Michael Hudson, Why the Bail Out of Freddie Mac and Fannie Mae is Bad Economic Policy

The Democratic congress pushes for American families to pay higher home prices

Congressional banking committee heads are simply behaving as politicians traditionally do by giving priority to their major campaign contributors in the financial and real estate sectors. Led by Democratic senators Charles Schumer from Wall Street and Christopher Dodd from Connecticut’s insurance industry, and supported by Congressman Barney Frank from the real estate sector, Congress is seeking to bail out the bubble’s sponsors, not its victims. The plan is to re-inflate the housing bubble at least long enough for the largest banks and other financial speculators to dump their riskiest holdings. Book values on these mortgages – and the real estate that backs them – are purely fictitious, despite the AAA whitewash from bond-rating agencies which themselves are now under investigation for the fatal Arthur Anderson-style conflict of interest between their research and sales arms.

Dealing as they do with real estate, and hence with local urban politics where most of the property values and maneuvering occur, Fannie Mae and Freddie Mac are largely Democratic creations. James A. Johnson ran Fannie for most of the 1990s and was its main lobbyist. Until June he headed Barack Obama’s vice-presidential search team, but resigned when it was revealed that he got mortgages on unrealistically favorable terms from Angelo Mozilo’s notorious Countrywide Financial. FNMA’s former head, Franklin D. Raines, was President Clinton’s budget chief. He was forced to step down when serious accounting problems were discovered. Other Fannie apparatchiks include Jamie Gorelick, former Clinton deputy attorney general, and Thomas E. Donilon, Clinton chief of staff to the secretary of state.

To be sure, political opportunism leads Fannie and Freddie to cover all the bases, becoming known for hiring relatives of powerful politicians wherever they may be in a position to help. But at least this time the problem is not George Bush’s fault. The Wall Street Journal seems closer to reason than the Democratic Congress. Over the weekend its editorial clarified what socialists since Marx have been saying: “What taxpayers need to understand is that Fannie and Freddie already practice socialism, albeit of the dishonest kind. Their profit is privatized but their risk is socialized.” Calling FNMA and Freddie “high-risk monsters,” the newspaper noted that “Wall Street and the homebuilders also cashed in on the subsidized business, and also paid back Congress in cash and carry.” It concluded by questioning whether these government-sponsored enterprises (GSEs) were justified at all. “Apart from outright failure, the worst scenario would be a capital injection that left the companies free to commit the same mayhem all over again two or 10 years from now.”

In a separate article the Journal noted that, “On a fair-value basis, the company [Freddie Mac] had negative net worth of nearly $17 billion.” The problem is that there is no “market” – that is, no supply of equally gullible buyers – to take on these bad loans, except at distress prices. Through short-term greed and incompetence, the home-debt industry has pawned off highly debt-leveraged mortgage loans drawn up from fraudsters. They can’t be called crooks exactly, because instead of being indicted, they have been rewarded with tens of millions of dollars in bonuses for making so much money as debt innovators for the finance, insurance and real estate sectors.

Their place is to be taken by the government as bad-debt buyer of last resort. I suppose this might be called Finance Socialism – the stage at which it becomes necessary to rescue Finance Capitalism, at least its largest institutions (“too large to fail”) at the top of the economic pyramid. Or it might be called “real estate finance capitalism.” But in Washington-talk it is euphemized in the Democratic Party’s usual populist garb as “democratizing property” and “increasing homeownership,” by which is meant indebting a rising share of the population to the point where carrying their mortgage absorbs most of their disposable personal income.

Can a new real estate bubble be inflated?

The fact remains that like every financial bubble in history starting with England’s South Sea Bubble and France’s Mississippi Bubble in the 1710s nearly three centuries ago, today’s bubble has been sponsored by the government. Forget the “madness of crowds” free-market propaganda. Insiders and enabling politicians always try to blame the victim. The reality is that Fannie, Freddie and the FHA gave a patina of confidence to irresponsible lending and outright fraud. This confidence game led them to guarantee some $5.3 trillion of mortgages, and to keep $1.6 trillion more on their own books to back the bonds they issued to institutional investors. Their strategy has been to issue bonds paying fairly low interest rates, and use the proceeds to buy mortgages yielding somewhat higher rates. This kind of interest-rate arbitrage is what the S&Ls did in the 1980s – a relevant parallel, as I will discuss below.

The myth is that Fannie’s and Freddie’s role is simply to spread homeownership by making it affordable for more of the population. Fannie Mae was established in the Depression, in 1938 as part of Roosevelt’s New Deal, and privatized in 1968. Freddie Mac was established two years later, in 1970, to buy up S&L mortgages and give “liquidity” to their mortgages, by developing markets beyond the banks and S&Ls that originated these loans. But this turned out to be the “original sin,” so to speak. Non-bank investors were obliged to place their trust in the mortgage originators – banks, S&Ls and mortgage brokers, whose ranks are filled with fraudsters and crooks.

Whatever we may call it, their dream is to bring back the seeming golden age sponsored by Alan Greenspan at the Federal Reserve. It was a decade of quick mortgage billionaires writing fictitiously high mortgages and selling them off to pension funds and to German and English bankers eager to seek a few extra fractions of a percentage point in current income so as to justify a big bonus by claiming to outperform more reality-based money managers.

All this is as American as apple pie. Altruistic political talk aside, the reason why the finance, insurance and real estate (FIRE) sectors have lobbied so hard for Fannie and Freddie is that their financial function has been to make housing increasingly unaffordable. They have inflated asset prices with credit that has indebted homeowners to a degree unprecedented in history. This is why the real estate bubble has burst, after all. Yet Congress now acts as if the only way to resolve the debt problem is to create yet more debt, to inflate real estate prices all the more by arranging yet more credit to bid up the prices that homebuyers must pay. The plan is thus to pretend that the Bubble Economy’s financial unreality may be made real by Finance Socialism.

Can the plan work? The reason why Fannie and Freddie have been able to borrow at lower rates than their rivals is because their public sponsorship led investors to believe that there was an implicit public guarantee not to let them fail. And in view of the fact that these two agencies account for some $5 trillion in mortgages – nearly half the nearly $12 trillion U.S. home mortgage market – they do indeed seem to be “too big to fail.” The face value of mortgages they have guaranteed is nearly as large as the entire U.S. federal debt held by the public. This means that the nominal federal debt would double if they went under. But at least the government can always print money, while the real estate backing the mortgages guaranteed by Fannie and Freddie (or held in their own accounts) is plunging in price into the dreaded Negative Equity territory.

But on their shoulders ride the hope of re-inflating housing prices to bail out the financial managers who sought to make money by debt creation rather than tangible capital formation. So the question is whether housing prices can be raised to a level that oblige families to run into even more debt than they now are carrying – with even lower down payments, subsidized at public expense.

In this case the subsidy would not really be for homeowners at all, but for the financial system’s mortgage holders. The aim would not be to make housing more affordable, but less so, because the debts would be larger!

Most investors view the situation as being more political than strictly economic. One hears again and again these days about the “implicit” government guarantee to make good on the bonds Fannie and Fred issued to fund these junk mortgages. Its constant repetition reflects the anxiety that bondholders feel about how sound their bond holdings really are. (The stocks of Fannie and Freddie have now plunged to less than 10 percent of their former highs. Investors obviously expect their equity to be wiped out, a la Bear Stearns.)

The word “implicit” means “not explicit.” There is a tantalizing hint of what might be, but does not yet exist in a legal sense. Financial free lunchers on Real Estate Finance Capitalism claim to be innocent victims of an “unexpected” bad turn in the market. (Bad news always is “unexpected” as far as financial spokesmen and media reporters are concerned, just as Claude Rains was “shocked, shocked” to find that there was gambling going on at Rick’s Café.)

The distinction between implicit and explicit may be too philosophical for most money managers who work in the financial institutions that have bought Fannie Mae and Freddie Mac bonds and packages of junk mortgages. Most of these apparatchiks don’t need much of an education. All they need is greed, and that can’t be taught. It is an addiction – and on Wall Street it lives in the short run, from one annual bonus to the next.

Wall Street bonuses are based on how well one “performs” relative to the norm – a Treasury bond’s rate of return, or the average mutual fund or money market fund. Anyone can out-perform these averages simply by buying the most risky and hence highest-yielding bonds around.