Fannie Mae and Freddie Mac, those bizarrely named American half-private, half-government creatures, epitomise everything that is wrong with modern financial capitalism. While they were formed for the apparently worthy purpose of enabling Americans to purchase their homes, they morphed into “Ponzi financiers” who profited from and abetted the growth of the biggest speculative bubble in world history.
In the aftermath to the Savings and Loans crisis, Fannie and Freddie began to buy mortgage securities. A lender would bundle up (say) 2,000 $500,000 mortgages paying 10% interest into a $1 billion bond paying 9%: once Fannie or Freddie bought the bond, the lender had a fresh billion with which to repeat the process.
They weren’t the only buyers of such bonds, but they took on close to $6 trillion worth of them. This generated a matching level of debt, much of it foist on low income families that really couldn’t afford it. But the mortgage origination fees were huge, and Fannie and Freddie also made a motza from the spread between the low rates their government guarantee gave them, and the high rates on these bonds.
It all worked a treat while house prices rose. Borrowers who couldn’t finance their loans from income could sell and get out — with a profit. But once the price bubble stopped, as it did in 2006, the whole house of cards collapsed.
So where were the regulators, and what happened to the laws that were supposed to enforce responsible borrowing? The regulators largely operated as cheer leaders for deregulation, arguing that “the market” was the best regulator, and drafted laws that enabled securitised lending to expand dramatically, and ultimately disastrously.
Clearly the myth that deregulated finance works better than regulated finance is now dead. Deregulated lending results in lenders extending as much debt as borrowers are willing to take on, since they profit from debt; and borrowers are willing to take it on if they perceive the possibility of profit from leveraged speculation on assets.
That is a short term private route to profit; at the level of society, it simply results in an ever rising level of debt. Borrowing to finance investment benefits society so long as most investors are reasonably prescient about future demand (they don’t all have to be Steve Jobs). But borrowing to enable individuals to gamble on stock and housing markets is socially a negative sum game — a Ponzi Scheme.
This sort of behaviour won’t be controlled by the economist’s usual panacea of more competition. In fact, competition for market share actually drove the willingness of lenders to reduce their lending standards: “if we don’t lend to this borrower who’s willing to take on debt servicing equal to 50% of net income, someone else will; and anyway if he isn’t able to repay, we can foreclose and sell the house for a profit anyway”.
Instead, we need real regulatory reform that limits the willingness of lenders to lend to finance speculation.
Ironically, one of the simplest reforms would be to enforce the old legal concept of “caveat emptor”, because in a lending contract, the buyer is actually not the borrower, but the lender.
Think about what happens when a borrower goes bankrupt. The borrower’s property is sold in what is called a “mortgagee sale”: this describes the bank as the buyer, not as the seller, and so it is. When a bank extends a loan, it is in fact buying a promise from the borrower to supply a stream of money over time (interest payments) in return for money now.
The lenders who gave loans to borrowers that were manifestly unable to finance those loans were BUYING a product that they should have known was a dud. But lenders got away with it because, if the borrowers couldn’t meet the payments, they got the right to sell the borrowers’ assets.
But if we enforced “caveat emptor”, there would be a limit to the amount of security the lender could claim. Throwing the risk of lending onto the lender may be the only effective way in the long term to seriously limit the growth of speculative lending.
Associate Professor Steve Keen is the author of Debunking Economics.