The federal government announced the takeover of Fannie Mae and Freddie Mac today. The stock market applauded the move sending stocks soaring. However, the recent moves of the Federal Reserve and the Bush administration raise important questions about where we are heading. (Before we discuss where we are heading it might prove useful to understand how we got here. For a quick primer, click here, otherwise continue on.)
Our friend Thomas Palley posted an op-ed on his page about a month ago anticipating the “scapegoating” of regulation:
The conservative argument is government’s provision of an implicit guarantee to Fannie and Freddie distorted the market by giving them subsidized finance. The implication is that this enabled them to pump up the housing bubble, while simultaneously making them the dominant players in the securitized mortgage market.
The insinuation that Fannie and Freddie were primary movers of the housing market excesses of 2004 – 2006 lacks even superficial merit. This is because since 2003 both Fannie and Freddie have had limited asset growth, and Fannie’s assets actually fell significantly after 2003.
Moreover, the roots of the crisis lie in the sub-prime market. That is where “no doc” and “zero down” mortgages proliferated, where loan originations exploded in volume, where losses started, and where the bulk of losses have been so far. Yet, Fannie and Freddie are prevented from financing such mortgage products by their charters.
These facts should make clear that Fannie and Freddie did not cause the crisis. Instead, it was driven by loose and negligent lending by banks and Wall Street.
Palley then concludes that the companies should be nationalized and that stricter regulation is necessary. While he is correct to point out that Fannie and Freddie did not cause the crisis, I must disagree as to the implications of their existence and his policy conclusion.
While it is clear that Fannie and Freddie did not cause the crisis, they have subsequently rose to its center. The reason that Fannie and Freddie are at the center of the crisis is due to the fact that they have risen so much in size. The implicit guarantee of it debt has led to a de facto subsidization of mortgage debt (beyond that which is in the tax code) through the organizations’ ability to issue bonds at lower rates. So while Fannie and Freddie did not cause the crisis, the increase in size coupled with (and as a result of) the implicit guarantee of the debt has created a potentially heavy tax liability on taxpayers, which has been made larger (and explicit) by the announced government takeover.
So where do we go from here?
Increasingly, there is a greater push for more regulation. However, I am not certain the more regulation is what is necessary. The current regulatory system is a disaster, full of overlapping agencies and poor performance. The Fed is responsible for oversight of its member banks and bank holding companies; the Treasury department for national banks; states for state banks (even those within the Federal Reserve system); the FDIC for state banks that are not members of the Federal Reserve system, but are insured. The entire system is entirely too complicated to navigate. Further, many of the innovations such as securitization arose in response to government regulations such as reserve requirements and, more importantly, restrictions on interest payments for deposits.
Perhaps more troubling is the development of new programs within the Federal Reserve to deal with this crisis. I have previously mentioned that the Fed has performed admirably in the face of the crisis, but this point needs to be better clarified. The Fed, contrary to its performance during the Great Depression, has been vigilant in its effort to serve as lender of last resort. However, as Allan Meltzer has pointed out, they have surpassed this goal and have actually become the “creditor of last resort.” This distinction is important because as lender of last resort, a central bank is an entity that serves to provide liquidity to the market whereas the creditor of last resort refers to a central bank that holds all of the bad debt that others are unwilling to hold.
The creation of the Term Auction Facility (TAF) and the Primary Dealer Credit Facility (PDCF) have expanded the role of the Federal Reserve and allowed them to provide liquidity to the market in new and unique ways. However, as I have argued elsewhere and as John Taylor and John Williams have pointed out, these efforts have done little to close the widening risk spreads. For example, the spread between the LIBOR (London Interbank Offer Rate) and the Overnight Indexed Swap (OIS) remains elevated several months after the origination of the new tools of the Fed.
The continued elevation of the risk spreads continue to lend support to my hypothesis that they do not reflect a lack of liquidity, but rather the persistence of counter-party risk. They also raise concerns about the recent expansions of Federal Reserve power. These new tools obviously serve as a means to providing liquidity to all members of the financial sector, but restoring confidence is much more complicated. One hope of the Fed was that these tools would provide other institutions with the confidence to lend with one another and accept commercialized debt obligations (CDOs) as collateral. However, these other institutions are not blessed with the ability to print currency nor are they backed by the government of the United States. The failure of the TAF and the PDCF to reduce the risk spreads and restore confidence therefore raise grave questions about this recent expansion of power.
The complicated structure of regulation in the banking industry and the unending desire of financial institutions to circumvent regulation suggest that adding additional layers is not sufficient nor is it desirable. However, some type of regulation is necessary. Even under free banking systems, clearinghouse associations provided regulatory oversight of their member banks. Rather than create new regulations, we need to consolidate regulatory agencies and oversight so that it is easier for the firm to comply and for the regulator to observe. Further, we need to get the Federal Reserve out of the business of regulation and begin to eliminate the programs that have pushed the Fed’s power too far to the role of “creditor of last resort” and have proven unable to restore confidence to the markets. Finally, the takeover of Fannie and Freddie should begin a slow and gradual process toward their ultimate elimination. We need not continue to subsidize home ownership at the potential cost of taxpayers.
This isn’t enough to fix all of the current problems, but it is a start.