Topic: Regulatory Studies

Fannie and Freddie

Paul Gigot has an outstanding piece on Fannie Mae and Freddie Mac today in the WSJ. “The abiding lesson here is what happens when you combine private profit with government power.” Exactly.

Here’s what I said about the twin-headed hydra in my 2005 Downsizing the Federal Government:

Federal taxpayers also face financial exposure from the mortgage giants Fannie Mae and Freddie Mac. These ‘government-sponsored enterprises’ are private firms, but taxpayers might become responsible for their debts because of their close ties to the government. The value of these ties created an implicit federal subsidy of $23 billion in 2003. The large size of GSEs threatens to create a major financial crisis should they run into trouble. Balance sheet liabilities of the housing GSEs grew from $374 billion in 1992 to $2.5 trillion by 2003.

A benefit of fully privatizing the GSEs would be to end the corrupting ties that these entities have with the federal establishment. Fannie Mae’s expansive executive suites are filled with political cronies receiving excessive salaries. They spend their time handing out campaign contributions to protect the agency’s subsidies.

Federal Reserve Chairman Alan Greenspan and others have argued that Fannie and Freddie need to be subject to more regulatory control because they pose a threat to financial market stability. But a better solution is to make these and other GSEs play by the same rules as other businesses, and to end the distortions caused by federal subsidies. The federal government should completely sever the ties with Fannie, Freddie, and the other GSEs.

My analysis sadly proved to be correct, and my policy solution is more needed than ever.

Arrogant European Bureaucracy Run Amok

The European Commission is an unelected bureaucracy that is slowly but surely seizing powers to govern member nations. This is bad news for national sovereignty and jurisdictional competition, but it also leads to crazy regulations, including proposals to prohibit the British from using acres instead of hectares, banning the traditional preparation of Peking Duck, and detailed rules about the proper size and shape of vegetables. 

But regulatory overkill is just the tip of the iceberg. Far more troubling is the effort to subvert democracy in order to further centralize power in Brussels. The EU Constitution, which would have expanded the powers of the European Commission, was rejected by the voters of France and the Netherlands a few years ago. Rather than shelve the proposal, the European elites renamed it the Lisbon Treaty and said that it no longer was necessary to let the people vote. Fortunately, Ireland still has the rule of law and held a referendum - and the EU Constitution/Lisbon Treaty was decisively rejected. 

The French President has since asserted that the Irish should vote again (and presumably again and again) until they reach the “right” decision. But perhaps the most Kafkaesque reaction came from a French bureaucrat, who was quoted in Le Figaro stating, “It isn’t about putting pressure on the Irish.  We well understand that they have expressed themselves democratically.  But so have the other 26!” Only the French could deny their people the right to vote and then claim their voters (and the disenfranchised people in the European Union’s other 25 nations) had somehow expressed their views.

On Google-Yahoo! as an Antitrust Problem

My favorite anti-Google gadfly Scott Cleland has a post up entitled “Debunking the Google-Yahoo Antitrust Myths” in which he purports to debunk some erroneous thinking about the Google-Yahoo! deal.

Scott often furnishes the world with interesting ideas in an over-the-top way, but here I think he’s gotten it wrong.

He walks through a series of purported “myths” about the antitrust implications of Google-Yahoo!, which got a hearing in the Senate this week. I want to walk through just a couple of them because I think he’s framing the relevant market wrongly.

Cleland’s “Myth #1” is that there can’t be an antitrust problem as long as consumers are just one click away from a competitive search engine. Rather, he says, “Google is becoming a de facto essential facility for advertisers seeking to reach the global Internet audience.”

It’s helpful for him to frame the antitrust discussion of Google as being not about consumers’ access to search, but about advertisers access to eyeballs. The low barriers to entry for Google competitors is relevant, though. Too much success on the part of Google in capturing advertising market share will draw competitors to go after Google’s traffic, which is obviously crucial for holding advertising market share. They can do so easily because, indeed, consumers are one click away from competitive search engines and every other site or service they might visit.

“Myth #2: There can be no antitrust problem because Google and search advertising comprise such a small percentage of the advertising market.” Debunking it, Cleland says:

The relevant antitrust market is search advertising because there is no competitive substitute for search advertising. As Google has successfully convinced advertisers, search is a unique way to reach consumers because people self-identify their intentions through active search that they don’t do when they are a passive consumers of mass media advertising through: TV, radio, newspapers, magazines, billboards, or direct mail. Moreover, the search medium enables collection of unprecedented private information about intentions, preferences, economic suitability, etc., which enables unprecedented “targeting” of users with “relevant” advertising that consumers will be most receptive to.

(characteristically quirky formatting omitted)

This I think is wrong. Cleland has whittled down the market to where Google has unique strengths, but that is not the relevant market to this dispassionate, forward-thinking observer. Of course Google has convinced advertisers of how special search advertising is, but that doesn’t make it true. There are plenty of ways to target advertising equally well or better than through search, and the large consumer data and targeted marketing industry is there because of it. (Here’s the DMOZ directory of “micromarketing” firms, for example.)

What’s more, there are plenty of ways to target equally well or better than with search terms. Providers of hosted email, hosted documents, chat, microblogging, and other services have access to information as good or better than what Google has about people’s particular interests at particular times. They are all positioned to deploy targeted ad systems like Google’s keyed to the content that they process for users.

Whether they deploy such a thing or not depends on whether Google is able to reap higher than ordinary rents from its access to search information. If Google-Yahoo! is prevented from going forward and the two companies are prevented from increasing their profits through the combination – it remains speculative that they will – a signal to potential competitors will not go out, and innovations along many vectors will not materialize.

With due respect: Not this time, Scott! Let the markets and the technologies play out as they will.

‘Ballooning Commodities’?

“The S&P GSCI commodities index is up 73% in the past 12 months,” writes Edward Hadas of breakingviews.com in The Wall Street Journal.

The author goes on to speculate about speculation, concluding, “This bubble could get bigger still.” Unfortunately, he assumes the S&P commodity index (which is shown in a graph) demonstrates a huge ongoing boom in the prices of commodities in general. In reality, all the index shows is that oil prices doubled over the past year and that most of that increase happened in the past four months. Energy commodities (mainly crude oil) account for 78 percent of the S&P GSCI commodity index.

The price of crude oil rose from $100 a barrel on March 4 to $136 on July 8, so the energy-dominated S&P GSCI index naturally soared too.

What happens to the widely reported “commodities boom” if you leave out oil? Look at The Economist’s index of 25 farm and industrial commodities, which excludes oil. The Economist’s commodity price index fell from 271.9 on March 4 to 265.6 on July 8.

It is on the basis of such fatally flawed evidence as the S&P commodity index that Congress has been trying to bully the Commodities Futures Trading Commission into bullying U.S. commodity traders to stop some sort of “commodity boom.”

The dollar was also quite stable during the past four months, contrary to numerous angry and overconfident Journal editorials about the alleged commodity boom being caused by the supposedly falling dollar. The Fed’s broad index of the dollar’s value was 95.97 on February 28 and 95.97 on July 8.

Do We Need Fannie and Freddie?

All eyes were on Wall Street Monday morning as Freddie Mac, one of the two giant government-sponsored enterprises that dominate U.S. mortgage finance, floated $3 billion in bonds to continue its role as a buyer and reseller of mortgage obligations. The bond sale came after a week in which Freddie’s stock, and the stock of its sister Fannie Mae, plummeted as analysts and economists worried that the housing bubble collapse would push the two GSEs into insolvency. To fortify Fannie and Freddie, the Bush Treasury Department, with blessings from the Democratic Congress, worked feverishly over the weekend to cobble together a bailout plan should the GSEs’ conditions worsen to the point that they can no longer function. The successful bond sale indicates the Bush plan has reassured the market — albeit barely.

It is an article of faith across the political spectrum that Freddie and Fannie cannot be allowed to fail — especially not at this time when the broader housing market is undergoing painful correction. Why do they have such exalted status?

Before Fannie Mae — the first of the twins — was created amidst the “Recession within the Depression” in 1938, home mortgage lending was highly risky for banks. State regulation kept banks small and geographically limited in order to make them better targets for taxation and political manipulation. As a result, banks could not geographically diversify their loan risk, leaving them highly vulnerable to localized economic downturns. Because they lent money (as mortgages and business loans to farms and other firms) to local borrowers for long periods of time but they had to honor local depositors’ withdrawal requests, banks were often one bad harvest and one bank run away from insolvency. For that reason, they shied away from financing long-term home loans.

Fannie Mae (formally, the Federal National Mortgage Association) provided badly needed lubricant to the mortgage industry. It purchased loan obligations from banks, putting money back in the banks’ vaults and making that money available for more home loans. Fannie financed its operations by borrowing on Wall Street and, later, by pioneering the creation and sale of mortgage-back securities (MBSs) — selling large “bundles” of loans to investors and then servicing the loans on the investors’ behalf. In this way, Fannie diversified loan risk, allowing a nationwide (and worldwide) pool of investors to finance (at first indirectly, then directly) a nationwide pool of mortgages. This wasn’t the ideal solution that banking reform would have been, but Fannie was a good second-best solution.

Because of its tax-free status and government backing (as well as banking regulations that constrained would-be competitors), Fannie quickly came to dominate the mortgage industry. This system hummed along, unchanged, until 1968 when Fannie’s costs conflicted with Lyndon Johnson’s efforts to rein in the federal budget amidst the war in Vietnam and the war on poverty. It was decided that Fannie would be spun off as a private corporation whose investors would bear its costs. However, Fannie retained its tax-free status and received a $2.25 billion line of credit at the U.S. Treasury. It also was allowed to operate with much lower reserve requirements than banks. But the most valuable of Fannie’s parting gifts was its implicit too-big-to-fail status: because of its history and role in mortgage lending, investors believe the federal government will ride to Fannie’s aid if it ever became financially unable to function. For this reason, investors buy Fannie’s stocks, bonds, and MBSs.

Congress realized that, with those perks and its original dominant position, Fannie would continue to monopolize the U.S. home loan market. In 1970 they created Freddie Mac (formally, the Federal Home Loan Mortgage Corporation) as a competitor, with the same structure and perks as Fannie. It’s unclear why Congress believed a duopoly was better than a monopoly. (For more on Fannie and Freddie’s history, listen to Peter Van Doren’s recent podcast.)

Over the last decade, analysts have offered numerous criticisms of Fannie and Freddie’s dominance and nature, and issued calls for reform. (In Regulation alone, see: Van Order 2000, Frame & White 2004, Wallison 2004, Jaffe 2006.) Besides the GSEs’ dominance of the market and the risk that their too-big-to-fail status poses to taxpayers, the implied guarantee encouraged the GSEs to retain possession of some of their mortgages instead of selling them to investors. Retaining mortgages and reaping the payments enriched Fannie and Freddie shareholders, but it subjected the two GSEs to interest rate risk as well as the default risk of all Fannie- and Freddie-guaranteed loans.

Despite the criticisms and reform calls, the issue gained little traction, even in the go-go real estate market of the mid-2000s when Freddie and Fannie were involved in a relatively small 40% of new home loans. The result is that, in the aftermath of the housing bubble collapse when preserving mortgage financing is incredibly important, the market for those loans is dominated by two teetering giants.

Fannie and Freddie are currently involved in roughly half of all U.S. mortgages. That includes a large majority of post-bubble mortgages, as private investors have pulled back from financing non-guaranteed loans. Given that position and the overall turmoil in the housing market, the federal government cannot leave Fannie and Freddie to struggle — after all, their debt equals the debt of all other U.S. corporations combined, and imagine what would happen if all U.S. corporations suddenly defaulted on their loan payments.

So, there seems little that federal policymakers can do now except promise to prop up Freddie and Fannie if they become insolvent and hope that doesn’t occur. But this situation demonstrates why the mortgage industry should not be dominated by two firms — especially two government-sponsored firms.

If Congress does adopt legislation to protect Fannie and Freddie, that legislation should spare taxpayers and the nation from a repeat of the current crisis. The legislation should include an ironclad commitment to make Fannie and Freddie fully independent of the government over the next decade. It should also require that the GSEs be broken into several smaller firms that aren’t too big to fail. Those firms would be put under strict government oversight and conservative risk controls until they are fully independent. The legislation should also strip Fannie and Freddie of their tax-free status, putting them on equal footing with private lenders (including banks, which can now geographically diversify following the 1999 banking reform). With this reform implemented, the mortgage market would become supported by numerous institutions (some of which would be Freddie and Fannie spin-offs, others not) instead of just two vulnerable pillars.

It is because policymakers refused to reform state banking regulation in the 1930s that Fannie (and later Freddie) were created. It is because Fannie and Freddie were not reformed in the last 10 years that we’re stuck with this problem now. Federal policymakers cannot disregard another opportunity at reform — or else the U.S. mortgage industry will remain at the mercy of the financial health of two firms.

Postscript (7/15): Cato senior fellow Gerald O’Driscoll sketches a plan for breaking up Fannie and Freddie and making them truly independent in this excellent WSJ op-ed [$].

Dionne’s April Fool’s Column

Anybody can play an April Fool’s Joke in April, but E.J. Dionne deserves credit for pulling a fast one on gullible readers in July. And I’m brave enough to admit that I was briefly fooled by his column asserting that even conservatives now recognize that free markets don’t work. It was only after thinking about his column that I realized he surely must be engaging in some leg pulling if the first person he quotes is one of the most collectivist-minded members of Congress, Barney Frank. Dionne tries to trick readers by then citing the Chairman of the Federal Reserve, who (gee, what a surprise) is in favor of more regulatory power for the Federal Reserve, but he neatly avoids any explanation for why this is evidence that conservatives are abandoning markets (perhaps he is assuming that Bernanke is a conservative because he was appointed by Bush, but surely Dionne is not so naive):

Since the Reagan years, free-market cliches have passed for sophisticated economic analysis. But in the current crisis, these ideas are falling, one by one, as even conservatives recognize that capitalism is ailing. …The old script is in rewrite. “We are in a worldwide crisis now because of excessive deregulation,” Rep. Barney Frank (D-Mass.), the chairman of the House Financial Services Committee, said in an interview. …While Frank is a liberal, the same cannot be said of Ben Bernanke, the chairman of the Federal Reserve. …Bernanke sounded like a born-again New Dealer in calling for “a more robust framework for the prudential supervision of investment banks and other large securities dealers.”

Wait a minute. Perhaps Dionne is writing a serious column. He quotes Irwin Stelzer of the Hudson Institute, who reasonably can be considered a conservative:

What’s striking is that conservatives who revere capitalism are offering their own criticisms of the way the system is working. Irwin Stelzer, director of the Center for Economic Policy Studies at the Hudson Institute, says the subprime crisis arose in part because lenders quickly sold their mortgages to others and bore no risk if the loans went bad. “You have to have the person who’s writing the risk bearing the risk,” he says. “That means a whole host of regulations. There’s no way around that.”

Dionne seems impressed that Stelzer says that markets don’t work perfectly. But that is a reflection of Dionne’s unfamiliarity with economics. After all, failure, like success, is a part of the market process. Dionne does note, however, that Stelzer is endorsing more regulation, so there is a tiny shred of evidence for his hypothesis that conservatives want more government intervention. But if this is the evidentiary bar that has to be cleared for such assertions, I’m going to write a column saying that all socialists now support a flat tax. And I won’t even have to find one left-leaning writer to “prove” my point. I can just point to the various socialist-led governments in Eastern Europe that have adopted single-rate tax systems.

Before signing off, I feel compelled to point out that Stelzer has a fair diagnosis but a misguided prescription. Yes, hindsight shows that lenders were cavalier about loans since they knew other investors would be the ones bearing the risk. But after absorbing billions of dollars in losses, investors obviously have a huge incentive to avoid the same mistake. Indeed, that is why failure plays a crucial role in a market economy; people learn from mistakes. Additional government regulation, by contrast, is at best a case of closing the barn door after the horse has escaped. In the vast majority of cases, however, regulations throw sand in the gears and/or distort incentives for the efficient allocation of resources.

EPA: Your Life is Worthless

Splashed across the front pages today — well, at least one paper I saw — are headlines about the EPA slashing the value of life revising the value of a statistical life downward. This is highly newsworthy, but only because most people haven’t been paying attention to economics or regulatory policy. (One can’t really blame them …)

There are two things that make the news juicy: the fact that regulators are placing a value on life, and the fact that they’re revising the value down.

Most people don’t know that you can put a value on human life. Most people don’t know that they put a value on their own lives all day every day. The slogans that we grow up with - “life is precious” - dominate their thinking. Our parents value our lives very highly and teach us to at least talk about the value of life in exaggerated terms.

This kind of talk and thinking isn’t universal, of course — in our culture and others, sacrificing one’s life for a high ideal is well regarded, as is sacrificing one’s life for science, or for fun. That said, being cavalier or anti-life is generally not a good idea. No, there’s some balance between prizing life and prizing fun, the greater good, ideology, religion, or what-have-you.

We do strike those balances every day. When we go to cross the street, we make judgments about the threat to our life and health from oncoming cars and decide whether to cross in the middle of the block, at a cross-walk, at a controlled intersection, or at a pedestrian footbridge. Most of us have had occassion at least once to think about crossing a freeway — and we haven’t done it.

All this is because we are weighing the value of getting to the other side against the risk of costing ourselves our own lives. To articulate this balancing, what economists are doing is using a dollar value to measure the relative importance of life versus other things.

Think about the alternative: What if you had no way of balancing the value of life against the value of going to the movie theater? People might step into six lanes of onrushing traffic just to be first in the popcorn line. People might cower at the side of an empty two-lane road, passing up a small-town-theater showing of Fun in Acacpulco for fear of setting foot on macadam where a car tire has been. You’ve got to have some measure of the value of life, and you’ve got to use it.

Now, what about the second issue: revising the value of life downward? Under the “life is precious” presumption, that sounds horrible. It should always be revised upwards, right? Well, guess what. If you do, you’re gonna miss the movie.

If you value life too highly, you will take steps to protect life and health that undermine the value of living. Why is life “precious”? Some say for it’s own sake. But most people believe it’s because of the wonderful range of experiences, adventures, tastes, emotions, and relationships we get to enjoy in life. The freedom. If we give up too much of that, focusing strictly on keeping our hearts pumping and air flowing in and out of the lungs, we’ve lost track of the reason for living. Simply maintaining bodies in a state of sentience is not what it’s all about. So regulatory policy must do what we must do as individuals: strike a balance between life and living. Fall too far out of balance in either direction and you’re either prematurely dead or living a life without meaning.

I know nothing about the methodology that the EPA is using to calculate the value of a human life. They came up with $6.9 million. Frankly, that sounds fair to me. (So would $10.2 million, though, or $5.5 million.) There is one problem with it, though. It’s not the value I place on my life. It’s their estimate of the average value that the average American places on his life. Coming up with a single number is a gross collective judgment about how much risk and how much safety each of us should have. It’s incredibly dehumanizing to be lumped together with everyone else this way.

If you disagree with placing a dollar value on human life, well, you disagree with the idea of describing human action in a standardized way. You might as well disagree with giving names to colors.

But if you disagree with the value the EPA is placing on human life, there might be something to that. The regulatory process makes a huge collective judgments about the value of life, lumping us all together into one big average.

We should be as free as possible to make our own judgments about risk and the value of life. It’s difficult with things like air pollution, but even those kinds of risks can often be controlled through individual judgments.

Whatever the case, get over your concerns about placing a dollar value on human life. And revising the value down? — that’s a good thing. It means that we get to have more freedom and more fun!