Tuesday, July 20, 2010

Do Freddie and Fannie Create More Costs Than Benefits?

Economist Mark Thoma weighs the pros and cons of keeping Fannie and Freddie around to subsidize the mortgage market. Thoma suggests that the GSEs help stabilize the macro economy in times of crisis by concentrating risk and also helps to overcome some mortgage market failures, however they also can cause banks to take on excessive risks. See the following post from Economist's View.

The Economist asks:
What should be done with Fannie Mae and Freddie Mac?
Here's my response (additional responses from Laurence Kotlikoff, Phillip Swagel, Tom Gallagher, and John Makin, with others to follow, all responses):

There are two potential justifications for the existence of institutions like Fannie and Freddie. One is to solve a significant market failure in the private sector mortgage market. If there is some reason why the mortgage market does not function properly on its own, perhaps due to lack of information on one side of transactions, inefficient risk management, adverse selection, the presence of moral hazard, etc., then government can step in and fix the problem.

The second justification is the role these institutions can play in stabilizing the macroeconomy. Contrary to what you may have heard from people who want you to believe that government is always the problem and never the solution -- the people who try to blame Fannie and Freddie for the crisis despite evidence they weren't the primary cause -- having such institutions in place may allow a better response to a financial crisis than would otherwise be possible.

With respect to the market failure justification, no market is perfect, and the mortgage market is certainly no exception. Even so, I think it's hard to justify the existence of Fannie and Freddie based upon their ability to solve private sector market failures. To the extent that market failures do exist, there are better ways to overcome them. For example, there may be externalities from home ownership that accrue to the local community, but these benefits are not captured in the price of homes. If this is the case and the external benefits are large, then there may be a role for government to subsidize home ownership. However, simple mechanisms such as tax rebates can be used to solve this problem, we wouldn't need Fannie and Freddie. Since the same is true for most other examples of mortgage market failure I can think of, it's hard to justify the existence of Fannie and Freddie based upon their ability to effectively overcome imperfections in the mortgage market.

I think a better case can be made for Fannie and Freddie based upon the role that they can (and did) play in helping to stabilize a financial system that is in crisis. Fannie and Freddie concentrate risk that is dispersed across many different banks and other financial institutions. If a systemic shock hits, instead of having all the difficult problems that come with the nearly simultaneous failure of such a large number of banks, only one or two institutions get into trouble. This allows regulators to focus their efforts on these institutions as they attempt to stabilize the financial system.

The politics of the recent bailout of Fannie and Freddie are lousy, and the distribution of benefits to large banks through the backdoor bailouts Fannie and Freddie provide could certainly be improved, but mortgage markets may have failed entirely were it not for Fannie and Freddie. In addition, they have helped to keep long-term interest rates low through their purchase and guarantee of mortgage contracts. Things are bad, but a completely dysfunctional mortgage market coupled with much higher long-term interest rates would have been much, much worse.

However, it's important to note that it's not certain that the effect of institutions like Fannie and Freddie will, on net, be positive. The benefit of these institutions is that they allow us to more effectively stabilize mortgage markets -- which are prone to bubbles -- when they get into trouble. However, there is also a cost. The implicit government guarantee that stands behind Fannie and Freddie increases risk taking behavior overall making crises both more likely and more severe.

This means that effective regulation of risk taking behavior will improve the chances that Fannie and Freddie are beneficial on net. As explained at the link given above, regulation of Fannie and Freddie was relatively successful in this regard, but far from perfect. It was the private sector, not Fannie and Freddie, that took the lead in exploiting the short-run profit potential of risky mortgage products. Initially, regulation kept Fannie and Freddie out of these highly risky markets. It wasn't until Fannie and Freddie began losing market share that they began to find ways around the restrictions that prevented them from pursuing the same risky strategies. They were followers, not leaders, into subprime markets.

However, the fact that they could follow at all indicates that regulation was less than perfect. The loss of market share should have been a signal that the private sector markets needed closer scrutiny, and Fannie and Freddie should not have been allowed to follow the private sector down the sinkhole. The fact that Fannie and Freddie were allowed to follow private sector into risky markets when they began losing market share to private sector firms, and the failure to adequately regulate the risk that private sector institutions could take undermines faith in regulators and makes the case for Fannie and Freddie murky.

I still think that, overall, having Fannie and Freddie was beneficial, and I'll give lukewarm support for these institutions. But that support is conditional upon the expectation that regulators will do a better job of monitoring and regulating the amount of risk that is present in financial markets. The presence of institutions like Fannie and Freddie encourages banks to take on additional risk, and the additional risk generates costs that can more than offset the benefits Fannie and Freddie provide in terms of helping to stabilize the financial system when it gets into trouble. We need to do a better job than we have in the recent past of regulating the amount of risk that banks can take in response to the insurance that they get from the implicit government support of Fannie and Freddie. If we can't, then the case for the existence of Fannie and Freddie is much harder to make.

This post has been republished from Mark Thoma's blog, Economist's View.
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