If you have been following the news you have no doubt heard that in order to prevent a total collapse of lenders Fannie Mae and Freddie Mac, the US government placed the companies under the control of the government and will provide capital to the tune of hundreds of billions of dollars. The impact to you has many details, but the bottom line is: you lose.
Is this a failure of the system? I think that any reasonable person can look at the facts and answer yes:
The downfall of Fannie and Freddie stems from a series of miscalculations and deferred decisions, both by their executives and government officials, according to company insiders, regulators, auditors and outside analysts. The companies expanded rapidly in recent years, initially playing down the risks posed by a housing bubble. Then, as the housing slump expanded nationwide, they resisted raising enough new capital that might have provided a financial cushion to weather the storm. Lawmakers, paralyzed by partisan infighting, delayed strengthening regulatory oversight of the politically powerful companies.
Even this quote understates the issue and how long it has been known. At the very root of the problem is that these two government sponsored enterprises (GSEs) were permitted to take too much risk and keep too little capital on hand to cover market downturns on the $12 billion mortgage market--of which they own roughly half. Some argue that failures elsewhere in the system (such as excess capital from investment banks, or poor regulation of rating companies) created a perfect storm that could not be withstood. But this rings hollow, especially considering that we seemed to have repeated our failures of the previous generation.
Most readers will at least recall the "Savings and Loan Crisis" of the 1980. It's helpful now to recall what happened, and what the lingering effects have been. Savings and loan banks (or 'thrifts') grew out of depression-era reforms that offered low-cost federal funding to encourage banks to become mortgage lenders. In other words, they were the instruments of a very progressive policy intended to increase home ownership and bring more citizens into the middle class.
However, deregulation of the savings and loans in the 1980s allowed the banks to take greater risks and offer a broader range of services. By 1982, savings and loans could invest in commercial loans (especially real estate) and at the same time retain a lower level of capital to offset these risks. The banks themselves became lucrative investment opportunities, and capital flowed in. Driven by the idea that growth and profitability of banks would trickle down to the average consumer, the savings and loan industry boomed and became a huge money making vehicle for those who invested directly in the banks themselves. These banks, many of them not particularly sophisticated, tried to rapidly expand and in doing so exposed themselves to risk and sometimes fraud.
In the end, a number of economic factors led to the S&L Crisis but poor oversight and regulation was the primary culprit for allowing the savings and loan industry to become overexposed to risk. As hundreds of these banks collapsed, the government moved in to cover the losses to avert a wide financial crisis. By the end of 1994 some 1,600 banks had failed at a total cost to the taxpayers of about $160 billion, or roughly $1,000 for each taxpayer at the time.
At the time of the S&L Crisis, I distinctly remember politicians from both sides of the isle claiming that "our grandchildren would be paying off this bailout" and that the failure of the government to regulate the financial industry would be a cautionary tale to guide us moving forward. Never again would we allow such critical institutions to become exposed to risk and speculation. The promise was that we, as a nation, would safeguard the financial services that the average citizen needs most and resist the temptation to turn those institutions into high-risk, high-return investment vehicles.
So fast forward to today. We now know that Fannie Mae and Freddie Mac--originally created to increase home ownership and increase the wealth of the average citizen--were perverted into money-making vehicles for investors. They took on increasing risk and were not prepared for the event of a major downturn. Some argue that the rapid growth and high returns from these GSEs made more home ownership possible, and this is technically true. But they did so by offering a huge volume of bad loans, which in turn exposed the entire portfolio to risk and rapidly inflated the cost of homes. (This also led to a rash of home equity loans, a problem which only compounded the problem.)
A big part of the American Dream is home ownership. But creating a situation where home ownership is completely dependent on the rapid appreciation of real estate values is reckless and irresponsible. Private companies can participate in this kind of speculation, but the behavior of GSEs like Fannie Mae and Freddie Mac should be conservative even in times of rapid growth. Some argue that the heads of these companies could not have seen this coming, but past crises clearly show that while the mechanics may be hard to predict, the fundamentals are the same: rapid growth can have massive downside.
How does it make you feel to hear Treasury secretay Henry M. Paulson Jr. say the following:
"[Fannie Mae and Freddie Mac] will no longer be managed with a strategy to maximize common shareholder returns.”
Really? That was the strategy up until now? America thought the whole idea was to help more Americans achieve the dream of home ownership. We were sadly mistaken.
When we look at this debacle--and past failures like the S&L Crisis or the Energy Crisis of 2000--as responsible citizens we should be compelled to have an opinion, and the size of this failure demands a strong opinion. To me, the conclusion is inescapable: we should mandate that the institutions that we need most be protected from failure, even at the expense of growth. That our leaders should be strive for economic expansion and prosperity, but be vigilant that excess, exuberance, and greed do not allow our most critical financial assets--our houses, our savings--to be caught up and overexposed to risk.
Or, to put it simply, be conservative even when you think you can't lose. Because you can always lose. And we just did--in a very big way.