Thursday, April 03, 2008

Whence Systemic Risk?

William Poole's departure from the St. Louis Fed calls to mind a speech he gave in 2003 on Fannie Mae, Freddie Mac and systemic risk. In Poole's view, the concentration of mortgage risk in the two institutions was per se dangerous. I think it is fair to say that Poole's view was at least partly grounded in the idea that the implicit subsidy the two institutions received created alarming moral hazard issues. It was (is) a view shared by many fine economists, including Dwight Jaffee and Larry White, both of whose work I admire.

My view--and it is one that has led me to feel lonely at times in the company of other economists--is that the benefits of the GSE subsidies outweigh their costs, and that the GSE subsidies are not materially larger than those received by, say, Citigroup. Indeed, the pool of financial institutions with an implicit guarantee has recently moved beyond GSEs and commercial banks to include investment banks.

I think it is worth noting that Fannie and Freddie's core business--prime mortgages--is doing ok. To the extent the companies are having trouble, it is because they were pushed into buying subprime and Alt-A loans by a set of misguided regulations known as affordable housing goals. I don't know whether it is a coincidence or not, but Fannie and Freddie market share of mortgages declined dramatically between 2002 and 2007; they gave up their market share to private label institutions. So if Poole was correct, systemic risk should have declined between 2002 and 2007. The prediction didn't work out too well.

I should disclose that I worked at Freddie for 15 months in 2002 and 2003. While I learned a lot there and met some wonderful people who remain my friends, I pretty much knew I wanted to leave the place within a month of arriving. How this biases my views on GSEs is not entirely clear to me. But I do sometimes wonder if some of the GSE's most vociferous opponents, such as the American Enterprise Institute and the Wall Street Journal Editorial page, just can't stand the idea that government created institutions have spread the benefits of capital markets to a broad swath of ordinary people in a very responsible way.


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Anonymous said...


Politics is key here. The senior execs of Freddie and Fannie have been heavy contributors to the Democrats. There are analogies to the 'Welfare State Capitalism' that sociologists have analysed in Sweden: certain companies and government backed enterprises (as well as the unions, of course) are heavily aligned with the Social Democratic Party that ruled Sweden through much of the postwar period.

Austria this is formally recognised. Banks and other enterprises are either Black (conservative) or Red (socialist), and their senior execs move easily amongst the Party apparatchuks.

And so we come to the GSEs, which are a Democratic creation, offering mortgages to people who vote Democrat (sub $419k would include relatively fewer Republicans, i think we would agree, and then there are the rigorous enforcements of affirmative action and anti-discrimination legislation, whereas private sector mortgage lenders persist in 'red lining' and other discriminatory measures: psychologists have shown that even apparently consciously unprejudiced people display strong racial biases. The only thing that stops that is if there are formal rules that have to be applied in, eg, recruiting and selection decisions).

By contrast other socialistic enterprises in the US (like the Defence Industry, or the Oil Industry) that rely heavily on government policy or tax subsidies, tilt towards the Republicans.

(Telecoms, Pharmaceuticals, Media-- all of which are completely dependent on US government regulation, tend to tilt Republican, but not to the same extent. The airline industry seems to play both sides quite effectively).

The Banking industry plays both sides of the fence, but has tended to tilt Republican, achieving for example things like the new personal bankruptcy act, which Clinton repeatedly vetoed.

The GSEs are one of the few corners of the state-industry nexus in the US that the Democrats unambiguously dominate.

And so places like the Wall Street Journal, which are anti-Democrat, are anti GSE.

Whether they are right or not is unclear. The US housing finance system (the one before the last 3 years or so of the bubble) was widely admired: in no other country can you get a 30 year, fixed rate mortgage, that you can refinance if interest rates drop.

It's undoubtedly one of the main causes of the huge prosperous middle class suburbs you see in America, that other countries just don't have to the same extent.

Americans are well housed, and a big part of it has to do with their home lending system.

I've always thought there are disturbing financial risks inherent in having 2 mortgage lenders that were growing so much faster by taking assets onto the balance sheet: much faster than the markets in which they operated.

However as their growth has been restrained for the last few years by the accounting scandals, they cannot be accused of having fueled this housing bubble to an abnormal extent.

This one lands squarely on the lap of the private sector.

But don't think for 10 seconds that at the core of this, isn't the party political divide.


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