“Capture” of Regulators by Fannie Mae and Freddie Mac-Becker

 

 Political economists describe the process whereby government officials end up being the servants rather than the masters of the firms they are regulating as the “capture” by the industry of their regulators. When regulators are captured, much of what they do is motivated, consciously or not, by a desire to help the companies they are regulating, even when the social goals that the regulators should pursue are very different.

 A famous illustration of capture is given by the way airlines were regulated under the Civil Aeronautics Board (CAB) from 1940 to 1978. Large airlines of those times, like American and Delta, naturally had a strong incentive to try to keep new airlines from entering the industry. As a compliant ally of the airline industry, the CAB did not approve one new interstate airline during this almost 40-year period. Many airlines entered the industry when President Carter abolished the CAB, and some of the old standbys, such as Pan Am and Eastern, ceased operations because they could not adjust to a competitive environment.

 An economically disastrous example of the capture theory is provided by the disgraceful regulation of the two mortgages housing behemoths, Fannie Mae and Freddie Mac, before and leading up to the financial crisis. In their fascinating recent book, Reckless Endangerment, Gretchen Morgenson and Joshua Rosner explore in great detail how Fannie Mae used political connections and intimidation of anyone who stood in their way to gain a highly dominant position in the residential mortgage market. The authors’ show that various government officials, including congressmen and presidential cabinet members, closed their eyes to what these two government-supported enterprises (GSE) were doing. They allowed them to take on enormous risks, while publicly defending their behavior as not being highly risky.

 

Fannie Mae was created in 1938 as a government enterprise that purchased mortgages from banks that loaned money to homebuyers. It eventually became a private investment company regulated by the government, where investors expected that the government would help out if these companies got into trouble. By the beginning of the crisis in 2008, Fannie and Freddie held or guaranteed about half of the United States’ $12 trillion of assets in the residential mortgage market. In September 2008, both Fannie and Freddie were taken over by the federal government when they became insolvent. The loss to taxpayers is likely to be in the hundreds of billions of dollars because many of the mortgages are subprime and of little value.

 Reckless Endangerment shows how the chief executive officers of Fannie Mae furthered the reach and reduced the regulatory control over their company by assiduously courting congressmen, Fed officials, the Congressional Budget Office, high-level officials of the U.S. Treasury, the Secretary of Housing and Urban Development, and major economists. The prominent and well informed congressman, Barney Frank, gets especially sharp criticism for his continual support of Fannie and Freddie while he was initially a member, and later chairman, of the House Financial Services Committee, the powerful committee charged with oversight of the housing and financial sectors. Barney Frank remained an unwavering supporter of Fannie and Freddie until 2010, when he admitted that they should have been more closely regulated. In a bit of irony, he is a principal author of the 2010 Dodd-Frank act that attempts to reform the financial sector mainly by giving even greater discretion to the regulators.

 Fannie and Freddie had so much money and political power at their disposal that it became risky for anyone to oppose what they wanted: large increases in their holdings of subprime and other mortgages, with no questions asked. Different government agencies that were supposed to either regulate or oversee these GSEs ended up as advocates instead. Well-known economists wrote favorable articles downplaying the riskiness of the holdings of Fannie and Freddie. These articles were sometimes published in journals or other publications sponsored by these companies.

 A few government officials were brave enough to risk the wrath of Fannie and Freddie. The authors give particular praise to June O’Neill (I am proud to say she is a former student of mine), who was then head of the Congressional Budget Office. A member of her staff wrote a report that was critical of the degree of risk to taxpayers from the assets held by Fannie and Freddie. These companies tried to get June to suppress the report- she refused- and then a few members of the House of Representatives in cahoots with Fannie and Freddie subjected her to vicious attacks when she steadfastly defended the report in testimony before Congress.

 The Fed also comes in for sharp criticism by the authors. One example discussed was a Boston Fed publication in October 1992 claiming that minorities were widely discriminated against in gaining access to mortgage credit. The media, many regulators, and some economists widely praised this study as offering definitive evidence of extensive discrimination against minorities in the credit market. Fannie Mae’s head, the politically astute James A. Johnson, seized on this reaction to promote a large increase in mortgages to poor residents of African-American and Hispanic communities with bad credit histories.

 Since I had written a book on discrimination against minorities in the economy, I was curious to see how the authors reached such definite conclusions about mortgage discrimination. I became convinced after reading their study that it was deeply flawed, and failed to show what they claimed about discrimination in the market for mortgages. The theory of discrimination against minorities implies that minority applicants for mortgages would need to have better credit records and higher employment stability than comparable whites in order to obtain mortgages. This suggests that default rates would be lower and profitability higher on loans to minorities.

 The study’s authors presented no evidence to support these implications of discrimination theory. All the circumstantial evidence, and some real evidence, showed just the opposite. I published my criticisms in a column for Business Week in 1993 (reprinted on pp. 119-120 in The Economics of Life, a collection of my Business Week articles). The Boston Fed and their supporters tried defending this article against my attack and those by others, but their arguments were weak. Nevertheless, the view persisted that the Fed had “proved” widespread discrimination in the credit market against minorities, and this helped justify an expansion of mortgage loans to families with low incomes and poor employment records.

 The Fannie and Freddie story does not demonstrate that government officials, congressmen, economists, and others who sang their praises were corrupt, although undoubtedly some were. But rather that powerful companies and industries can bring massive resources to bear in promoting their interests through lobbying, congressional testimony, financial support to help political candidates win elections, attacks on critics, hiring experts to promote their views, and in many other ways. The result is, as Simon Newcomb, an outstanding American economist and astronomer of the 19^th century, said a long time ago, “one cent per year out of each inhabitant would make an annual income of $500,000. By expending a fraction of {their} profit, the proposers of policy A could make the country respond with appeals in their favor…Thus year after year every man in public life would hear what would seem to be the unanimous voice of public opinion on the side opposed to the public interests” (p. 459 of his 1885 Principles of Political Economy).

 I am not claiming that the reckless behavior of Fannie Mae and Freddie Mac was solely, or even mainly, responsible for the financial crisis. Enormous blame must go to the commercial and investment bankers who took on vastly excessive risks that endangered their companies and the economy. Nevertheless, that officials charged with overseeing Fannie and Freddie protected the interests of the companies instead of the interests of taxpayers and the general public does not only offer resounding support for the capture theory. For this capture of regulators also inflicted great harm on taxpayers, the American and world economies, and many of the families who exposed their life savings to undue risks in the mortgage market.

 

 

 

Comments

[Luap Namgurk]

Yes, but one of these days we will finally devise a system whereby regulators will not be captured. Furthermore, we will finally convince people to work half their day for the community and the rest for themselves and their families, day in day out, and with enthusiasm and productivity unmatched by any other country. The dream lives on! America’s decline continues.

[Jwalker]

Two points on Becker. First, members of Congress and the Senate were enablers and (considering the opposition to Elizabeth Warren) continue to enable capture of agencies. Second, I am very interested in part of Simon Newcomb's quote "By expending a fraction of {their} profit, the proposers of policy A could make the country respond with appeals in their favor…Thus year after year every man in public life would hear what would seem to be the unanimous voice of public opinion on the side opposed to the public interests” And yet the Supreme Court has ruled this Free Speech.

[NEH]

This seems to be a classic "Fox in charge of the Hen house" argument with Fannie May and Freddie Mac as culprits. Not too mention, disingenous. I do believe that the true scenario is much deeper and more insidious. What of the private Financial Institutions who created the new and fabulous Mortgage Secured Financial Instruments that became toxic and were swallowed up by the likes of Fannie May and Freddie Mac. Were the Regulators also not captured here? Talk about buying and selling "Pigs in a poke" and a true lack of Market Regulation. Perhaps what the Nation needs is a Financial Industry "Pure Food and Drug Act"...

[TANSTAAFL]

On this issue, Becker's analysis is more persuasive than Posner's.

The commenter above who wishes that "one of these days we will finally devise a system whereby regulators will not be captured" should go sit in the corner and read Hayek.

[Vinny Margott]

I think different government agencies that were supposed to either regulate or oversee these GSEs ended up as advocates instead.

[david]

great article! thanks for your post!

[jamesperin]

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[Robert Kelly]

Please look up Bill Black's work on control fraud. I think we have a concensus on the need to reregulate appropriately. Too bad it always takes a crisis to realize it.

[NEH]

tanstaafl, Hayek this, Hayek that, Hayek! Hayek! Hayek! If Hayek were the great God of Political Economics we certainly wouldn't be in the fix we are today and the World would be a Utopia. But he ain't and we aren't... ;)

[Paul]

It's become quite painfully OBVIOUS that the ENTIRE U.S. Federal Government has been 'captured' by a handful of U.S. financial corporations such as GOLDMAN SACHS. The Obama administration (just like its predecessor) doesn't even feel the need to disguise the fact any longer. Why should they? WHO IS GOING TO DO SOMETHING ABOUT IT ANYWAY?

Moreover, it is equally clear that the U.S. suffers from INSTITUTIONALIZED FRAUD. The die is cast and nothing will change these facts other than a MASSIVE POPULAR UPRISING.

Unfortunately for Americans however, morbidly obese, oversexed deadbeats with a preference for fast-food and pornography are NOT the ideal revolutionaries. Which means that YOU CAN STICK A FORK IN AMERICA ..BECAUSE IT'S D-O-N-E!

[Mardik]

A little bit more "hope" a little bit more "change" towards socialism and a little bit more time and things will work out fine.

[dell cheap computers]

But as the United States emerged from the Great Depression, something remarkable happened: the crises stopped. New financial regulation—including federal deposit insurance, securities regulation, and banking supervision—effectively protected the system from devastating outbreaks. Economic growth returned, but recurrent financial crises did not. In time, a financial crisis was seen as a ghost of the past.
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[LHF]

According to Morgenson, there was definitely corruption involved at least at Fannie Mae. The CBO report noted above showed that Fannie executive Jim Johnson, while claiming the opposite, was lining his own pockets rather than passing along the subsidy resulting from Fannie's quasi government status to home buyers. AND, he served on the boards of private companies, including Goldman Sachs and colluded with Angelo Mozilo, enriching them both, while he served on the board of KB (or HB?) Homes. Johnson got loans for his own fabulous homes as a "friend of Angelo." Regardless, he has never been held accountable and still wields enough power that some who provided information to Morgenson wished to remain anonymous.

Describing a visit from Fannie Mae employees as similar to a visit from the mafia was how one brave bureaucrat described his dealings with them. This is more than "regulatory capture."

[pandora uk]

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[Michael Brophy]

We do all of course have our own opinions but probably wonder at their soundness or balance; so we appreciate very much your analysis. Like 'observer' in the next post I found only the idea, 'whereupon the industry lost all confidence in government policy' with the fall of Lehman perhaps too telescoped an idea. Of course part of Greenspan's justification for the low interest rates was to prevent too much of a shock after 9-11. They say something like it is useful to have the central banker as a friend and Greenspan did keep the economy going long enough to keep the war president Bush in power and allow for the demonstration of the success of the surge; so we didn't have 2 great war failures in a generation. That also would have harmed the national interest.

[NEH]

Michael, And so the "success" of the Surge has been achieved by massive deficeit spending at the tune of 11 - 13 billion dollars a month (depending on the reports). Couple this with the massive tax cuts and Financial Fraud which were supposed to stimulate the Economy and didn't; resulting in a massive Recession/Depression. And so we are now confronted by the specter of massive budgetary crises at not only the Federal level, but also at the State and Local levels.

The fact of the matter is, we can no longer afford long term military adventures overseas. As for "2 great war failures in a generation" this generation will have to learn to get used to it. Like the Vietnam Generation did. We survived that failure in Foreign Policy and we can and will survive this one.

It's all about "Guns and Butter" and at present we just can't afford Guns. Perhaps, if we reinstitute the lost taxes, we can afford both "Guns and Butter"...

[Michael]

In the words of an early American, 'Gentlemen cry, "Peace, Peace, but there is no peace."' We were in a war with an autocracy and a spin off of an autocracy of the Middle East. It would have cost us more than $10 billion a year to have been defeated in that crisis. People have seen that it is not us but the autocracy that has fallen and people have risen against autocracies there.

[discount coupon]

The theory of discrimination against minorities implies that minority applicants for mortgages would need to have better credit records and higher employment stability...

[Lynn Chu]

The issue with Fannie is that it was a national insurance plan, a development program for the US, post-Depression, to pool mortgage debt, guarantee and resell it. Fannie institutionalized this process. In doing so, it eliminated all the economic checks and balances by which banks up to that time made loans, held them on their books, then had to find willing buyers, should they wish to make new loans. Over time, this had the effect of building the banks up to much larger size than if Fannie hadn't been around funnelling all the banks' loan books off for resale after affixing its US government guarantee. This national insurance program process also tended to turn banks from savvy lenders concerned about debtor loan quality, into mere volume processing bureaucrats, lending under rules for loan quality that Fannie set. It was in fact, in its day, a brilliant program, as lending of mortgages certainly was easily routinizable, and it proved excellent for the country; in the 30s, according to Raghuram Ragan in his book Fault Lines, the average home mortgage was 50% down and no more than 5 years to pay off. However, for banks later to walk off with this Fannie process of securitization, for themselves, on a mass scale, with no intelligent oversight or proper regulation, in my view violated the spirit (at the very least) of the Securities and Securities Exchange Acts of 1933 and 1934. The economic checks and balances missing from the Fannie packaging process now needed to be reinstated. Each "package" being sold was equivalent to a company in which shares would be sold to the public. But there was no arms' length transaction or due diligence going on in the missing enterprise packaging step. The securities laws centralize checks against the potential for fraud in all dark pools, which all enterprises inherently are, in the form of detailed rules about material disclosures, and transparent public exchange trading. In the securities situation you also inherently have an arms' length transaction with due diligence in all dealings between a (reputable) investment bank, and the enterprise seeking to sell shares in itself. These missing economic transactional steps needed to be reinstated by regulators. Instead, the fad of the 1980's-90's was a generalized cry for "deregulation," which translated to regulators, pleasingly, as "don't bother to do any work."

[Adriano]

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[Just Energy]

People have seen that it is not us but the autocracy that has fallen and people have risen against autocracies there.

[femmes]

Thank you, it's been very useful. I agree with just Energy.

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[MBT Sale]

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