel mileage standards, clean air) or to simply raise money to increase government coffers. Regulation, when used to promote free market economics, is what Common Sense Capitalism supports.

In that case, Fannie Mae and Freddie Mac could have benefited by having regulations that promoted sound business practices over trying to create as much paper as possible to grow the general mortgage market. In 2004, questions were raised about how Fannie and Freddie were accounting the books. Democrats knew that lower income Americans benefited from the continuing growth of Fannie/Freddie backed residential mortgages. In a 2004 hearing, Republicans brought concerns about Fannie and Freddie's accounting practices, including the fact that Sarbanes-Oxley accounting regulations did not apply to the two companies. The Democrats subsequently shouted down the call for regulations and stated that Fannie/Freddie were fundamentally sound.

Video from that hearing

In 2008, as the mortgage market deteriorated, Fannie and Freddie could no longer conceal their questionable accounting practices. As the write-offs mounted, it became clear that the companies would become insolvent and since the government backed the mortgages, the government would have to step in and bail out the lenders.

For more details on how Fannie and Freddie failed, check out this article by the Economist which was ironically written 2 months before the official failure of the institutions. Notice how due to implicit government backing, Fannie/Freddie could borrow cheaply short, lend long, and required only a slight capital reserve. Does this sound like a company in a capitalist environment, especially considering the government involvement?

When the initial seizure of the banks occurred, many believed that the total cost would be around $25 Billion (article). However, as the mortgage market continued to deteriorate and the mismanagement at these two companies continued to play out, the cost estimate has grown to $170+ billion. This is another example of how substituting government management for private management only makes a bad situation worse.

In addition to the $170 billion cost that the taxpayers will not recoup from Fannie/Freddie, the government seizure of the lenders cost the private banking sector $10 to $15 billion in losses from the stock being wiped out. This translated into about $100 billion in less lending for the finance industry (article).

All of these problems stemmed from the fact that the government did not realize that Fannie/Freddie needed to follow proper accounting guidelines in order to keep the mortgage industry stable. The Democratic Party pandered to politics over common sense to properly regulate the finance industry. This begs the question: Do we really want to rely on the same individuals to responsibly clean up this mess? I would feel more comfortable if Congress looked to guidance from the FASB and other professional accountancy organizations. These are people who live and breathe finance and would do better to help draft SMART regulation. Instead, I fear that Democrats are going to over-regulate and focus on unimportant items such as bonus and salary limits, lending paperwork standards (because people did not read the papers before they signed), and a variety of other regulations designed to willfully force their opinions into the private finance market.

The solution should be to unwind GSEs like Fannie and Freddie and end this practice of government-encouraged speculation of fixed assets. Otherwise, Fannie and Freddie are going to continue to take unnecessary risks with no penalty for loss. If the mortgage market truly is so large that it needs some liquidity method in order to keep the mortgage lending business stable, financing firms should be able to go straight to the Federal Reserve for financing. That way, financing firms are borrowing in order to lend and simply not creating money through the practice of mortgage-backed securities whose risk is backed by the taxpayer.

What do you think?

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