The U.S. government takeover of Fannie and Freddy

Just to avoid confusion: I'm actually replying to this post in another thread. Just seems to make more sense that way.


To be fair, I think Will sort of denies this. He thinks they were "not compelled to take up more risk," despite their obvious mission to do so and the quotes urging them to do so I posted earlier. So part of my response is directed at that notion.

But for purposes of this branch of the discussion we can both agree that they played a significant role and go from there.


Them's arguin' words!
Not even the Republican minority report from the bipartisan commison on the bank crisis

I think the difference is that we think of market "failure" (that's the key word) from very different perspectives. More in a bit.


I think this really hits on the difference between us. I will attempt to summarize what I think you're suggesting here. Correct me if I am mistaken.

You are first acknowleding that Fannie and Freddie did indeed provide "insulation" or "cover" for banks issuing bad loans because they were willing to buy them up and assume that risk. But you are also suggesting that the reason they had to assume such risk is that banks were already issuing the loans. You suggest this is partially because of the widespread availability of credit, which relaxed borrowing standards. And you make a reference to other "market missteps," which I assume is a reference to complicated package derivatives and other things.

I have a few thoughts in response:

First, that we define "market failure" in very different ways. You seem to feel that (again, correct me if I'm wrong), a business which exploits an easily exploitable government program indicates some kind of problem with the market. I feel it indicates a problem with the government program. That a healthy market is one in which exploits and inefficiencies are constantly exploited and inevitably exposed. This exploitation is why competition works to reduce prices and increase wealth, and we could hardly expect it to take the day off when government gets involved.

In other words, if the government says it's going to buy up risky debt, and a business simply takes advantage of the notion, I don't blame them for it. They are responding to incentives in exactly the way rational beings generally do. I don't feel this is a "market failure" any more than it's a "dog failure" when you dangle a steak in front of him and he takes a bite out of it.

Second, that the market is forward looking, and that even implicit government backing or the chance of it changes the standards of risk which are acceptable. We see this in all other sorts of places: the mere possibility of inflation changes the level of interest people charge for loans, for example. Similarly, if we have a government-backed institution with even a mandate to buy up mortgages, it is inevitable that this fact will alter the way people lend. And creditors are just as capable as anyone else to try to discern whether or not this mandate will be expanded, and a good deal more affected by it, too. And in this case it didn't require much in the way of guessing, given the rhetoric surrounding "redlining," politicians openly calling for more relaxed standards, and the fact that two reform attempts died a quick death.

Third, even if we posit that the availability of credit dramatically enhanced the problem, it can't have done so for very long. The availability of credit is really just another phrase for inflation, and its effect on new borrowing is ultimately temporary. It will inevitably be accounted for by higher interest rates (which politicians love to call "predatory lending"). It takes some time for this effect to diffuse throughout the economy, but it happens, and it probably happens a heck of a lot sooner with banks and the other institutions who are most directly effected by it.

There is also the point that, even if this is all ignored or explained, the inflation is not the doing of private business, but of the central bank. Which means the blame would not really be shared between government and private lenders, but between one aspect of government and another.


I find it difficult to believe for a couple of reasons.

The first reason is that it's easier to believe a handful of people would make the same mistake than that many, many people would make the same mistake. "You can't fool all of the people all of the time." That sort of thing. If someone tripped in front of me, I wouldn't think twice. If 50 people tripped in front of me simultaneously, I'd start looking for external explanations. By sheer numbers, it is harder to swallow that many people (most private lenders) made the same error than that just a few of them did (a few regulators and politicians).

The second reason is that it's not merely that one group of people is larger than another, but that those people are often experts in their field. Their livelihood is based in not making exactly the kind of error they are accused of making. It is the core of their entire business. The smaller group, however, is not only smaller, but has no such incentive and no inherent expertise. They respond to political incentives, not business ones. They are penalized for seeming this way or that, not for the actual, hard results of their decisions.

Those are the more abstract, universal reasons. They'd be pretty compelling to me even if we had no other information about whatm ight have caused it. But throw in the government's insistence that private lenders relax their standards and the presence of a massive entity that is willing to assume so much risk on their behalf, and it becomes difficult for me to find a more compelling alternative theory (or distribution of blame). Basically, I find it far more likely that private lenders exploited a flaw in the government's plan than that they somehow created their own downfall.

What are your thoughts?