FANNIE MAE & FREDDIE MAC
Socialization of loss
July 17, 2008
The stated ideology of the Bush era has been that the free markets should run unfettered. In light of the federal government's intervention with Bear Stearns Cos. and its more recent intervention with Fannie Mae and Freddie Mac, it is clear that the actual ideology of our time is the privatization of profit and the socialization of loss, at least as far as massive financial institutions are concerned.
Fannie and Freddie are emblems of this ideology. Chartered decades ago by the federal government to create a national secondary mortgage market, Fannie and Freddie have used their special relationship with the government to grow stunningly large. Indeed, the two of them have roughly $5 trillion (that's "trillion," folks!) in mortgage-related obligations. That's about equal to the amount of U.S. government debt held by the public.
An implied guarantee
As they grew so large, Fannie and Freddie ascribed their success to the extraordinary efficiency of their operations and the talent of their management. But, in fact, that growth was driven by an aspect of their special relationship with the federal government, which gave an implied guarantee of their obligations. Lenders were willing to fund Fannie and Freddie's growth because they understood, notwithstanding the denials of high-level Treasury officials, that the federal government would step in to ensure the payment of Fannie and Freddie's debts if they were unable to do so. And that is the crux of the ideology that governs today. While Fannie and Freddie shareholders and management were taking home outsized profits for decades, it looks as if the U.S. taxpayer is going to have to make good on their debts now that things have gone bad. This may cost American taxpayers hundreds of billions of dollars to fix, dwarfing what we had to pay during the savings & loans crisis 20 years ago.
We are in too deep to do anything about it now, except to stabilize the current situation. After we take our licks, however, we should ask ourselves: How do we protect ourselves from similar situations in the future? To do so, our regulatory structure has to address three issues. Some financial institutions are too big to fail. Some are too complex to fail. Some are too politically connected to fail. Fannie and Freddie, unfortunately, are all three.
• Too big to fail. After the S&L crisis, the federal government realized that it was very bad to signal that some companies were too big to fail. This was because lenders would lend to such a company with the understanding that the federal government would make them whole if the company did, in fact, fail. After the S&L crisis was weathered, the Federal Deposit Insurance Co. (FDIC) took concrete steps to signal that this would not be the case for the banks that it regulated. With Fannie and Freddie, however, government officials have spoken from both sides of their mouths, stating both that there is no implied guaranty of Fannie and Freddie's obligations and also stating that both are too large and thus too important to the American residential mortgage market to be allowed to fail.
• Too complex to fail. The Bear Stearns bailout, like that of Long Term Capital Management, signaled a new basis for intervention in the capital markets. Regulators were afraid that if Bear and Long Term were allowed to fail, they would create havoc because they were counterparties to innumerable transactions with many, many other capital markets players. If they defaulted, it could create a catastrophic chain reaction that could shut down whole sectors of the capital markets. And, as the auction rate securities fiasco demonstrates, even hamstringing one obscure part of the capital markets can create immense hardship for an incredibly broad range of people and entities. The complexity embodied by Fannie and Freddie puts that of Bear Stearns and Long Term to shame. The federal government has given Fannie and Freddie securities a special status within the financial institutions overseen by the Federal Reserve, the FDIC and other regulators. As a result, innumerable financial institutions holding hundreds of billions of dollars worth of Fannie and Freddie securities have reasonably relied on the safety of those securities.
• Too politically connected to fail. Some corporations are known for their political savvy and power. For instance, when Travelers Property Casualty Corp. wanted Depression-era financial regulations to be changed so that it could merge with Citibank, it got Congress to change the law after the merger was announced. Again, Fannie and Freddie outdo their peers in this regard. Fannie and Freddie have the most effective lobbyists who, time after time, fend off efforts to reign in the privileges that have allowed them to grow so large and so risky.
Financial services entities cannot have it both ways: unregulated during boom times and rescued by taxpayers during the inevitable busts. Whether they are too big to fail or too complex to fail, they must be supervised more closely. Otherwise, the American taxpayer gets the worst of both worlds — none of the upside and all of the downside.
David Reiss is an associate professor of law at Brooklyn Law School. His research focuses on the secondary mortgage market.
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