Patrick Garry
A non-budgetary reason for reigning in government: the Fannie Mae example
By Patrick Garry
July 9, 2011

With federal budget talks at a tense and near urgent stage, perhaps it is important to remember that spending levels and budget deficits are not the only reasons to keep government at least somewhat limited. An ever-expanding, all-powerful government can have severe unintended results. The Fannie Mae/Freddie Mac experience provides one such tangible example.

In their recently released book Reckless Endangerment, Gretchen Morgenson and Joshua Rosner reveal how Fannie Mae contributed to the financial crisis of 2008. Fannie Mae, a nominally private company that effectively operated as a government agency, used its government-granted monopoly to dominate the mortgage market and become the nation's second-largest debt issuer — second only to the U.S. Treasury.

Pushed by government officials, who in turn perpetuated its monopoly privileges, Fannie Mae violated traditional standards of underwriting by issuing mortgages to people with insufficient assets. In 1992, Congress adopted affordable housing requirements that forced Fannie and Freddie to buy the increasing numbers of risky, subprime mortgages that ultimately drove them into insolvency. The stated goal was to increase home-ownership among poor and minority populations, but the ultimate effect was a housing bubble that eventually brought the U.S. financial system to the brink of collapse.

The goal of increasing home-ownership was pursued through reducing down payments and loosening underwriting standards, making it much easier for more people to afford more expensive houses. Consequently, housing leverage increased to historically unprecedented levels by 2007; at the same time, the quality of housing debt was deteriorating because of the lowered underwriting standards. And since Fannie Mae, with its special government backing, was the lowest cost provider of housing loans, it essentially dictated the underwriting standards of the residential mortgage industry, thus contributing to a highly leveraged, subprime mortgage market.

Yet even though Fannie Mae and Freddie Mac were setting the standards in the residential mortgage market, there was an absence of financial discipline at these firms, largely because much of the risks they were taking were being borne by taxpayers. Consequently, as the housing bubble was pushing up property values to unsustainable heights, the excessive leverage in the mortgage market — e.g., the high debt-to-equity ratio — meant that only a small drop in property values could bankrupt the lenders and debt holders, which is what happened to firms like Bear Stearns, Washington Mutual, Fannie Mae and Freddie Mac.

Fannie Mae was able to engage in such reckless lending because of its government backing, which helped drive out competitors while at the same time insulating it from any bank-style regulation. And this government backing was possible because the federal government had become so involved and powerful in both the individual home-buying and mortgage-issuing sectors of the economy. (Experts debate whether Fannie's reckless lending was done to meet government affordable housing requirements or to curry favor with Congress so as to preserve its special privileges in the mortgage industry; but regardless, it was the power and activities of the federal government from which everything stemmed.)

Three lessons come from the Fannie Mae/Freddie Mac meltdown. First, the nature of big government is that it is almost always justified in terms of lofty, idealistic, even utopian (the-country-will-be-saved) arguments — and indeed, the acts of big government are almost always billed as reformist. Second, once justified by such utopian promises, the power of government can end up having unforeseen and unintended effects, far different from the idealistic effects once promised. And third, government power gone awry has an almost unlimited destructive capacity.

The Framers, in drafting a constitution giving only limited power to the federal government, knew that a centralized government of near unlimited activity and authority could never be transparent or accountable. And this is just what happened with the Fannie and Freddie breakdowns.

Because of the size and reach of government power, few questions were raised prior to the financial crisis of 2008. There was little inquiry into what role the federal government should play in the financing of individual homes. There was no serious debate about how and whether the federal government should help low-income people buy homes. Consequently, there was a confusion of the economic goal underlying the creation of Fannie Mae — facilitating a viable national mortgage market for quality mortgages — with the social goal of increasing home ownership of low-income borrowers.

Because the operations of Fannie and Freddie were off the federal budget, the government could, for awhile anyway, pursue this social goal without any budgetary consequences. Moreover, because the federal government pursued its policies through Fannie Mae and Freddie Mac, it created a situation in which the term "home ownership" became a misnomer, since the highly leveraged mortgage market meant that tens of millions of "home owners" in fact couldn't afford their homes and couldn't keep their homes once the housing bubble burst.

As a result of broad federal power in the residential mortgage market, the shareholders of Fannie and Freddie lost their investment, tens of millions of home owners lost their homes to foreclosure, and the American economy was thrown into chaos and recession. And aside from the economic cost was the moral hazard cost, in which the dictates of the federal government and the activities of its agents encouraged both lenders and borrowers to abandon financial discipline and take ill-conceived and short-sighted risks — risks that pushed individuals into bankruptcy and foreclosure, and the entire economy into a debt-crisis recession.

© Patrick Garry


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Patrick Garry

Patrick Garry is a professor of law at the University of South Dakota, and Director of the Hagemann Center for Legal & Public Policy Research... (more)


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