MAPLETON, UT | July 22, 2008 | Recently, two names have been plastered across headlines so often you’d be forgiven for thinking they were the latest hollywood pair. Their celebrity status has been cemented by constant mentions in the top news programs, length pieces on their life history, and endless gossip and rumors about their sudden fall from grace in the current housing crisis.

They are the 800-pound gorillas of home ownership: Fannie Mae and Freddie Mac, the biggest owners of mortgages in the country.

In order to understand how such trusted institutions could sink to the notoriety of tabloid fodder, shocking the country with revelations of their default-ridden mortgage portfolios, let’s use an imaginary example. While it is helpful to study their historic origins, a hypothetical situation will demonstrate the cause of their tragic fate…

Imagine you started a company that loaned money to people. In order to raise capital, you pitched your business plan to potential investors, who would be interested in knowing how you would manage the risk of borrowers defaulting on their loans. If you were like every other private company, you would provide a effective strategy that would reassure your investors of the relative safety of their investment. Obviously, no plan would be foolproof, thus investors would determine if they valued the potential gains more than the potential risk of defaults that could cause your business to fail and their investment to go up in smoke.

Now imagine that next door, a new business is formed to provide the same service, only this one makes a unique promise to investors: if for any reason they fail to operate profitably, they have access to financial reserves unlike any other –  an enormous pile of cash replenished annually by every taxpayer in America (not to mention a fine collection of special printing presses). Other companies might have large insurance policies, or additional streams of revenue, but what could compare with the ability to extract money from millions of people under threat of force?

Which company do you think will attract the most investors over time? Which company would possess a nearly unlimited ability to increase their loan portfolio? Which company do you think will eventually cease to exist, leaving its competitor to absorb nearly the entire market for lending in America? Which would you choose if you were the investor?

In a free marketplace, where force was only used to punish fraud and enforce contracts (and not reassigned to the job of eliminating risk), the growth and success of any financial services company would be directly tied to their ability to demonstrate fiscal responsibility and profitability over time. They would be limited in their ability to raise capital in that all funds would have to come from voluntary sources – no guarantee other than that of their capability to manage risk and operate profitably would be possible. Such a company would have a vested interest in carefully scrutinizing every transaction, knowing that their very future depended on it. No investor would voluntarily invest in a company that had a reputation for poor stewardship.

But a company with the advantage of an armed, wealthy godfather like the one in our story has no such incentive to personally insure the solvency of its business. Additional funds could always be extracted from taxpayers, who had no say in the matter (and thus had no interest in evaluating the safety of their “investment”). There would occasionally be complaints and concerns, voiced in committee hearings, but other than enduring some boring meetings, no real threat would be posed to the existence of the company. Even the bureaucrats, prodded by their angry constituencies would be unable to stop feeding the unprofitable beast  – especially now that the company is “too big to fail”.

And thus another naturally corrective process would be suspended by force: the process of failure, in which losses are experienced, lessons are learned, and ideas are re-evaluated. In an attempt to avoid the pain, the benevolent godfather would step in and make the consequences of the original bad idea seemingly disappear (through another violation of principle).

Some are crying that Fannie Mae and Freddie Mac were originally “good” institutions, created for the purpose of helping the poor and underprivileged acquire home financing they would not otherwise have qualified for. Ironically, the very violation of principle that made those companies so attractive in the housing market (reducing risk by promising security with funds taken by force, thus removing the possibility of failure) made them appealing to everyone in the housing market – and reduced the incentive for Fannie and Freddie to be more careful about the risk they purchased so rampantly. Even if Fannie and Freddie never purchased a single sub-prime loan, their very existence as an unlimited source of funds had an enormous effect on the availability of easy money for home financing, which in turn influenced the rise in real estate values that was the enabler for much of the speculative and sub-prime transactions in recent years.

By creating a company that was perceived to be protected from the risks that would challenge any private mortgage buyer or insurer, a distortion was created in the marketplace. Such a company has an artificial advantage, having the sanction and protection of the only entity in America with the legal power to use force to provide funding for its endeavors – the U.S. government.

In a recent article in the New York Times, the following explanation was given:

The case against Fannie and Freddie begins with their peculiar status: although they’re private companies with stockholders and profits, they’re “government-sponsored enterprises” established by federal law, which means that they receive special privileges. The most important of these privileges is implicit: it’s the belief of investors that if Fannie and Freddie are threatened with failure, the federal government will come to their rescue.This implicit guarantee means that profits are privatized but losses are socialized. If Fannie and Freddie do well, their stockholders reap the benefits, but if things go badly, Washington picks up the tab. Heads they win, tails we lose.

Such one-way bets can encourage the taking of bad risks, because the downside is someone else’s problem. The classic example of how this can happen is the savings-and-loan crisis of the 1980s: S.& L. owners offered high interest rates to attract lots of federally insured deposits, then essentially gambled with the money. When many of their bets went bad, the feds ended up holding the bag. The eventual cleanup cost taxpayers more than $100 billion.

This particular author, who clearly describes the contradiction inherent in the business model of Fannie and Freddie, is nevertheless adamant that they should not be allowed to fail. Despite his articulation of the system of “privatized profits and socialized losses”, he acknowledges no violation of principle, and advocates continued support of the flawed enterprises, while blaming greedy speculators for dragging down the whole housing market, and causing defaults in the “good mortgages” that Fannie and Freddie hold. In other words, no one would have noticed that the emperor has no clothes if it wasn’t for everyone else losing their shirts.

The only thing the current crisis has done to Fannie and Freddie is reveal the fatal flaw in their very foundations. It has simply sped up a process that cannot be stopped, only delayed. Violating principle, even for a “good cause” has consequences that cannot be avoided, but are often hidden from view for years in an attempt to defy reality. The very birth of Fannie Mae and Freddie Mac, as institutions wishfully set apart from the rules that would govern every other private endeavor, held the seeds of their own destruction.

Many critics today cry foul at lenders who provided the “easy money” to those who they claim should never have been given money due to their “sub-prime” status – in other words, the likelihood that they would default. What they forget is that those lenders and the investors that supported their efforts are now paying the price for their decisions. Loss is the natural consequence of their bad ideas. In an attempt to ease the pain of loss, little tyrants everywhere are calling for regulations to keep people from making such “risky” investments. But government has no place telling people how to invest their money. Such efforts to revise government regulations would be better spent removing the poison in the well that perverted the minds of irrational investors – those institutions that stood as the bastions of the illusion of security in the housing market, Fannie Mae and Freddie Mac.

Action Steps

1. Learn more about how Fannie Mac and Freddie Mac were formed and what their role is in the housing market. Learn about how the mortgage market works, how liquidity affects it, and what 
2. Write your Congressmen and Senators to express your opinion of a taxpayer bailout of Fannie and Freddie – include your view of the violations of principle involved in the current situation and the very existence of the institutions.
3. Share what you have learned with your friends and family. Teaching principles helps us to live by them, as we strive to advocate principles effectively.

MRFC Principles:  (5,6,7,8,12)

Sources

Julie Creswell, Protected by Washington, Companies Ballooned, New York Times, July 13, 2008.

Making Sense of Problems at Fannie and Freddie (informative graphic showing how Fannie and Freddit supply liquidity to the mortgage market), New York Times, July 11, 2008.

Paul Krugman, Fannie, Freddie and the Threat of Economic Meltdown, New York Times, Reprinted on alternet.org, July 15, 2008.

Paulson: Support for mortgage giants needed, MSNBC, July 22, 2008.