From Political Exchange to State Vampirism: The GSEs

Freddie and Fannie are in the news again.

Freddie is currently seeking an additional $1.8 billion in funding (to be added to the $160 billion that has already been spent on the two government sponsored enterprises or GSEs). This recent news has led me to pose an account of how a standard political choice story of political exchange evolved into one of state vampirism. Let us review some of the facts.

The financial collapse revealed the weakness of many institutions, much to the surprise of regulators. No one in government fully appreciated the fragility of AIG or Lehman, for example.  But the same cannot be said of the GSEs. A partial accounting of the warning signs:

• When accounting scandals led to the collapse of Enron in 2001 and WorldCom a year later, attention turned to the misapplication of accounting standards in other large firms. In January of 2003, Freddie Mac admitted that it had engaged in creative accounting to “smooth out” its earnings growth and mask underlying volatility.
• That same year, the IMF  identified a host of problems at the GSEs including the “systemic risks inherent in the agencies’ large mortgage portfolios and their hedging operations” and the “lack of transparency.”
• In 2004, the OMB warned: “The GSEs are highly leveraged, holding much less capital in relation to their assets than similarly sized financial institutions….a misjudgment or unexpected economic event could quickly deplete this capital, potentially making it difficult for a GSE to meet its debt obligations. Given the very large size of each enterprise, even a small mistake by a GSE could have consequences throughout the economy.”
• Congress held hearings over the course of the next several years to consider strengthening the oversight of the GSEs  and limiting the size of their portfolios. Greenspan—usually skeptical of regulation—testified that the GSEs should be forced to reduce their trillion dollar portfolios to $100 or $200 billion, a position echoed by Treasury officials. Although proposals to create a new agency to oversee the GSEs were introduced in both chambers, Republicans and Democrats blocked reforms—refusing to place restrictions on the size of their portfolios, preventing the regulator from considering systemic risk, or tying passage to the creation of an affordable housing fund to make grants to advocacy groups.

The GSEs avoided the kinds of regulations that, if introduced early enough, might have limited the extent of the crisis.

Making Sense of Nonsense

The above pattern might not seem to make sense until once considers it through the lens of public choice.   The GSEs, although private in the pre-crash days, benefitted dramatically from the implied backing of the US government. They were able to attract capital more cheaply because investors believed that their debt was as good as T-bills.

The GSEs preserved their status by funneling large amounts of money into politics. As Open Secrets noted in a brief 2008 piece on Freddie, Fannie, and political giving:

Fifteen of the 25 lawmakers who have received the most from the two companies combined since the 1990 election sit on either the House Financial Services Committee; the Senate Banking, Housing & Urban Affairs Committee; or the Senate Finance Committee. The others have seats on the powerful Appropriations or Ways & Means committees, are members of the congressional leadership or have run for president.

During the 1989-2008 period, Open Secrets reported that “Current members of Congress have received [as of 2008] a total of $4.8 million from Fannie Mae and Freddie Mac, with Democrats collecting 57 percent of that.” Top recipients of GSE largess for the period 1989-2008:

1. Christopher Dodd (D-CT)
2. John Kerry (D-MA)
3. Barack Obama (D-IL)
4. Hilary Clinton (D-NY)
5. Paul Kanjorski (D-PA)

Obama’s performance is pretty amazing given his short tenure in the Senate. In case your are wondering, the top 25 also included Barney Frank (D-MA), Rahm Emaunuel (D-IL), Nancy Pelosi (D-CA), and Steny Hoyer (D-MD) were also in the top 25. And even if the top of this list was full of Democrats, Republicans were recipients of GSE funds as well, claiming a majority in 2006.

So, we have profit-maximizing firms (in this case the GSEs) investing in vote-maximizing politicians (see above) and receiving special regulatory treatment. The costs were borne by consumers and taxpayers. Many members of Congress undoubtedly thought they were doing good while doing well. By requiring via statute that the GSEs make 55 percent of their mortgage purchases from low and moderate income borrowers, they were furthering pressing social goals and contributing to the creation of an ownership society.

From Political Exchange to Political Vampirism

As we know, in 2007-2008, many of the misguided policies interacted to produce a daunting financial crisis and the largest issuance of debt relative to GDP since World War II.  Freddie and Fannie, carrying large portfolios that had been politically insulated by Congress, all but collapsed, forcing a government bailout that has cost, to date, $160 billion.

In 2010, Congress passed the financial reform legislation (formally, the Dodd-Frank Wall Street Reform and Consumer Protection Act).  As noted in a previous posting, Dodd-Frank was expansive enough to cover everything from conflict metals to the racial composition of financial institutions. What was left out? The provisions of the act did NOT cover the GSEs.

One reason for leaving the GSEs alone may have been their continued utility as instruments of social policy.  As Zachary Goldfarb notes in today’s WaPo:

Since then [the collapse], they have been run by government overseers who have told the companies to help carry out the Obama administration’s housing policy. They have focused on continuing to guarantee mortgages to keep interest rates low and on reworking unaffordable home loans so borrowers can avoid foreclosure. The federal government has pledged to keep the companies solvent.

One might be surprised that the administration is using the GSEs to promote the same kind of credit policies that contributed to the housing bubble—on second thought, who would be surprised, since the clownish and melodramatic explanations of the collapse are the ones that have prevailed politically.

Some things did change with the collapse of the GSEs. When the government stepped in with a bailout, new bans were placed on campaign donations. Amazingly enough, Congress believed that once it owned an entity, it might be somewhat unseemly for it to extract donations from it.  Some predicted that after decades of Freddie and Fannie dominance of housing policy, this would have some profound implications. As the WaPo noted on August 7: “now Fannie Mae and Freddie Mac, titans of the mortgage finance industry, are wards of the state, bailed out by Washington to the tune of $160 billion and banned from political activity.”

But even if political donations are temporarily off the table, there are other ways to extract blood from Freddie and Fannie.  From today’s WaPo:

The firms are also paying steep dividends to the government in return for the aid. The dividend rate, 10 percent, is far more than the companies would pay to raise money in the capital markets. After the latest round of assistance, Freddie will be required to pay $6.4 billion in annual dividends to the government. “This dividend amount exceeds the company’s annual historical earnings in most periods,” Freddie said in a statement. “Freddie Mac expects to request additional draws under the Purchase Agreement in future periods.”

So let us review the key facts: Initially, Congress provides the GSEs with an implicit guarantee in exchange for a steady flow of donations and lax oversight. That equilibrium proved quite stable for decades and delivered the goods for legislators regardless of their political stripe. However, exogenous and endogenous shocks punctuated this equilibrium and gave rise to the political vampirism witnessed today. The GSEs are given a lease on life, but a life that might feel more like a slow death as its resources are being drained away.

How are things working out? In Goldfarb’s words: “Now, it is government decisions that are driving a good bit of the companies’ losses.”  How great are these losses? Since the collapse, Freddie has received over $60 billion from the public coffers, and now it is approaching Congress for an additional  $1.8 billion in government aid.  The combined GSE bailout has cost a mere $160 billion, as if anyone other than bondholders are counting.