Fannie Mae, Freddie Mac And The Capture Theory Of Regulation

See “Capture” of Regulators by Fannie Mae and Freddie Mac by Gary Becker. Excerpts:

"An economically disastrous example of the capture theory is provided by the disgraceful regulation of the two mortgages housing behemoths, Fannie Mae and Freddie Mac, before and leading up to the financial crisis. In their fascinating recent book, Reckless Endangerment, Gretchen Morgenson and Joshua Rosner explore in great detail how Fannie Mae used political connections and intimidation of anyone who stood in their way to gain a highly dominant position in the residential mortgage market. The authors’ show that various government officials, including congressmen and presidential cabinet members, closed their eyes to what these two government-supported enterprises (GSE) were doing. They allowed them to take on enormous risks, while publicly defending their behavior as not being highly risky."

"...investors expected that the government would help out if these companies got into trouble. By the beginning of the crisis in 2008, Fannie and Freddie held or guaranteed about half of the United States’ $12 trillion of assets in the residential mortgage market. In September 2008, both Fannie and Freddie were taken over by the federal government when they became insolvent. The loss to taxpayers is likely to be in the hundreds of billions of dollars because many of the mortgages are subprime and of little value."

"Reckless Endangerment shows how the chief executive officers of Fannie Mae furthered the reach and reduced the regulatory control over their company by assiduously courting congressmen, Fed officials, the Congressional Budget Office, high-level officials of the U.S. Treasury, the Secretary of Housing and Urban Development, and major economists. The prominent and well informed congressman, Barney Frank, gets especially sharp criticism for his continual support of Fannie and Freddie while he was initially a member, and later chairman, of the House Financial Services Committee, the powerful committee charged with oversight of the housing and financial sectors. Barney Frank remained an unwavering supporter of Fannie and Freddie until 2010, when he admitted that they should have been more closely regulated. In a bit of irony, he is a principal author of the 2010 Dodd-Frank act that attempts to reform the financial sector mainly by giving even greater discretion to the regulators.

Fannie and Freddie had so much money and political power at their disposal that it became risky for anyone to oppose what they wanted: large increases in their holdings of subprime and other mortgages, with no questions asked. Different government agencies that were supposed to either regulate or oversee these GSEs ended up as advocates instead. Well-known economists wrote favorable articles downplaying the riskiness of the holdings of Fannie and Freddie. These articles were sometimes published in journals or other publications sponsored by these companies."

"The Fed also comes in for sharp criticism by the authors. One example discussed was a Boston Fed publication in October 1992 claiming that minorities were widely discriminated against in gaining access to mortgage credit. The media, many regulators, and some economists widely praised this study as offering definitive evidence of extensive discrimination against minorities in the credit market. Fannie Mae’s head, the politically astute James A. Johnson, seized on this reaction to promote a large increase in mortgages to poor residents of African-American and Hispanic communities with bad credit histories.

Since I had written a book on discrimination against minorities in the economy, I was curious to see how the authors reached such definite conclusions about mortgage discrimination. I became convinced after reading their study that it was deeply flawed, and failed to show what they claimed about discrimination in the market for mortgages. The theory of discrimination against minorities implies that minority applicants for mortgages would need to have better credit records and higher employment stability than comparable whites in order to obtain mortgages. This suggests that default rates would be lower and profitability higher on loans to minorities.

The study’s authors presented no evidence to support these implications of discrimination theory. All the circumstantial evidence, and some real evidence, showed just the opposite."