Streetwise Professor

September 13, 2008

Moral Hazard

Filed under: Economics,Politics — The Professor @ 3:14 am

On Sunday Treasury Secretary Hank Paulson announced plans to place Fannie Mae and Freddie Mac into conservatorship. If Paulson’s plan is implemented, the operations of the mortgage giants will be reduced dramatically over the coming years.

This is good news, in a way. These GSEs were a disaster waiting to happen–and it just happened. The government’s implicit guarantee of the debt of these enterprises–just made explicit–encouraged excessive risk taking, and excessive risk taking eventually leads to an implosion if the game goes on long enough. In recent years Fannie and Freddie had dramatically increased their interest rate and credit risk and house price risk exposure by purchasing and warehousing larger and larger quantities of mortgages, including large amounts of higher credit risk stuff. This increased their exposure to housing price risk (housing price declines raise the probability of default). When that price decline occurred, these highly leveraged institutions soon blew through their capital. (Arguably, the advantages of these institutions also encouraged greater risk taking by other financial intermediaries attempting to compete with them.)

It would of course have been better if the administration and Congress had responded to numerous, informed warnings of the inherent dangers posed by the GSEs by reining them in years ago. The administration tried, in a half-hearted sort of way, but Congress ardently defended Fannie and Freddie even in the face of accounting shennanigans that would have made Enron proud.

And that’s where the real moral hazard lies. At root, moral hazard exists when a decision maker is not accountable for his actions, when he is able to reap the benefits but somebody else pays the costs. Due to the arcane nature of the GSEs, the ability of Congress to deflect attention, the advantages of incumbency, and myriad other factors, Barney Frank and Chris Dodd and the others in Congress who have protected Fannie and Freddie at every turn will never, ever, pay a political cost for their actions. They have reaped the political benefits, in the form of campaign contributions and the channeling of Fannie and Freddie funds to their pet political causes in housing, but you and me and every other taxpayer will have to pay to clean up the mess. Few people who matter–the constituents of Frank and Dodd et al–will understand the connection between their actions and the F & F blowup, and what’s more, the costs are spread broadly among all taxpayers, the vast majority of whom would be unable to exact a punishment on the perps even if they had the information and incentive to do so.

It is nauseating in the extreme to see Frank and Dodd express not the slightest remorse for contributing to Fannie’s and Freddie’s disasters. Indeed, both have ardently defended the role of these institutions, and have stated that they intend to ensure that some entity continues to fulfill the redistributive functions of Fannie and Freddie, i.e., subsidizing home ownership and the construction of low income housing.

In the past, F & F supported these functions out of the cash flows generated from its for-profit operations. These operations, in turn, benefited from the funding cost and competitive advantages associated with their special status as GSEs, and the implicit federal guarantee. The whole idea here was to run a shell game that provided monies for certain activities desired by certain politicians without requiring explicit claims on tax revenue. Nonetheless, as was long apparent–and as is now painfully evident–the implicit claim on taxpayer revenues was very real. These entities were, in some degree, analogous to royal monopolies from medieval or mercantilist times, whereby the crown granted special privileges to certain companies in exchange for the companies’ support of activities desired by the crown.

Frank, Dodd, et al, want to continue the shell game, and want to continue to support favored activities without the discipline and accountability (such as it is) of the normal appropriations process. Thus, they will fight tooth and nail to maintain as much of the F & F structure intact. The inexorable logic of this kind of structure creates moral hazard, and if Frank and the gang get their way, sometime not too far into the future, some Son (or should it be “Daughter”) of Fannie will require another bailout. And thus, the lack of political accountability creates the true moral hazard that is at the root of our current financial travails.

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1 Comment »

  1. […] for Frank and his partner in slime Dodd were the creators of the monster that is Frank-n-Dodd.  So what I wrote in September, 2008 holds: And that’s where the real moral hazard lies. At root, moral hazard exists when a decision maker […]

    Pingback by Streetwise Professor » Sorry Don’t Feed the Bulldog — August 24, 2010 @ 8:35 pm

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