Deal or No Deal?

Arnold Kling makes an important observation that “Democrats want to [pass the Paulson-Bernanke bailout proposal] without deliberation, because putting the financial sector under government control is what they want.”

Despite the sturm und drang of the Left blogosphere (not to mention protesters) over the proposal, it is not their Blue Team heroes who are standing against the proposed bailout. Instead, a bloc of limited-government Republicans is providing the only significant congressional impediment to the proposal. Meanwhile, Capitol Hill Democrats are ready to embrace Paulson-Bernanke and the Left punditocracy is miffed that John McCain helped to disrupt the endgame.

Why would a cadre of Republicans side against a plan drawn up by a Republican Treasury secretary and Fed chair, while Democrats favor it? One reason, as Arnold diagnoses, is that the bailout would give Congress justification to intervene (further) in financial markets. That should worry us because earlier congressional mischief deserves much blame for the current financial mess — and portends future mischief and crises.

The meltdown of recently developed products in the financial markets — like the sale of tranches of collateralized debt obligations and derivatives connected with those products, primarily credit-default swaps — are at the heart of the financial crisis. It is important to remember who fueled the market for those products: congressional puppets Freddie Mac and Fannie Mae.

For decades, the federal government (and other levels of government) have pursued the (questionable) goal of ever-higher homeownership rates. However, politicians (correctly, I suspect) believed that the public would oppose a broad, explicit taxpayer subsidy program for homebuyers.  So federal lawmakers encouraged the development of elaborate financial products to provide loans for higher-risk mortgage borrowers — the financial products that have now gone toxic following the collapse of the real estate bubble.

Fannie and Freddie did not issue these higher-risk subprime and “Alt-A” mortgages as part of their traditional operation of purchasing and packaging low-risk “conforming” loans in the secondary market. However, as Charles Calomiris and Peter Wallison explain in their excellent Tuesday WSJ op-ed, Freddie and Fannie became the dominant players in the subprime and Alt-A market, sinking (along with their GSE brethren) more than $1 trillion into the riskier mortgages and growing them from 8 percent of all U.S. mortgage originations in 2003 to more than 20 percent by 2006.

Freddie and Fannie arguably have more government oversight than any other corporations in the United States, with their own federal regulator, regular congressional oversight, and board members appointed by the White House. Yet, all that oversight did not keep the firms from fueling the high-risk mortgage industry; as Chris Edwards notes, their regulator gave them a clean bill of financial health less than a year ago.

Why the forbearance? Because Fannie and Freddie’s government overseers wanted the firms to achieve political goals, despite the risk that posed. Calomiris and Wallison have the money quote from Rep. Barney Frank (D-Mass.), now chair of the House committee that oversees Freddie and Fannie:

“Fannie Mae and Freddie Mac have played a very useful role in helping to make housing more affordable … a mission that this Congress has given them in return for some of the arrangements which are of some benefit to them to focus on affordable housing.”

One can appreciate Frank’s sentiment. He highly values homeownership for low-income Americans, and he believed that allowing Freddie and Fannie to play (heavily) in the subprime and Alt-A markets would bring the American dream to poor people without (directly) burdening American taxpayers. However, these machinations proved too clever by half.

If the Paulson-Bernanke plan gives Congress enduring justification to become more involved in financial markets, can you imagine how much more clever lawmakers will get?

Postscript: Hat tip to Susan Semeleer for sending along this Barney Frank quote from the 2003 effort to increase regulatory oversight of Fannie and Freddie:

”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”