Thursday, October 9, 2008

Many Democrats, along with the mainstream media, seek to portray the mortgage bailout mess as a failure of the free market and deregulation. Nothing could be further from the truth. Laissez-faire is more accurate.

The collapse of government housing insurers Fannie Mae and Freddie Mac illustrate perfectly what can go wrong when Russian-style crony capitalism replaces a genuine free market. Fannie and Freddie were never private businesses in the true sense. They are known as government-sponsored enterprises (GSEs) - public/private partnerships in which profit gets privatized and risk is dumped on the taxpayer. The estimated cost of the bailout of Fannie and Freddie is $200 billion and counting.

The taxpayers are being fleeced, but senior officials at Fannie and Freddie have made out very well. For example, Franklin Raines became Fannie’s chairman and CEO in 1999, and he earned $90 million in compensation before he was forced to resign in 2004 in the wake of an accounting scandal. Shortly after becoming head of Fannie, Mr. Raines talked about the very easy-money policies that helped ignite the mortgage meltdown. “Fannie Mae has expanded home ownership for millions of families in the 1990s by reducing down payment requirements,” he said. But that was not generous enough for Mr. Raines, as he announced in September 1999 a new plan to help banks make more loans to persons with poor credit ratings in order to increase the number of minority and low-income homeowners. Peter Wallison, resident fellow at the American Enterprise Institute, suggested at the time that Mr. Raines might be sowing the seeds for a financial debacle reminiscent of the savings-and-loan meltdown of the late 1980s. “If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry,” Mr. Wallison presciently warned.

Neither the White House nor Congress heeded the warnings, Fannie and Freddie retained strong bipartisan support during the 1990s and early part of this decade. After several investigations uncovered questionable accounting practices in 2003 and 2004, Mr. Raines and some other senior officials were forced out. Roger Barnes, a former Fannie Mae accountant said he took his concerns about earnings manipulation directly to Mr. Raines and CFO Timothy Howard, but that his concerns were ignored, and he faced continued reprisals for raising concerns about the issues. Mr. Barnes told the House Financial Services Committee in October 2004 that the “atmosphere and culture” under Mr. Raines and Mr. Howard was “one of intimidation, restraint of dissenting opinions and pressure to be part of the ‘team’ ” - in other words, to give his bosses the numbers they wanted to please Wall Street.

Daniel Mudd, Mr. Raines’ successor, didn’t fare much better. The New York Times reported that between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers, more than triple the amount in all its earlier years combined. Mr. Mudd disregarded warnings from his managers that lenders were making loans that could not be repaid. Instead, he listened to Angelo Mozilo, head of Countrywide Financial, who warned Mr. Mudd that Countrywide would take its business to firms like Bear Stearns and Lehman Brothers (both of which went bankrupt like Countrywide) if Fannie did not begin buying subprime loans from his firm. Mr. Mudd complied - with disastrous results.

Management practices at Freddie Mac were questionable, too. Freddie’s chief risk officer, David Andrukonis, warned chief executive Richard Syron in 2004 that the company was financing questionable loans that threatened its financial health. But Mr. Syron, he said, replied that “we couldn’t afford to say no to anyone.” Mr. Syron, who took the helm of Freddie in the wake of an accounting scandal that swept his predecessor from office, has collected at least $38 million in compensation since 2003.

What were Congress and the Bush administration doing while this took place? Mr. Wallison and AEI colleague Charles Calomiris point out in a new paper titled “The Last Trillion-Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac,” the political strategy was successful. Congress did not adopt any reform of Fannie Mae and Freddie Mac until this summer, when Republicans demanded it in exchange for Senate passage of housing legislation. By then, it was too late. Politicians might be paying for this debacle for years to come.

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