Should we blame the GSEs?

American Enterprise Institute economist Peter Wallison blames Fannie Mae for the financial crisis. He claims that NINJA loans and the collapse of lending standards, were caused by the government’s desire to extend home ownership into poorer communities, aided and abetted by the two privately owned, publicly backed government sponsored enterprises (GSEs).  According to Tea Party supporters “government entities like Fannie Mae and Freddie Mac occupied the epicenter of the housing bubble crisis.” The US Securities and Exchange Commission (SEC) seems to agree. Last Friday, the usually cautious organization brought fraud charges against six top executives at Fannie Mae and Freddie Mac, accusing them of understating their exposure to subprime mortgages to potential investors.

Fannie Mae was originally just a government agency whose task was to stimulate home ownership. Created during the Great Depression, it bought bundles of mortgages from local banks and sold them on, freeing bank capital so that it could be lent again. Fannie Mae single-handedly invented mortgage securitization decades ago by creating a secondary market in home mortgages. For most of its existence, it operated under very strict rules, only allowed to repurchase the highest quality mortgages. Indeed, one of the original definitions of sub prime was loans that Fannie Mae could not touch.

In 1968, Lyndon Johnson privatised Fannie Mae. He short-sightedly saw an opportunity to massage down federal budget deficit numbers by taking the GSE’s debts off the government’s balance sheet. Fannie and her brother Freddie became hybrids, for-profit firms whose debts were implicitly backed by the US government. This, of course, gave them a licence to print money. With their government guarantee, they could borrow much more cheaply than their competitors and so Fannie and Freddie became very rich and powerful Washington players. Newt Gingrich on the right and Barney Frank on the left each received massive donations from them. Their CEOs and shareholders made hundreds of millions.

During the housing bubble, the GSEs sought to expand market share and get a piece of the lucrative and higher yielding subprime mortgage market. They lobbied hard to limit restrictions on their lending practices. Still, their share of the sub prime market was miniscule compared to the major investment banks.

So are Fannie and Freddie to blame for the financial crisis? No. Conservative economists like Wallison get the direction of causality backwards. It was Wall Street’s lust for high yielding sub prime securities that caused mortgage brokers to lower their lending standards, not the desire of poor people to own their houses that forced Bear Stearns to give them money. Even Chicago school economist Gary Becker—who is no fan of Fannie and Freddie and is an opponent of regulation and government interference—admits “I am not claiming that the reckless behavior of Fannie Mae and Freddie Mac was solely, or even mainly, responsible for the financial crisis. Enormous blame must go to the commercial and investment bankers who took on vastly excessive risks that endangered their companies and the economy.”

The Tea Party wrath towards Fannie and Freddie reflects the right wing adoration of free markets and antipathy towards government. To the heirs of Ronald Reagan, government is always the problem so the financial crisis must be the government’s fault.

But they, and the SEC, do have a point in their attacks on the GSEs. A privately owned firm, with government backing and a mandate both to serve the public and create huge returns for its shareholders has an inevitable tendency towards corrupt behaviour. A government agency cannot be effectively run when it is motivated by creating profit for its shareholders. A commercial business should not have government guarantees. The original sin wasn’t Fannie’s mandate to buy mortgages and stimulate home ownership, but rather its privatization. Lyndon Johnson created what Jane Jacobs would call a "monstrous hybrid," a private entity using political power to serve its own and not the public’s interest.