Mortgages' Regulation Addiction

For Americans who wholeheartedly believe in the idea of capitalism "red in tooth and claw," the past month has been a time for serious re-examination of your premises and assumptions.  On every hand, we find what we thought were august business enterprises face down in the dirt, begging for the government to lift them back to their feet at taxpayer expense.  First there was Bear Stearns; then Fannie Mae and Freddie Mac; now IndyMac Bancorp, and various experts are expecting hundreds more bank failures.

We've previously written about the risks of government bailouts: if taxpayer funds are to be provided to private enterprise, it's only reasonable for the government to have increased control over those enterprises.  The consensus of people far more knowledgeable of finance than ourselves (as a quick comparison of bank accounts will prove) seems to be that some of these groups are "too big to fail"; if they were allowed to collapse, they'd take our entire economy down with them.  We have to increase regulation and government intervention to forestall this possibility.

Don't we?

The great libertarian philosopher Ayn Rand wrote, "Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong."

Running from Bank Runs

Ever since the Great Depression, the government has operated the Federal Depositor's Insurance Corporation.  All banks which accept deposits from ordinary people are required to join the program and pay fees based on the deposit amounts; next time you go to your bank, you'll almost certainly see a bronze sign on the counter proclaiming it to be a member of the FDIC.

The FDIC, in turn, is backed by the government: its purpose is to guarantee the first $100,000 in each person's bank account.  Not many people keep more than this sitting around in the bank, so the effect is to mean that even if the bank fails, normal people won't lose their life savings, or their operating cash to pay for next week's groceries.

Bank failure used to be common.  Before the FDIC, a bank was only as strong as people thought it was.  If for any reason - real or imagined - depositors got the willies, they would run to their bank and withdraw everything they had there.

By the nature of the way a bank operates, such a "bank run" is automatic death to the bank no matter how well-run or fundamentally healthy it is.  In the movie It's a Wonderful Life, Jimmy Stewart's character George Bailey barely manages to survive a run on his bank, and gives this classic explanation of what a bank actually is:

You're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can. Now what are you going to do? Foreclose on them?

A well-run bank will always have a certain amount of cash on hand, obviously.  But the vast majority of its "deposits" aren't sitting in the safe, as George said; the money has been loaned out, at interest, to businesses and homeowners.  A loan is an asset, with a value, but can't be turned into cash instantly.  When people want to take cash out faster than the bank can turn assets into cash, we have a bank run.

This risk is inherent to the nature of a bank.  A bank run can be caused by events that the bank managers have no control or influence over, and which cannot be predicted; Mary Poppins portrays a fictional bank run caused by a misunderstanding between a small boy and the bank director over a tuppence piece.

Obviously, a bank run will ruin the owners of the bank and the reputations of its managers.  In the past, a bank run also ruined anyone who happened to have deposited money in the bank and wasn't lucky or quick enough to get it out when the run occurred.

In the Depression, this reality caused a cascade of bank failures: a weak bank's depositors would get concerned and start a run.  The bank would fail, and half the depositors would be left penniless.  Their neighbors would get nervous, and go to their previously healthy bank to withdraw all their money, killing that bank.

Then the people in the next town over would panic, run to their bank...  And so on down the line.  In theory, the entire banking system could be destroyed in a matter of weeks, as everybody tried to withdraw their money all at once, which is physically impossible.  The result would be... well, obviously, the Depression.

The FDIC ended this.  Since its inception, not one cent of depositor's insured money has been lost.  Banks have failed and been taken over by the government as happened to IndyMac Bancorp last week; their stockholders lost everything, and hopefully the managers will be fired.

But the depositors themselves will receive every cent due to them; if the bank doesn't have it, the FDIC will pay.  And there's never a run on the FDIC because it is explicitly backed by the Federal government.  It can't run out of money; the Treasury will supply as much as is required.  Precisely because of this, it never needs to provide very much, because everybody trusts that the money is safe where it is.

An F for Fannie and Freddie

Which brings us to Fannie and Freddie.  Like the FDIC, Fannie and Freddie are not ordinary companies.  They are Government Sponsored Enterprises (GSEs).

Unlike the FDIC, Fannie and Freddie operate from day-to-day mostly like any other financial firm.  The FDIC has a crystal-clear mandate: collect depositors insurance fees from banks according to an agreed-upon price list and pay depositors when banks fail.  Fannie and Freddie have a mandate too, but not quite such a clear one: encourage home ownership by making loans cheaper.

This is a problem.  The FDIC has an explicit backing from the government: by law, if the FDIC runs out of money, the Treasury will pony up.  Fannie and Freddie have an implicit backing.  This means that everyone assumes that the government stands behind them, and if you ask, the Treasury will wink and nudge - but the law doesn't actually say so.

What's more, the FDIC is chartered to do something which, by its nature, can only be done by government (because only government can print money at need); Fannie and Freddie are in the business of home mortgages, in competition with ordinary private banks that do the same exact thing.  However, they compete on the strength of their tremendous advantage of the implicit government backing they enjoy.

Because of this implicit backing, Fannie and Freddie can borrow money more cheaply than a normal financial firm, which lets them lend it out more cheaply too.  This artificial advantage is what has made Fannie and Freddie the Goliaths of the mortgage industry: they back somewhere around half or more of the mortgages in America.

This share has been growing because of the bad loans made by the private mortgage vendors; as companies like Countrywide go bust, obviously they aren't loaning money for mortgages anymore.  Thus we approach a situation where just about the only way you can get a mortgage is via government backing.

Hence, the newspapers are filled with people saying "We can't let Fannie and Freddie die!  It'll completely kill the mortgage market!  It'll collapse the housing market!  It'll cause a complete financial panic, and another Depression!  Nobody will be able to sell their houses!"  It's hard to argue against the doomsayers, because all that they predict is in fact true.

But we can't fix the problem unless we understand why it is true.  Why are Fannie and Freddie so essential?  Why are they too big to fail?  Why have they reached the point where we must we bail them out?

They have become essential, not because of lax regulation, but because of too much regulation.

You see, once upon a time ordinary banks wrote ordinary mortgages for ordinary people.  The banker had to use his judgment as to the creditworthiness of the individual.  If the banker made a loan that the borrower couldn't repay, he'd have to go to the trouble and expense of foreclosure; and if the house wasn't worth the amount owned, the banker would take it on the chin.

Naturally, mortgages were somewhat difficult to get; but they were reliable.  This kept house prices down, because most people could not borrow beyond their means.  You could borrow to buy just as much house as you could afford, but no more.

What caused the housing bubble and resulting crash?  People borrowing more than they could ever pay.  What sort of a fool banker will make a loan like that?  A banker who knows that he isn't going to be stuck with the loan, because he's going to sell it on to Fannie, Freddie, or some other ignorant investor, making it their problem.  Why didn't Fannie and Freddie worry about it?  Because they were backed by Your Tax Dollars.

What's more, as the great economist Thomas Sowell writes,

The practice of not lending in some neighborhoods was demonized as "redlining" and the fact that minority applicants were approved for mortgages only 72 percent of the time, while whites were approved 89 percent, was called "overwhelming" evidence of discrimination by the Washington Post...Laws and regulations pressured lending institutions to lend to people that they were not lending to, given the economic realities. The Community Reinvestment Act forced them to lend in places where they did not want to send their money, and where neither they nor the politicians wanted to walk.  Now that this whole situation has blown up in everybody's face, the government intervention that brought on this disaster in the first place is supposed to save the day.

Dishonesty on All Sides

Perhaps the most disgusting aspect to this whole affair is that for all these years, despite the implicit backing of the Feds, Fannie and Freddie operated just like ordinary companies.  Ordinary financial companies of their size invariably provide massive salaries and bonuses for their executives; Fannie and Freddie were no exception.

Americans don't mind people making massive piles of money as long as they are visibly at risk themselves.  There isn't too much anger at the fortunes of Bill Gates and Warren Buffett.  Most Americans recognize that they risked their own money and efforts; if Microsoft or Berkshire Hathaway had failed, Gates and Buffett would have spent their lives working in cubicles like everyone else and we'd never have heard of them.

Voters get a bit put out when executives take huge salaries when they aren't taking any real risk.  When Fannie and Freddie were making money, the executives and their cronies took home massive amounts, as did the shareholders.  Now that they are broke, are the executives suffering?  No... the taxpayer is on the hook.

That's not right.  And the inevitable, instinctive response that we see is: more regulation, please!

The root problem is that government meddling in the market, unless done in a clear and transparent fashion, invariably causes problems that lead to calls for more regulation.  Then those regulations cause other problems, which require additional regulation... and so on and on, until the government all but controls the entire market, as is perilously close to true with mortgages.

Left alone, this would never have happened.  The bad regulations have now caused a need for more regulation, in a perverse ratchet effect.  But it's absurd to think that government has to be involved in mortgages.  The commercial lending market operates just fine without a Fannie and Freddie.  What's so different about houses?

The purpose of regulations should be only to ensure transparency and probity, and to ensure that the risk is appropriately placed.  It's proper for the government to require banks' accounting to be clean and for mortgage lenders to be honest.  If there is fraud being committed, it's entirely correct for the appropriate agency to shut the bank down and hopefully send the dishonest executives to prison.

Since bank runs harm innocent, ordinary people, and the government is the only entity with the size and credibility to backstop the entire banking system, deposit insurance is also an appropriate job for the government.  But it's not only wrong, it's deeply unwise for the government to pursue social goals like increasing home ownership through tinkering with regulations or meddling directly in the market.

If the government decides to encourage or discourage something, it ought to directly and transparently tax, subsidize, or in some cases award a prize for it, so the costs and benefits can be clearly seen by all.  Meddling via regulation is attempting to do it on the cheap.  This might seem to work for a while; but the result is usually far more expensive in the end.

So what do we do now?  Yes, we have to bail out Fannie and Freddie; we've no choice.

Once we've done that, however, the Treasury needs to clearly state that, as of one year from now, Fannie and Freddie will be out of business.  No more mortgages will be underwritten; no more backing will be provided.  The existing mortgage assets they have will be auctioned off to whichever bank wants them for whatever revenues can be raised; this will go to offset the taxpayer's investment.  Shareholders and executives of Fannie and Freddie will get nothing - after all, a bankrupt firm shouldn't be rewarding those who put it into bankruptcy in the first place.

Then, we can move forward as we should have been doing all along: with ordinary civilian bankers making their own judgments regarding making loans.  The housing bubble has popped.  This is painful for people who borrowed more than they can afford; but you're not supposed to do that.

For house prices to plummet is a great thing for all those young families who cannot afford homes and never could at the inflated prices of a few years ago.  Don't worry: the houses will be bought, the market will clear, and life will go on - without the elephant in the room.

We need to break the addiction of government meddling through regulation.  There will be some pain, but we'll be far healthier for it in the long run.