Everyone has missed the point.

When invented, Fannie Mae seemed to legitimize the process of mortgage securitization. Later, Wall Street walked off with that process. In doing so it also walked off with Fannie’s exemption from the securities laws. It now was allowed to “compete” with Fannie. This really was not competition. It was a cartel, all members of which emulated a single business model, originated by the government.

Fannie was a national mortgage insurance program, meaning a government-run monopoly. Laudably, FDR intended it to prop up small banks and homeowners after the Depression by massively loosening the credit then available to homeowners. Wholly appropriate at the time. Back then, home mortgages typically required half down, and full payoff within 5 years. Then, in 1968, Fannie was “privatized” by LBJ in a cynical effort to get it off the government’s books to make room for the Great Society and Vietnam.  By 2006, Fannie was found to be trying to manipulate its earnings. The GSEs were now just market animals, emulating the rest of Wall Street. Simultaneously they took their role as government agencies seriously. Yet now, this dual role was conflict of interest. In evaluating the risks to the system at large, Fannie’s corrupt acts in 2006 were probably a self-preservative response to the building risks it saw in the system. Regulatory agencies such as SEC and CFTC were fully engaged with rote institutionally inherited chores. No forest seeking through obstructive trees going on there. Buck passing and bureaucratic games, as usual in large firms, held the priority.

The implications of Wall Street’s walking off with Fannie’s process seems to have gone unnoticed.

The government has a duty to ensure the integrity of the overall markets and regulate them appropriately. These are the securities laws. These laws beget others like the commodities laws, which are different enough from securities to have their own regulatory package. Are our government level regulators attentive and skilled enough today? Wall St. hasn’t much incentive to blow whistles on themselves, much less shoot their profits in the foot. Mortgage packaging was enterprise formation. Critically, it was not being done at arms’ length. The packager had no incentive to inspect the quality of the stuff in the package. It was just a flip. All risk could be offloaded, and fees simply collected. What a racket!

Fannie itself originally could package debt securities safely because at the time it was created it was a monopoly. Also, systemically, all of the risks of the 1930s were super low, given credit conditions then as compared to today. But the public at large is still on the hook. The privatization of the GSEs in the 1960s just turned the mortgage packaging monopoly into a cartel. This is very far from pure theoretical free markets under conditions of infinite competitive diffusion.

In copying Fannie’s business model, Wall Street’s derivatives products priced slightly higher to account for higher risk. What did this reflect? Fannie’s greater likelihood of government guarantee—its greater crony intimacy with its fellow Washingtonians. But as Wall St. has discovered in recent decades, crony intimacy with Washington can be replicated. By them.

How to get the rules right? And how to ensure that they are followed? Markets have to have rules. Right structure, competent government oversight and most important, enforcement of the rules, plus adequate disclosure and thus, informed consent in the making of contracts. These are the basics. The more detailed you get, the more your rules require tweaks to fit particular alternate circumstances. Our markets were set up to be suckers after the long sleepy ride with the Good Housekeeping Seal of approval of the GSEs. In reality there is a lot of fraud and junk everywhere, and it is not at all clear that government is keeping up with it in any respect whatsoever.

Regulation is to correct imperfect markets. But sometimes the cure can be worse than the disease. Cures have side effects, i.e., unintended consequences. Monopoly is the classic “imperfect market” that requires checks and balances, usually in the form of regulation. But regulation has its limits. It can work well in some situations, but not others, particularly if it tries to rig outcomes or there is too much of it.

Too much power generates abuse. Unfair trade practices are one example. Complicated law is also hard to enforce. Markets work in conditions of either liberty or constraint. Either way they need to have a stable backdrop of rules that don’t fluctuate wildly, because this changes outcomes unfairly—people expect to rely on rules that are broadly consistent and fair. America has a solid common law foundation, but also so much legal complexity that everything becomes hard. And expensive. Regulators are often behind the curve. They are hard to replace. Their replacements might not be better, they might be worse! In general, bureaucrats tend not to be big thinkers and not to be entrepreneurial. They don’t like change.  Even Brooksley Born could not trigger any change despite solid effort. Sometimes government works at cross purposes, or duplicatively, inefficiently or wastefully.

As a very young law associate in NYC, I was once tasked to explain for the CFTC, “What Is a Security?” I spent the summer of 1981 on it. The question was whether the new derivatives that Wall St was in the process of dreaming up (futures on options and vice versa) were securities.  Given the broad antifraud intent of the law as structured to deal with the issues raised by the Depression, I said they were, and that they needed large scale regulatory thought by the government.  I was told later by a junior partner of the firm that my interpretation had touched off a fight between the older partners and the younger ones eager to speed off to make big bucks on Wall St. It was a go-go period in the markets at the time, and the memo held plenty of wiggle room since deregulation was all the rage then.

You can’t very well try history and bad policy in retrospect, in courtrooms.  And you can only fix what’s broke when it breaks. The government took responsibility for the markets in the early 1930s, so it had to fix what went wrong with them that came to a peak in 2008. Wall St. copied the government model (of monopoly). Congress pretended to restore competition in 1968. But it was still a monopoly, just now in the form of a cartel. Congress seems to have lost adequate understanding of the larger meaning of the securities laws. Instead it just abandoned the task of regulating to newly cocked up “markets” that were in fact malstructured and in some cases improperly, even dangerously, rigged.  Wall St. might have behaved honorably and blown whistles on itself, but from its point of view, why should it? Rent-seeking, after all, is its middle name.

Where Republicans go very wrong is in thinking that mere declarations of a return to free markets is somehow self-executing. There Democrats have a point in directing a hate routine at them except that I don’t trust any of them to be anything other than Marxist-Leninists or self-appointed celebrities these days. You don’t have people in that party like Daniel Patrick Moynihan anymore. More likely you get the pattern seen in the collapse of the USSR—a handful of oligarchs running off with pieces of the government’s former exclusive business.

Where the few remaining sane and moderate Democrats go wrong is in thinking that for every perceived market failure, there is a new law that must be passed to correct it. All they are doing at this point is making a mess. To wit, Obamacare.

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