A new American reality: The government as provider

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NEW YORK: In a country that holds itself up as a citadel of free enterprise, Washington has morphed from being the lender of last resort into effectively the only resort for home loans for millions of Americans engaged in the largest transactions of their lives.

Before, the government's more modest mission was to make more loans available at lower rates. Now it is to make sure the loans that matter most to middle class Americans are made at all.

The new reality is scorned by libertarians and conservatives, who fear intrusions by the state in the market, and by populists and progressives, who rue a society in which education and housing increasingly rest upon the government's willingness to finance it.

"If you're a socialist, you should be happy," said Michael Lind, a fellow at the New America Foundation, a research institute in Washington. "But you should really wonder whether you want people's ability to pay for housing and college dependent on the motives of people in Washington."

Why is this happening? Much of the private money that once surged into the mortgage industry has fled in a panicked horde, leaving most of the responsibility for financing American homes to the government-sponsored Fannie and Freddie.

Two years ago, when commercial banks were still jostling for fatter slices of the housing market, the share of outstanding mortgages Fannie Mae and Freddie Mac owned and guaranteed dipped below 40 percent, according to an analysis of Federal Reserve data by Moody's Economy.com. By the first three months of this year, Fannie and Freddie were buying more than two-thirds of all new residential mortgages.

A similar trend is playing out in the realm of student loans. As commercial banks concluded that the business of lending to college students was no longer quite so profitable, the Bush administration promised in May to buy their federally guaranteed student loans, giving the banks capital to continue lending.

How the government came to dominate these two crucial areas of American life is - depending on one's ideological bent - a narrative of regulatory and market failure, or a cautionary tale about bureaucratic meddling in commerce. Perhaps it is both.

To those prone to blame lax regulation, the mortgage fiasco was the inevitable result of a quarter-century in which U.S. policy makers prayed at the altar of market fundamentalism. The officials who could have stepped in and restored order stayed out in the belief that prosperity is maximized when entrepreneurs are allowed to succeed and fail on their own.

This was the spirit in which Alan Greenspan, the longtime chairman of the Federal Reserve, allowed banks to engineer unfathomably complicated webs of mortgage-based investments that, through the first half of this decade, sent real estate prices soaring and expanded home ownership.

The banks relied on these investments to raise money for the next wave of loans. The system worked so long as lenders could keep selling their mortgages, and so long as someone would guarantee most of the debts. Fannie and Freddie took care of both facets. Together, they now guarantee or own roughly half of the $12 trillion mortgage market in the United States.

Belief in Fannie and Freddie gave banks a sense of certainty as they plowed more of their capital into residential mortgages. That easy finance, in turn, brought more and more people into the market for homes, generating belief that American real estate prices could keep rising forever.

And that contributed to the banks ultimately making extraordinarily risky loans that brought the market down by handing out mortgages to people without jobs, income or down payments. Those were the people who defaulted first, once home prices started falling. But as their demand exited the market, the whole speculative bubble burst.

As some called for intervention by the Fed to cool a speculative binge, Greenspan resisted. He believed the risks of real estate were effectively limited because debt was widely dispersed. The market would sort it all out.

"Alan Greenspan had this view that the light hand of regulation was best," said Vincent Reinhart, a former Federal Reserve economist and now a scholar at the American Enterprise Institute. "His solution was to do nothing at all. He preferred zero to the efficient, modest amount of regulation, because of what he saw as the risk that if he applied any regulation, Washington would push the needle too fast."

When housing prices commenced plummeting, the ugly truth emerged that many banks did not understand the details of the mortgage-backed investments they owned. Ignorance proved expensive.

As one bank after another announced losses that now exceed $400 billion and that some estimate will ultimately cross the trillion-dollar mark, money ran screaming from the field, leaving Fannie and Freddie pretty much the only players.

A general fear of debt took hold. Banks that had offered loans to students under a federally guaranteed program suddenly could not sell investments linked to those outstanding debts, meaning they could not raise cash for the next crop of loans. Dozens of banks pulled out of the program.

"What's happened kind of speaks for itself," said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. "You had this effort to weaken the government's role. There was this conscious effort to turn things over to the private sector, and it failed."

But there is a parallel narrative, the story that critics and competitors of Fannie and Freddie have told for years: how the two companies exploited their pedigree as entities backed by the government to secure an unfair advantage over the private sector.

They swelled into highly leveraged behemoths, it was said, on the implicit guarantee that the government would step in and rescue them if they ever got into trouble. This allowed them to borrow money more cheaply than their competitors could, enabling them to make loans more cheaply.

That secured more business and rewarded their shareholders, along with their handsomely compensated executives. It emboldened them to trade in highly risky investments.

"They were using their privileged position as favored children of the government to dominate the market, and taxpayers were on the hook for substantial risk," said Martin Baily, a chairman of the Council of Economic Advisers in the Clinton administration. "You couldn't possibly say this was a pure unfettered market."

The government was getting something for its protective largess. It was using Fannie and Freddie to pursue the social goal of broader home ownership, particularly among racial minorities.

"When you're looking at the upside, here's the government helping people get mortgages and student loans," said David Henderson, a self-described libertarian economist at the Hoover Institution at Stanford University. "The downside is there might be a bailout and then you pay in taxes. These things don't come cost-free when government gets involved."

As the Bush administration readies funds to buy student loans from cash-strapped banks, and officials plot a potential bailout of Fannie and Freddie that could run tens of billions of dollars, the government's outsized role in these two huge areas will not shrink anytime soon.

It seems a strange coda to an era in which markets were sacred, and regulation heresy.

For a generation, U.S. policy makers have lectured the world on the need to unleash the animal instincts of the market. China's rickety banks should stop lending to protect state factory jobs, Americans said, and focus on the bottom line. Now the Bush administration is reluctantly concluding that Fannie and Freddie might need to be propped up to protect the U.S. homeowner.

During much of Japan's lost decade of the 1990s, Americans called for an end to the nation's coddling of weak banks. Better to let them keel over, along with the paper tiger companies they sustained. No company was "too big to fail," Washington said.

Yet here, in the aftermath of a financial crisis brought on by what were once called American virtues - financial engineering and risk management - Washington may bail out Fannie and Freddie for the simple reason that they are too big to fail. If they go down, so do whole neighborhoods. So, perhaps, does the global financial system.

"The thing we have to do now is to make sure that Fannie and Freddie remain solvent and continue to make loans," Baily said. "We just don't have any choice."

http://www.iht.com/articles/2008/07/13/bus...s/guarantee.php

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The free market works great. We should disband Freddie and Fannie. No more socialism!

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Fed releases details of new mortgage rules

By Greg Robb

Last update: 9:48 a.m. EDT July 14, 2008

WASHINGTON (MarketWatch) -- The Federal Reserve released Monday details of new rules governing mortgage origination. The final rules will be voted on by the Fed board later this morning. The final rules create a new class of high priced loans that include most subprime loans. For these loans, lenders are banned from making a loan without regard to a borrower's ability to repay the loan from income and assets other than the home's value. Lenders must also verify income and assets of the borrower. For all mortgages, the rule requires advertising to contain more information about rates, monthly payments and other loan features.