Capture Theory and the Financial Crisis—Posner

The phenomenon of regulatory capture—the transformation of a regulatory agency into an anticompetitive tool of the regulated industry—is real, but I think Fannie Mae and Freddie Mac are more accurately regarded as examples, though no less unlovely, of something else: a capitalist-socialist hybrid. They were not regulatory agencies; until they collapsed during the financial crisis of 2008 and were taken over by the federal government, they were private corporations that had been chartered by Congress to promote home ownership. Their status as GSEs (government-sponsored enterprises) created an expectation that the government would guarantee their debts. This expectation enabled them to borrow at lower interest rates than other private corporations. They were supposed to promote home ownership by buying or guaranteeing home mortgages. They did that; they also pioneered mortgage securitization—in effect turning  mortgages into bonds, which are more liquid than mortgages and so could be sold all over the world, bringing more capital into the U.S. residential real estate market, thus promoting home ownership, just as Congress wanted. Because of the low interest rates they paid, Fannie and Freddie were immensely profitable until the financial crisis brought them down. 

As Becker points out, Fannie and Freddie were effective in obtaining congressional and presidential assistance to ward off threats to their activities and their profits. But I don’t think that that assistance, unseemly as it was, and perhaps corrupt as well, was the basic problem of Fannie and Freddie, or the cause of their collapse; nor do I think their collapse was of any great consequence for the nation. 

I don’t think there was ever a good reason to promote home ownership over renting (so I would favor the abolition of the deductibility of mortgage interest from federal income tax). It ties up a lot of the capital of individuals and reduces labor mobility. Maybe it makes for more responsible citizens by giving people a property interest, but there must be better candidates for federal largesse. And even if there were a good reason for government to promote home ownership, federal chartering of mortgage institutions would not be a sensible means of implementation. Are the external benefits of home ownership, if any, so great that the mortgage-interest tax deduction is not subsidy enough? True, the lower the interest rates that Fannie and Freddie paid to borrow money, the riskier the mortgage loans they would agree to underwrite by buying or guaranteeing the loans, but home ownership is not promoted in any meaningful sense by the granting of mortgages to people likely to default. 

Conservative critics led by Peter Wallison of the American Enterprise Institute lay on Fannie and Freddie a significant measure of blame for the housing bubble of the early 2000s and the ensuing financial crisis of September 2008. But these critics have not persuaded me. Private banks like Morgan Stanley and Goldman Sachs and Countrywide bought mortgages, securitized them, and sold interests in them (these firms also bought mortgage-backed securities created by other financial firms)—a sequence wholly separate from the activities of Fannie and Freddie. It was an immensely profitable activity, so there is no reason to think that had there been no Fannie and Freddie the volume of mortgage-backed securities would have been less than it was. Whether a market has X firms or X – 1 firm is unlikely to affect the volume of market activity. I don’t think Fannie and Freddie took more risks than their competitors; the difference is that they were more deeply committed to the housing market (that was their mission) than most other firms, so less likely to survive a housing bubble. 

The financial crisis might actually have been worse without Fannie and Freddie. They collapsed and were simply taken over by the federal government. Had their debts instead been debts of Morgan and Goldman and other private banks, those banks might have collapsed and been taken over by the federal government as well, providing daunting challenges to the government’s ability to run the banking system. The cost to society of the government’s taking over Fannie and Freddie is hard to estimate. The takeover resulted in a transfer payment to creditors of Fannie and Freddie from (ultimately) the federal taxpayer. Had there been no Fannie or Freddie, other mortgage companies would have had more debt, and the owners of that debt would also have been bailed out by the federal government, in all likelihood. 

Congress would do well to abolish Fannie and Freddie. But it won’t. The constellation of political forces that supports subsidizing home ownership is too strong. 

But if Fannie and Freddie are not at the root of the financial collapse and ensuing depression (as I insist we should call it, eschewing the tepid euphemism “recession”), this is not to exonerate the government. I would go so far as to contend that the government is entirely to blame for the crisis (see my book The Crisis of Capitalist Democracy [Harvard University Press, 2010]). The housing bubble was enabled to expand to bursting point by unsound interest rate policies followed by the Federal Reserve in the early 2000s, under the chairmanship of Alan Greenspan. Interest rates were kept too low, and because a house is a product bought mainly with debt, low interest rates reduce the cost of acquiring a house. The result was a surge in demand for housing, forcing up price because the housing stock cannot be rapidly expanded. (The Fed controls only short-term interest rates directly, but short-term interest rates influence long-term rates; moreover, interest rates on adjustable-rate mortgages are in fact short term, and those mortgages became immensely popular during the bubble, as they facilitated speculation on rising house prices.) House prices rose so steeply that the increases became self-sustaining (that’s the bubble phenomenon). The Fed and the other banking agencies were oblivious to the bubble, and the Fed (by then under Bernanke) made a disastrous error by allowing Lehman Brothers to fail after having led the banking industry to believe that the Fed would not permit a major bank failure—whereupon the industry lost all confidence in government policy. And finally financial deregulation had gone too far, enabling—and by virtue of competitive pressure compelling—banks and other financial firms to take risks that were excessive from a social though not private standpoint. 

But the role of Fannie Mae and Freddie Mac in all this probably was minor.

 

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