Tuesday, August 17, 2010

Fannie Mae, Freddie Mac and the Future

Earlier this year a friend of mine and his wife got a mortgage on their new home. (As of today, they have only been married three hundred and fifty-three days.) Let me just say that the price of their home is well into the six figures. They borrowed twenty percent of the purchase price. Both of them have established, on their own, a credit rating of at least A and they pay off all of their revolving credit every month.

About two months after signing the mortgage my friend came to see me. He could not believe that his mortgage was now owned by Fannie Mae! Never in his lifetime did he expect to have a mortgage of his owned by this organization!

But, this is a part of modern America. It is a part of the whole effort by government for people to own “things.” Owning “things” in America is good! Monarchs and other royalty owned “things”. The evolution of the wealthy capitalist included owning “things.” It became the right of every American to own “things.”

And, this desire to own “things” played right into the hands of greedy politicians because politicians could promise to deliver “things” to the people that elected them and thereby get elected and re-elected. In the twentieth century, the “thing” of most importance was a home of one’s own. After all, the number one job of a politician is to stay in office! (http://seekingalpha.com/article/219804-wall-street-greed-vs-washington-greed)

Talk about financial innovations. The United States government is one of the most prolific financial innovators the world has ever seen. Just look at the last one hundred years: savings and loan associations, the Federal Home Loan Bank Board, the Federal Savings and Loan Insurance Corporation, the Office of Thrift Supervision, the Federal National Mortgage Association, the Federal Housing Authority, the Department of Housing and Urban Development, the Federal National Mortgage Association, the Government National Mortgage Association, the Mortgage-backed security, and so on and so on.

The surprise is that Fannie Mae and Freddie Mac don’t own more mortgages than they do!

Government programs based on achieving outcomes generally fail. There are two reasons why they fail. First, the goals and objectives of programs focused upon outcomes are generally not based on economics but are based upon achieving desired social consequences. Second, if a program seems to contribute in any way to politicians getting re-elected, more and more resources will be put into that program going forward.

“Popular” programs based on outcomes seem to grow exponentially as each party seeks to “out-do” the other in promising even more to more people. The underlying economics of the situation do not seem to play any role in the cumulative expansion of such programs.

How can people improve things when they tend to hold onto the “old” assumptions? This is a very difficult problem. We see the tip of the iceberg in the column by Andrew Ross Sorkin, “2 Zombies to Tolerate for a While,” in the New York Times (http://www.nytimes.com/2010/08/17/business/17sorkin.html?_r=1&ref=business) where Sorkin discusses what Congress should do about Fannie Mae and Freddie Mac with Congressman Barney Frank. To Frank, Congress has acted as it should have, well maybe a little later than it should have, but things are under control now. The point being: “money is not being lost by anything they (the agencies) are doing now.” The Congressional Budget Office says that taxpayers could absorb almost $400 billion in losses over the next decade, but, to Barney Frank, this is a result of what has happened in the past. Therefore, the agencies just need to be put on a working basis to go forward.

Yet, this doesn’t get at the fundamental issue which has to do with Americans owning “things”. As long as the focus of the government doesn’t change, the problems will not be resolved.

Again, Congress seems to be fighting the last war. As with the financial reform bill that has just been passed by the Congress (http://seekingalpha.com/article/213263-financial-reform-ho-hum), efforts to reform the housing agencies just aim at preventing what has happened over the past ten years or so. It does not deal with the fundamental issue of what it is trying to achieve (the goal itself) and whether or not this goal can be achieved.

However, the world has already changed and will continue to change.

For one, the world is changing at a much faster pace than it did a decade or two ago. Technology, for one, is changing at an ever increasing pace. People do not stay in the same place as long as they did in the past. Families are more divided geographically than ever before and one out of every two marriages ends up in divorce. Small- and mid-sized businesses rise and fall, grow and are sold, and expand and contract. Many people argue that owning “things”, especially “things” that cost a lot of money, will not be as attractive in the future as they have been in the past. The spending (leasing and renting) habits of Americans are changing.

In finance, the environment has also changed over the past fifty years. The whole idea behind the mortgage-backed security was to generate more cash going into the housing market by creating an instrument that pension funds and insurance companies would hold to match their liabilities thereby getting mortgages off the balance sheets of depository institutions, the originators of the mortgages. The idea was that these latter organizations could then create more mortgages.

This effort was based upon a “static” model of how financial intermediaries worked. With the inflation of the 1960s and 1970s, the model for financial intermediaries changed and became more “dynamic” in nature. By the second half of the 1980s, mortgage instruments became the largest component of the capital markets and the volume of trading in this sector was huge. Trading in mortgages became the most spectacular and volatile part of the capital markets.

With the growth in the number of other mortgage instruments, securitization, and derivative instruments, the mortgage finance industry became one of the hottest things around. This was not something the creators of mortgage-backed securities in the late 1960s expected. And, as with other areas experiencing financial innovation, new and more wonderful instruments can still be expected.

Congress continues to work with a “static” model of financial institutions and a perception that people will continue to focus on “things”. Both are wrong!

As a consequence, whatever Congress creates out of Fannie Mae and Freddie Mac, financial incentives will be set up so that people can “game” the system and take advantage of the efforts Congress makes to attain its social goals.

Maybe one day the government will own all the mortgages on all the homes in America. Some people may think that this would be a good thing. On the contrary, it would be just another story of the less well-to-do paying for the pleasures of the more well-to-do.

Who do you think is going to bear the burden of the almost $400 billion cost of Fannie Mae and Freddie Mac the Congressional Budget Office projects? Certainly not the wealthy. Why is it so hard for the people in government to see that the wealthy have enormous resources available to them to protect their incomes and wealth. The less-well-off do not have those resources. Consequently, over time, the burden falls upon the latter even on the programs designed to help them.