Americans like to talk derisively of European socialist ideas and practices. The irony is, though, that the American economic landscape has some remarkably important examples of socialist arrangements. Take, for example, Social Security, Medicare, and Medicaid, instituted by law and very popular with Americans. And then there are implicit socialist arrangements that are popular with business, principal among them the “too large to fail” doctrine. It was that doctrine that helped bailout the insurance firm AIG, Citi Group, Wall Street and the auto industry in Detroit. I call these arrangements socialist because, while they allow the private appropriation of profits by shareholders they socialize the risks, meaning they spread them over all taxpayers.
Interestingly, there has been an important socialist experiment in the US directly related to the 2008 crisis. I don’t know whether you are aware that if you moved to Europe and wanted to finance your new home, you would have difficulty finding a long-term fixed rate mortgage. And such mortgage would cost you more (after other factors are accounted) than in the US. Why? Because the US has applied some innovative socialism in the housing market that Europe never did and still doesn’t.
If a bank gives you a fixed rate mortgage loan for 15 to 30 years it faces the risk the borrower might default on the loan or interest rates might rise in subsequent years. In the latter case, the bank would have to pay higher rates to attract deposits but wouldn’t be allowed to raise the mortgage rate.
Part of Franklin D. Roosevelt’s initiatives to restore the US economy after the Great Crash, the National Housing Act established the framework through which the US government would promote housing financing. These institutions are the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac). These agencies guarantee the interest and principal payments of mortgage loans that conform to their guidelines and gave rise to an innovative financing instrument, the mortgage-backed security (MBS). An MBS is a bond whose interest and payment are backed by the interest and principal payments on the mortgage loans that back up the MBS. To issue MBSs, Fannie and Freddie buy thousands of mortgage loans from banks and credit unions and then issue bond as MBSs. Turning loans into securities is called securitization. By selling its mortgage loans to these agencies, a bank passes the default (credit) risk and the interest rate risk to the buying agency. More importantly, the mortgage loan issuer recovers its money and uses it for new mortgage loans while earning fees from the origination and servicing of the mortgage loans. On top of that, the created MBS can be resold many times in the capital markets and generate trading fees and profits for traders. Because banks don’t have to commit capital for the long-run and the agencies (Fannie and Freddie) can sell the MBS to others, interest rates on mortgage loans can be lower than absent such an arrangement. Lower mortgage rates mean more affordable housing to the public. So, voila. You have an all-around wonderful win-win innovation for the agencies, the banks, the home buyers and the Wall Street traders who sell and buy MBSs.
So, where is the socialist ingredient in this recipe? By US law, Ginnie Mae is a Government Agency backed by the full credit and faith of the US government, i.e., backed by the US tax payers! Fannie Mae and Freddie Mac, which are considered Government Sponsored Enterprises (GSE), do not enjoy the same privilege, but are implicitly assumed to carry the backing of the US government. The implicit US guarantee was given by the Reagan Administration Treasury Department in a letter to the rating agency S&P in 1982 when Fannie Mae had run into trouble. The letter said that S&P should consider the special status of Fannie Mae. Special status? Yes, because Fannie Mae, in 1968, had been turned from a government agency into a publicly traded stock corporation that could potentially go belly up. That letter was enough to lull investors into the belief that Fannie Mae (and also Freddie Mac) deserved less scrutiny of their assumed risks given the implicit backing of the government. In capital markets, when investor monitoring and scrutiny decline, expect bad things down the road.
On the road to 2008, other government initiatives, meant to do good, were distorted by political expedience and greed, and turned the arrangements aimed to facilitate home ownership into a destabilizing force. One such noble initiative was the Community Reinvestment Act (CRA) of 1977. It came as a result of evidence of neglect of economically depressed neighborhoods by banks. Banks would take the deposits of these neighborhoods but would not reinvest them locally in home or business loans. The Act required that a substantial portion of mortgage loans sponsored by Fannie and Freddie come from low-income households. Later during the Clinton years, the government allowed Fannie and Freddie to extend sponsoring to mortgages of lower (subprime) standards in discharging their CRA obligations. As it turned out, opening the door to lower standards had unintended consequences.
The government arrangements to help home financing worked with great stability until the early 2000’s. However, starting in the 1980’s, deregulation had opened the market of mortgage-backed securities (MBS) to private investment banks (like Goldman Sachs) and gradually to commercial banks (like Citi Bank). In 1999, Clinton signed an Act, enthusiastically backed from both aisles of Congress, that gave commercial banks full powers to act in the securities business just like investment banks. This deregulation greatly increased competition for the creation/issuance of MBSs for all players, including Fannie and Freddie. The competitive advantage of private banks was that they could buy and turn into MBSs any type of mortgage loans whereas Fannie and Freddie were restricted to loans conforming to their standards. The pressure by the shareholders of Fannie and Freddie to produce sufficient returns pushed both agencies to further lower their standards in order to expand the pool of eligible mortgages for purchase and securitization. At the same time, mortgage loans of good and bad quality were created by mortgage companies and investment and commercial banks at a frenetic rate pushing house prices to unsustainable levels. Around 2005, the Republican-controlled Congress sensing the impeding housing bubble and disaster attempted but failed to reform Fannie and Freddie and the housing financing market in general.
In 2008, Fannie and Freddie came unravelling. The US Treasury gave each a life line of $100 billion, fired the top executives and cancelled dividend payments. It also obtained capital stakes in both agencies. The shareholders of both agencies lost their money, as they should have. To the surprise of many, by 2017, the government had spent the sum of $191.4 billion backing these agencies but had received back $279.7 billion in dividends. Not a bad bail out!
Presently, no one knows what to do with Fannie and Freddie. Some argue they should be converted to fully independent private firms. Many experts, though, believe that without government backing they will not be able to sustain their mission. Nonetheless, both sides are very leery of what would happen to home financing and the industries it supports under either alternative. It is for this reason that private business enthusiasts are not very eager to see these agencies operate as independent private intermediaries without any government backing. I am tempted to quip there is no government program that businesses don’t like if it lines their pockets.
The lesson is that back in the 1930s and the ensuing years, the US created an innovative – call it a socialist – solution to serve home ownership, but erosion of shareholder scrutiny and underwriting standards, and unregulated (prior to 2008) private firm activity converged to stoke the 2008 crisis. Also, mixing private ownership and the inherent profit motive with an implicit government guaranty mitigated shareholder exposure to risk and undermined investor vigilance. And one more thing: don’t let arguing about the housing crisis of 2008 sour your mood toward your Democratic or Republican friends. Both parties did their best to contribute to it by corrupting good government programs.
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