By buying mortgages, the state subsidizes speculators
Somehow, Fannie Mae and Freddie Mac did not understand the real estate cycle and that their own institutions would make the recession that much more severe
July 1, 2008
Fred Foldvary, Ph.D.

Fannie Mae and Freddie Mac are US government-sponsored companies which buy mortgages from banks and other originators. They raise funds by selling bonds. The Fannie and Freddie bonds have been considered good financial assets because of the implicit guarantee by the US government. However, the shares of stock of these firms have no guarantee, and with the real estate crash, much of the mortgage portfolio is nonperforming, so the price of the shares have plunged to the lowest prices in 16 years. Mr. Market has given Fannie and Freddie a good spanking.

Fannie (Federal National Mortgage Association) and Freddie (Federal Home Loan Mortgage Corporation) have become the keystones of the residential real estate interfered system. In the old days, a bank would loan a house buyer the funds, and hold the mortgage. The bank would have an interest in a sound loan, and would require a down payment, proof of income, and a good credit rating, aside from the collateral on the property.

Now, the bank just sells the mortgage to Fannie and uses the funds to make a new loan. The bankers don’t care much about the credit worthiness of the borrower, since they no longer hold the mortgage. The bank will just collect the payment from the borrower and send the funds to Fannie, which now has the risk.

But why would Fannie buy risky mortgages? Its chiefs figured that the mortgages were so profitable that a few defaults would not hurt their revenue. Somehow the financial wizards of Fannie and Freddie did not understand the real estate cycle and that their own institutions would make the downturn that much more severe.

The crash of Fannie and Freddie are a case study of governmental failure. Some people think that a partnership of government and private enterprise will synthesize the best from both. But in actuality, the partnership may well create a hybrid monster. The implicit guarantee from the government creates what insurers call “moral hazard,” the tendency of those who are insured to take on more risks, because the risk is with the insurer.

They say we don’t learn from history, and the sad fact is that we also don’t learn from theory. The theory of moral hazard says that there will be more risky loans when somebody else guarantees them. The history of the 1980s confirmed this, as the Savings and Loans lent out many billions for mortgages that went bust in the real estate downturn of 1990, and with deposits guaranteed up to $100,000, the government budget deficit soared to pay off the depositors.

Then in the ozo decade (2000 to 2009), the vast expansion of computer power and electronic communications made the secondary trade-medium for mortgages much greater. Fannie created mortgage packages and sold them to financial institutions worldwide. Spreading risk can be beneficial, but not if the risk is colossal, since then the great risk brings down the whole shebang.

Now the implicit guarantee is kicking in, as the chiefs of the US Treasury Department plan to inject billions of dollars of funds into Fannie and Freddie with purchases of their stocks and bonds. The Federal Reserve system may also get involved. They are confirming the “too big to fail” rule, and that will compound the moral hazard problem in the future. We are not learning from history, and never mind the theory.

The ability to sell mortgages to Fannie and others has not prevented losses by the banks and other financial firms, as they do hold many of their loans, and the whole credit market has been crippled. But people, even economists, are not learning the lesson that government intervention ultimately fails, and can be catastrophic.

Most folks only believe and understand superficially visible appearances. It takes a wise cat to understand the real but not evident reality. The reality is that the greatest government intervention is in the land factor. With a fixed supply, land values get pumped up by all the subsidies provided by government: streets, security, fire protection, parks, schooling, welfare, and coming soon, free universal medical guarantees.

This artificial land value then serves as collateral for bank loans and also generates much of the value of shares of stock. But the cost of production of land is zero, so the when speculation carries land prices to stratospheric heights, the subsequent crash shatters the foundations of the economy.

Government chiefs and some economic and financial gurus tell us that our economy is fundamentally OK, and we just have a rough patch to endure, and there won’t be any recession. But the economy is an animal that has been captured, shackled, drugged, and force fed. It’s alive, but living in a cage is not OK. The market should be a wild animal free to graze where the grass is greenest. The pure free market satisfies our deepest desires at minimum cost. Any interference in the market creates death and destruction.

But most free-market advocates also think superficially. They refuse to understand that only the tapping of site values to pay for public goods can eliminate the land-rent subsidy. That is why “free market” publications have refused to publish articles about the real estate cycle.

Given the interfered system of land subsidy, the price of land becomes a formidable obstacle, and then Fannie and Freddie become the logical answers. Only when the whole economic rent of land is tapped for public revenue or otherwise shared equally will the rationale for government sponsored mortgage enterprises disappear, and only then will the market become truly liberated.

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Fred Foldvary, Ph.D.

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.