A comment on the GSEs


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.

What really caused the financial crisis (Wall St walked off with securitization sans regulation)

The best way to get a handle on the causes of the financial crisis is to read two books, one a little hard for the lay reader, the other not at all—Gretchen Morgenson and Joshua Rosner’s Reckless Endangerment is a fun read; the Financial Crisis Inquiry Commission Report more of a slog—but still a barrel of monkeys for lawyers, accountants, and crisis aficionados. For a government report it is a veritable tour de force (if not as page-turning as The Starr Report).

Some in Washington want to pin blame for the financial crisis on “Fannie and Freddie.” To be sure, these State Owned Enterprises are a part of the story but it is grossly misleading to blame them, or laws like the Community Reinvestment Act, as the “cause” of the crisis. The FCIC Report found that the bad loans generated by these initiatives comprised an insignificant portion of all faulty loans, and that Fannie and Freddie’s loan standards, while joining the general lowering, were higher than the rest of the market. Fannie and Freddie are at the root of the crisis only in the broad, historical sense that we inherited them and the reality they reconstructed from the New Deal—not because during the 80s (Reagan) or the 90s (Clinton), as the partisans say, these companies ruined lending standards. In fact, Fannie and Freddie were the last gasp of holding lending standards up. Unless you believe in a purely literalist, fundamentalist sense that no government is the best government, and that this has been and always will be true at all times and in any and all circumstances, Fannie and Freddie were not the cause of the financial crisis—certainly not its proximate cause.

There is much to dislike about how Fannie and Freddie were run. As Reckless Endangerment recounts, in 2006 America discovered that Fannie was flagrantly violating the rules for public companies—having cooked the books and massaged their financials through the (no) good auspices of Goldman Sachs. Fannie’s richly paid CEO, Franklin Raines, seems not to have understood basics about how public companies are supposed to operate, putting in question the rationale for his massive executive comp. How could this be? By 2006, Fannie and Freddie had long been public companies. Originated as government programs, they just continued on as such, with all the lawlessness (l’etat, c’est moi!) inherent in all government action, particularly when government processes become disconnected from a commitment to the public good.

By definition a government program is not a business. It is a subsidy. Government programs do not function by market logic or subject to market discipline. They are the “nation.” They are backstopped by the taxpayer by simple legal pronouncement. Their liabilities are potentially a dangerous blank check.

Reckless Endangerment shows how Wall Street, in theory a market disciplined machine, gradually took on the essentially lawless character of Washington, especially its hardball political tactics. Wall Street proceeded to reform the securities laws to wipe out that aspect of its public utility function for the country that was interfering with their profit maximization. They had good cover, because the glut of banking, securities, commodities, and insurance laws and regs in fact did need significant updating—had for decades in light of the vast changes in finance, particularly its gargantuan aggregation (having evaded antitrust scrutiny during a period in which antitrust was unpopular), and most consequentially, computerization.

Like any good empirical scientist, Wall Street observed Fannie’s operations closely—and quietly replicated it. Yet Wall Street knew it was subject to the securities laws in all enterprise packaging operations. Wall Street is the world’s expert on the securities laws. Fannie, by contrast, as a government operation (yet now, confusingly, a “public company” that nevertheless did not operate as one), had not been. Fannie securitized but had forgotten why. Having been coded to do what it did, it just did it. Originally, to FDR, mortgage securitization was national insurance, a post-Depression development program set in place for the nation—for, and structured to be strictly limited to, small savers and homeowners. Limitation of its potential costs to the taxpayer was one reason for the stovepiping of all the laws, which formed subject matter boundaries around, in effect, business operations. This stovepiping would later become obsolete and confused, with large but hidden economic consequences.

Apart from unregulated securitization, Fannie’s process also revolved around political fixers and tactics to get whatever it wanted when it wanted it—hiring the best schmooze operators to grease wheels by hook or crook. Pure politics is Standard Operating Procedure for government bureaucracies. They survive in this way by nature, and one can’t really blame them for that—it’s the nature of the beast. The good will of government is supposed to take care of ethics. No market discipline is present, or required, in government.

The other component of this witches’ brew is that Congress today does not seem to take its job seriously as an intellectual matter. Its staffs are quite adroit at p.r., and word spinning, and general b.s., but complicated business and legal legislation requires a more sophisticated level of competence. Big banking is about as complicated as it gets, requiring expertise in many difficult areas of law. Complexity serves the banks’ (and lawyers’) purpose—that of obscurantism, and hours churned.

Yet legislators today are famous for not even reading the laws they advocate. They will not parse the creative sophistry a sentence may engender in the future, or a law’s potential for unintended consequences, or the interactive effects with other laws outside the categories of the one presently under discussion. Congress rarely if ever revisits a law after it is passed to assess its failures, its negative impacts, with an eye to revision. Their egos prevent them from ever admitting error of any kind. Congress focuses on “results” in the form of numbers of photo ops, the inspirational spin of the words in the press release describing each latest national legal panacea. It is a sort of “volume sales” approach to the law, ironically echoing the attitudes today of banks toward lending, or that of the police in 1960’s toward convictions (leading famously to ignoring drug kingpins while padding prosecution numbers with hordes of inconsequential street dealers). The media then lap up such press releases with little analysis or skepticism apart from tacking on what they today consider to be “selling” left-right narratives. More fodder for the daily copy grind.

Marketing was the true rocket-science fueling the “masters of the universe” over the last 20 years—that and computerization. What slogan pleases the ears of Republicans? Easy: “deregulation.” What pleases Democrats? “Housing for all.” Slam dunk. Wall Street rolled Washington with its favorite taglines and a fantastical promise of ever-expanding national wealth through securitization without end. A growth industry in financial innovation, with no limits! Wall Street profits seemed to validate the new, claimed reality. For politicians it was easy to believe the claim of the “rocket scientists” to have discovered the goose with golden eggs. Breathless paeans in the press to financial innovation and the magic of code glittered up Wall Street’s dog and pony show, probably adroitly manipulated by Wall Street’s p.r. efforts, since they have the cash to afford the best. Some individuals knew the truth, but they weren’t talking. The longer it all went on, the more money they’d make, in one form or another (legal fees, big shorts).

Wall St. is in fact a public utility. You can tell it’s a public utility just from the mass of regulations around it—a mind-blowing panoply of banking, securities, antitrust, housing, commodities, insurance and (even) gambling laws overseen by dozens of regulatory bureaus. The “regulators” almost never do anything cross-disciplinary or “systemic.” By definition what they do is bureaucratic and routine. If the regulatory alphabet soup were even asked to coordinate among themselves, they might have no time left over for their regular chores. Creative systemic oversight isn’t something it is even reasonable to expect of most bureaucrats.

As a public utility, what Wall Street does never strays far from what government says it’s supposed to do.

What this means is, if Wall Street is being evil, then government is necessarily complicit.

Deregulation had been botched early on. It was grossly irresponsible of Congress to pitch Fannie and Freddie into the private sector and let Wall Street just ape their processes without scrutinizing the precise economics. It was absurd for the government and the Fed to just blithely assume that Fannie and Freddie’s operations were honed by sound economics. (A mental error that too much study of pure theory such as the efficient market hypothesis can sometimes trick the literal-minded into.) Fannie and Freddie had never been in the market, and their operations had never been subjected to any market rationality or sustainability screens. Fannie and Freddie were never conceived as an investment bank to package and resell mortgage backed securities to begin with at all, but a national insurance pool to be run as a government monopoly. Fannie/Freddie’s actuarial risks had never been evaluated because the US simply stood behind them, come what may.  The taxpayer paid for this as a straight subsidy to the banks and to homeowners through the banks. And for the 1930’s, it worked beautifully: ordinary terms for mortgages improved tremendously for people as a result of this government subsidy: from 50% down and 5 years to pay in the 1930’s, to the 20% down and 15-30 years to pay of today. (See Raghuram Rajan, Fault Lines.) But no racket works forever.

With FDR’s subsidy, banks could grow very large. Banks also shifted their focus from evaluating loan quality in competition with other banks to generating maximum loan volume. For generations, the banks reaped huge financial benefits from the US government’s willingness to stand as ready buyer of all mortgage debt the banks could generate. But the system also bred a laxity that later would have grave consequences.

“Deregulation” as a slogan invited Wall Street to cheat Congress. Instead of wise, fully thought through regulatory reform, ideally involving massive simplification—blinded by the law’s very clutter—Congress and the regulators let Wall Street persuade them to “deregulate” the securities laws’ core—antifraud. This was accomplished less by any one legal smoking gun, but by indirection, a strategic progress by which key facts were at the right moment hidden, or masked, and dropped between stools. The arrangement of the stools itself had become obsolete, permitting a game of hide and seek by all manner of mischief-makers.