Paul Krugman: Fannie, Freddie and You

Paul Krugman says Fannie and Freddie won’t bring down the economy, and they did not cause the difficulties they are experiencing, but that doesn’t mean they don’t have problems such as under-capitalization:

Fannie, Freddie and You, by Paul Krugman, Commentary, NY Times: And now we’ve reached the next stage of our seemingly never-ending financial crisis. This time Fannie Mae and Freddie Mac are in the headlines, with dire warnings of imminent collapse. How worried should we be?

Well, I’m going to take a contrarian position: the storm … is overblown. Fannie and Freddie probably will need a government rescue. But since it’s already clear that that rescue will take place, their problems won’t take down the economy.

Furthermore, while Fannie and Freddie are problematic institutions, they aren’t responsible for the mess we’re in.

Here’s the background: Fannie Mae — the Federal National Mortgage Association — was created in the 1930s to facilitate homeownership by buying mortgages from banks, freeing up cash that could be used to make new loans. Fannie and Freddie Mac, which does pretty much the same thing, now finance most … home loans…

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 … threatened with failure, the federal government will come to their rescue.

This implicit guarantee means that profits are privatized but losses are socialized. … 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. …

But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending… In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t … by law…

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

In that case, however, how did they end up in trouble?

Part of the answer is the sheer scale of the housing bubble, and the size of the price declines taking place… The result is a rising rate of delinquency even on loans that meet Fannie-Freddie guidelines.

Also, Fannie and Freddie, while tightly regulated in terms of their lending, haven’t been required to put up enough capital — that is, money raised by selling stock rather than borrowing. This means that even a small decline in the value of their assets can leave them underwater, owing more than they own.

And yes, there is a real political scandal here: there have been repeated warnings that Fannie’s and Freddie’s thin capitalization posed risks to taxpayers, but the companies’ management bought off the political process, systematically hiring influential figures from both parties. While they were ugly, however, Fannie’s and Freddie’s political machinations didn’t play a significant role in causing our current problems.

Still, isn’t it shocking that taxpayers may end up having to rescue these institutions? Not really …, major financial crisis … almost always end with some kind of taxpayer bailout for the banking system.

And let’s be clear: Fannie and Freddie can’t be allowed to fail. With the collapse of subprime lending, they’re now more central than ever to the housing market, and the economy as a whole.


Originally published at Economist’s View and reproduced here with the author’s permission.Related RGE Content:1) U.S. Congress and White House Differ on the Extent of a Housing Bail-Out 2) The Latest Data on U.S. Housing: Still Far From Bottoming Out?3) Where is the U.S. Economy Headed? A Look at the Latest Data

One Response to "Paul Krugman: Fannie, Freddie and You"

  1. el pollo   July 19, 2008 at 2:37 pm

    Didn’t they buy up a huge amount of SIV toxic waste during the past 18 months? I used to love Krugman, but now I am educated. He was in the same department as Bernanke at Princeton for a short time, and you know what they say about apples.