This week saw considerable fanfare regarding Fannie Mae and Freddie Mac, the huge government sponsored enterprises (GSEs) that dominate the mortgage market. On September 05, 2008 the GSEs were placed into conservatorship - essentially declared bankrupt - and bailed out. Each company received $100-billion in new capital to make good their huge lending losses. Additional capital injections were made on December 24, 2009 - a date obviously chosen to minimize scrutiny. This week it was noted that since the 2008 bailout, the GSEs have now paid the Treasury Department more money in dividends than they received in bailout money. As a result many commentators judged the GSE bailout a success.
Judging the GSE bailout a success at this point betrays a complete lack of perspective for at least two reasons. First, in response to the crisis the Federal Reserve created trillions of dollars out of thin air. In September 2008 the Fed's balance sheet was approximately $800-billion. The Fed's balance sheet ballooned to over $4-trillion at the high of the crisis, and today is still close to $3.5-trillion. The Fed used all this credit money to purchase all sorts of toxic assets from Wall Street banks and the GSEs. Included in these assets were hundreds of billions of dollars of mortgage backed securities (MBS). The Fed paid full price for these MBS even when these assets were then trading considerably below their par value. Shouldn't any judgement on the ultimate success of the GSE bailout have to wait until the Fed sells all the assets it purchased during the crisis and returns its balance sheet to pre-crisis levels? After all, would Sears be flirting with bankruptcy if the Federal Reserve created hundreds of billions of dollars to purchase appliances and lawnmowers from Sears?
The second reason betraying a complete lack of perspective can be summarized in a maxim attributed to Gordon Bethune, the former chairman of Continental Airlines, now part of United. It states, “You're only as smart as your dumbest competitor.” For discussion purposes assume you operate an airline and a competitor starts to offer flights between New York and Los Angeles for $75. The average airline passenger won’t draw a major distinction between different carriers in terms of service. If one carrier is offering much lower fares between the same two destinations, then the average airline passenger will almost always fly on the airline offering the lower fares. With so much of your own costs tied up in crew salaries and aircraft, you will be forced to compete with these lower prices. Your cost structure may not allow you to meet your competitor’s fares, but you will certainly have to significantly reduce your fares to compete. This dynamic explains the boom and bust profitability cycle that the airline industry is known for. The entrant of a single competitor dedicated to lowering prices to increase market share will change the business conditions for all the airlines it competes with. Consequently, for most airlines their most widely traveled route is the one in and out of bankruptcy court! There is a saying in the investment community that states, “If the Wright brothers had any idea of how much money would be lost by airline companies, they never would have invented the airplane.”
The dynamics in the mortgage industry during the bubble years were no different than the theoretical discussion of the airline industry. The entire mortgage market was influenced by the GSEs; they dominated the mortgage market. All it took to be able to 'securitize' a mortage was for the mortgage to be judged 'conforming' by the GSEs. As the GSEs lowered their lending standards to advance President Clinton's homeownership goal, the rest of the mortgage market followed the GSEs down the path to financial ruin. Mortgage originators, who don't hold on to any of the mortgages they issue, could easily sell mortgage to investors by claiming the mortgages were 'conforming' to GSE standards. With a GSE stamp of approval, the lending practices of the GSEs didn't just undermine the GSEs, these lending practices undermined the entire mortgage market.
Implicit in this week's argument that the GSE bailout was a huge success are two completely false notions;
- A box can be drawn around the GSE losses,
- The incompetence of the largest company in a market can’t impact other companies in that market.
Of course, these notions are completely bogus and betray a massive misunderstanding of both the scale of the Fed's post-crisis interventions, (which have yet to be unwound), and a mistaken belief in a completely static business environment where companies act independently of one another. The simple fact of the matter is the lending practices of the GSEs completely infected the entire mortgage market, and played a major role in bringing the country to its knees. It is myopic in the extreme to judge the GSE bailout a success when the Fed is still laden with assets it purchased from the GSEs, and GSE lending practices led to losses throughout the mortgage industry. This complete lack of perspective and myopic view of the crisis does much to explain why there has never been a comprehensive examination of the causes and consequences of the financial crisis.
Peter C. Schmidt
Sugar Land, TX
September 08, 2019
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