Uncle Sam, Subprime Borrower - A Commentary By Professor Jonathan GS Koppell
"Uncle Sam, Subprime Borrower"
By Jonathan GS Koppell
Published in the Wall Street Journal on July 26, 2008
Read the article in its original context on the Wall Street Journal website.
The embrace of Fannie Mae and Freddie Mac by the federal government makes it official: Uncle Sam is the world's foremost subprime borrower.
Concern about the potential borrowing necessary to cover the two government-sponsored enterprises' obligations even prompted speculation in the bond markets of a lowered government credit rating. How did these two companies with the funny names get us into this most unfunny mess?
Not all by themselves, of course. Congress and the president are the primary culprits. And although the profligate spending of the federal government is obviously an issue, that is not the subject here. The root cause of the whole Fannie/Freddie mess is Congress's destructive unwillingness to treat risk seriously. There have been warnings about potential future liability associated with the ballooning balance sheets of these firms, which carry the implicit guarantee of the federal government. But these warnings have been largely ignored.
Should we really be surprised? For Congress, scouring the budget for funding that will take care of current needs (urgent or not) is hard. Turning a blind eye to an increasingly gargantuan potential liability is easy. Fannie and Freddie are a congressional dream come true. They offer a real benefit of central importance to millions of Americans, and they are completely free! At least that is how it felt until now.
And it gets even better. Like the oxymoronic "off-balance-sheet liabilities" that are plaguing the most hallowed names in American finance, the liabilities of the GSEs are off-budget. They don't count because the two companies are owned by shareholders, not the government. Indeed, one of the principal motives for the federal government selling Fannie Mae in 1968 was to move it off-budget. The peculiar status of the GSEs allows everyone to simply wish the liability away.
All one needs to do to understand the source of the problem is look at the bill likely headed to the president soon. In one remarkable piece of legislation, Congress has both provided the Treasury Secretary with government-financed life preservers to be used if the two companies are drowning, and also increased their borrowing powers, enabling them to purchase more and bigger mortgages than before. The House version calls for an assessment on Fannie and Freddie that would finance an affordable-housing fund and cover cost overruns of the Federal Housing Administration foreclosure bailout program. In other words, Fannie and Freddie are being encouraged to head for the deep end of the pool even as we wring our hands about their ability to swim.
How does this continue to happen? The S&L crisis of the 1980s showed that "costless" guarantees can turn into real on-budget expenditures — more than $120 billion worth at that time. That chastened Congress, and led to the creation of a financial regulator for Fannie and Freddie with modest bite. But the years pass, the memories fade and all that "free" public policy is sitting right there for Congress's taking, like a freshly-baked pie temptingly perched on a window sill.
The management of the enterprises urges Congress to take the pie because more pie is more business, higher returns to shareholders, and rising stock prices. All the housing-related industries from mortgage brokers to realtors to construction companies to Wall Street financiers push along too. More loans equal more business. The housing advocates join the chorus. Grab the pie, they say. More loans — provided they go to underserved communities — means more units to be built for their constituencies (and, not coincidentally, the voters in each member's district).
And who is urging restraint, warning of the potential consequences of taking the pie, cautioning against allowing these two private companies to create obligations with the implicit backing of the U.S. government? No one. There is no constituency for prudence, no well-financed interest group to mobilize voters in the name of American creditworthiness. It isn't even a fair fight.
Congress is not the only institution challenged by the management of risk. The whole financial crisis can be seen as the product of individuals and institutions discounting risk. From the homebuyer who agreed to an interest-only loan, assuming that the appreciation in two years would allow a painless refinance, to the highly leveraged financial institution that put itself at the mercy of unknown counterparties, each player either discounted or wished away the risk associated with their actions.
Some kind of intervention in this case is good public policy. Allowing Fannie and Freddie to falter — with the collapse of the global economy as a plausible side effect — would be an act of dubious risk management in itself. Moving forward, however, we need to ask whether Congress is capable of utilizing these powerful instruments responsibly. The regulatory reforms included in the bill may bulk up the enterprises' oversight. But they do not alter the essential dynamic described here.
The current situation shows just how ingenious and useful the GSEs can be. The creditworthiness of the federal government is employed to prod the market in socially valuable directions. But when the use of this tool endangers the very creditworthiness it relies upon, one must contemplate putting this invaluable tool behind glass, to be used only in the event of an emergency.
There are many proposals to fundamentally alter the relationship between the federal government and the GSEs. The current crisis opens a window of opportunity to make a change. Sadly, Congress seems to see it as an invitation to grab more pie.
Mr. Koppell, an associate professor at the Yale School of Management and director of the Millstein Center for Corporate Governance & Performance, is the author of "The Politics of Quasi-government" (Cambridge University Press, 2003).