Seeds of subprime

How flawed government policies and state backing for home loans led to disaster in the US housing market

Fannie Mae & Freddie Mac: Turning the American Dream into a Nightmare, by Oonagh McDonald, Bloomsbury Academic, RRP£55/$85, 496 pages

At the heart of the current global economic crisis, the worst within living memory, has been a near-global banking meltdown; and one major (although by no means the only) cause of that meltdown was the subprime mortgage disaster in the US. This book is the definitive study of that disaster and of Fannie Mae and Freddie Mac, the two government-sponsored enterprises, as they are known in the US, whose conduct in large part caused it.

An academic and former politician – she spent over a decade as a Labour MP, most of it on the front bench – Oonagh McDonald has produced a book that is scholarly and comprehensive, but at the same time, despite the complexity of the subject-matter, lucid and eminently readable.

Fannie Mae (strictly speaking the Federal National Mortgage Association) was founded by Franklin D. Roosevelt in 1938 as part of the New Deal, and Freddie Mac (the Federal Home Loan Mortgage Corporation) by Richard Nixon in 1970, ostensibly to compete with Fannie Mae. It is a curious fact that the US, of all countries, has for the entire postwar period had a semi-socialist home loans industry.

Neither Fannie nor Freddie made any home loans themselves. What they did was to buy them from the banks who made the loans, package them into mortgage-backed securities, and then sell the MBS to other financial institutions, both in the US and overseas, with a full guarantee against any losses from default on the underlying mortgages.

The flaw in the model was obvious enough (although it was at least in theory a regulated activity), but the consequences became a systemic disaster only following the launch by Bill Clinton, in 1995, of a “National Homeownership Strategy” designed to increase greatly mortgage lending to minorities and those on low incomes, with legislation to require lenders to lend to those with poor credit ratings or indeed without any credit rating at all.

This the lenders were happy to do, since the default risk was carried by Fannie and Freddie; and Fannie and Freddie were in turn happy to comply, not least because their chief executives and those immediately below them had awarded themselves handsome remuneration packages based on the volume of business done. (James Johnson, the long-time Democratic party insider and chief executive of Fannie Mae from 1991 to 1998, was paid some $28m during that time.)

Thus was the subprime mortgage boom born. When George W. Bush succeeded Clinton in 2000, he did nothing to stand in the way, buying into the prevailing so-called “affordable housing” ideology. And after the bubble burst, there was no option in 2008 other than to nationalise Fannie and Freddie completely, at a cost to the American taxpayer running into hundreds of billions of dollars.

McDonald’s verdict is both well-founded and unsparing: “As pivotal players in the market, Fannie Mae and Freddie Mac must take a large slice of the blame. But above all, it was the distortion of the banking system to achieve political ends that ultimately caused the crisis.” What she does not do is draw any wider lessons. Yet there are, I believe, at least two important lessons to be drawn.

The first is that government-sponsored enterprises, or what in the UK would be called public-private partnerships, are to be avoided like the plague. Designed to secure the best of both worlds, they invariably end up exhibiting, if not the worst of both worlds, the benefits of neither. In particular, they escape both the discipline of effective state (ie Treasury) control and the discipline of the marketplace.

Systemically important banks, considered too important to fail, come very close to being in this category – which is why they need to be as limited in scope and as small a part of the overall banking scene as is practicable.

The second is that the efficacy of financial regulation is strictly limited. Fannie Mae and Freddie Mac, in common with the rest of the US financial sector, were subject to detailed regulation. For reasons well described in this book, it failed completely.

The fact is that, while some degree of prudential financial regulation is required, the less complex the better (although even that can work only if there is adequate supervision); structure and incentives are both far more important. A structure that lends itself to abuse will, whatever its claimed merits, be abused, at great cost to the economy as a whole. And if incentives are in place, whether in the form of remuneration packages, taxation policies, or accounting standards, which reward reckless behaviour, there will be reckless behaviour – again at great cost to the economy as a whole.

Lord Lawson was chancellor of the exchequer from 1983 to 1989 and is currently a member of the Parliamentary Commission on Banking Standards

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