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Paul Kiesel
Paul Kiesel
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Bernanke, Greenspan and Paulson were Wrong on Fannie and Freddie, Housing Crisis

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On July 16, Federal Reserve Chairman Ben Bernanke told Congress that he believed Fannie Mae and Freddie Mac would be able to make it through the storm of the U.S housing crisis. In front of Representative Barney Frank’s House Financial Services Committee, Bernanke also said that troubled Fannie Mae and Freddie Mac were adequately capitalized and “in no danger of failing.”

Fast forward to last Friday evening, September 5, when reports started circulating over news wires that Fannie and Freddie were about to be taken over by the federal government, which, of course, ended up happening within 48 hours of that news breaking.

Did Bernanke really miss all of the troubles at Fannie and Freddie — their inability to raise capital, amid a multifarious of other issues — only seven weeks ago, and all of a sudden saw that the two GSEs needed the backing of the federal government? How did Alan Greenspan overlook or not understand the housing bubble that was taking place while chairman of the Fed, and warn the country of the potential ramifications from that bubble bursting? (Greenspan made several claims that the worst of the housing market’s problems were over, towards the end of 2006.) Why did Treasury Secretary Henry Paulson assume that Hope Now would be the one and only answer to the flood of foreclosures and default notices hitting the most problematic housing markets, even though within a year of its creation President Bush would sign a sweeping housing bill into law, designed to do what Hope Now never could have done?

(When President Bush was days away from signing the housing bill into law — a drastic change of heart considering just a week before he was adamantly opposed to a housing bailout package — he made several comments on how it would shore up Fannie and Freddie’s capital troubles, however, Wachovia economist Mark Vitter felt that housing bill would not successfully provide that relief, “[Won’t] speed up or lessen the impact of the correction of the housing market [. . .] It’s too late for that. There’s nothing that can be done.” Again, if Fannie and Freddie had capital troubles towards the end of July and that was Bush’s definitive reason for signing the housing bill, then why did Bernanke tell Congress two weeks prior that the two GSEs were “adequately capitalized” and “in no danger of failing?”)

All of these questions will be asked long after the housing market, credit markets and Wall Street have rebounded (sometime in 2010?), but ultimately, three of the nation’s supposed most erudite individuals on macro- and microeconomics ended up disastrously wrong in their observations and predictions. If Bernanke, Greenspan and Paulson truly didn’t know what was going on and what was going to be outcome of mistaken ignorance, then the housing/mortgage crisis is further evidence that banks and lenders lacked oversight and regulation, thus, subsequently allowing banks and lenders to be more inconspicuous in their lending practices (TELA violations). Or maybe all three knew, and chose not to tell the public in fear of expediting a problem that appears, after all of the deregulation that took place in the banking industry in the late-90s and early-2000s, to have been inevitable.

Academic economists, like Yale economist Robert Shiller and NYU economist Nouriel Roubini (a.k.a. Dr. Doom), were more perspicacious to the housing and mortgage fallout, so it’s not as if the signs weren’t there. The writing had been on the wall for awhile. (I wrote a blog back in May, “A Trillion Dollar Risk,” that examined Fannie’s and Freddie’s financial problems.) These two men based their economic theories off empirical data suggesting that the fallout would be in greater losses and more impacting to the economy than any information given to us from an economic surrogate of the Bush administration or CEOs on Wall Street (speaking of which, 18 year veteran CEO of WAMU, Kerry Killinger, was ousted earlier this morning).

For instance, The New York Times’ Irving Fisher gives a compelling argument as to why Fannie and Freddie needed to be bailed out — one of many opinions on the matter and proof that market observers and financial journalists were keen to the mortgage industry’s dilemma — and that the two GSEs should have been financially backed at an earlier date, in hopes of circumventing a lot of the chaos that’s recently taken place among other financial institutions. The reason: debt deflation. Fisher does argue, however, that the government take over of the two mortgage giants will prove beneficial to future mortgage borrowers.

As the economist Irving Fisher observed way back in 1933, when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a “stampede to liquidate” is a severe economic slump.

That’s what’s happening now, with debt deflation made especially ugly by the fact that key financial players are highly leveraged — their assets were mainly bought with borrowed money. As Paul McCulley of Pimco, the bond investor, put it in a recent essay titled “The Paradox of Deleveraging,” lately just about every financial institution has been trying to reduce its leverage — but the plunge in asset values has nonetheless left these institutions with more debt relative to their assets than before.

And the numbers keep getting worse. In July 2007 Ben Bernanke suggested that subprime losses would be less than $100 billion. Well, last month write-downs by banks and other financial institutions passed the $500 billion mark — and the hits keep coming.

Which brings us to Fannie and Freddie. They’re the only big financial institutions that haven’t joined in the rush to deleverage, which is why they now account for about 70 percent of new mortgage loans. But their financial foundations have been undermined by debt deflation, even though their lending was more responsible than average. (A subprime borrower is basically someone whose credit wasn’t good enough to qualify for a Fannie- or Freddie-backed mortgage.)

So Fannie and Freddie had to be rescued — otherwise debt deflation would have gotten much worse. Indeed, their financial troubles have already caused problems for would-be home buyers: mortgage rates are up sharply since earlier this year. With the federal takeover, which removes the pressure on the lenders’ balance sheets, we should see mortgage rates drop again — which is definitely good news.

The New York Times, 9/7/08

How we’re able to prevent a future financial crisis like the one that’s been taking place, and that will still continue well into 2010, can only be answered when we’re able to understand its initial causes. Until then, we’ll be wondering what else was overlooked by our bank regulators during the build up to the mortgage crisis, and when/how that will hit the U.S. economy.