osewalrus (osewalrus) wrote,

Why I Find the Fannie/Freddie Theory Absurd

With the total meltdown of the financial markets, we have seen the regrouping of the two groups that had preached the doctrine of the Market. On the one hand, we have the Republicans who were all about "the ownership society." OTOH, we have the U of C school and associated Libertarians who have the same belief that owning a copy of "The Fountainhead" conveys knowledge of economics that certain SCAdians have that sending membership dues to Milpitas makes you an expert in all things between 600 and 1600.

Both groups (and one should not confuse them, although one finds some overlap) have settle on the same culprit: Fannie Mae and Freddie Mac. While there is much to loath in the management of these companies, the purported evil Democratic (or generically government) plot to destroy the market by dumping cheap loans does not even come close to explaining the total meltdown, for reasons I explain below.

Most folks who want to blame Fannie and Freddie are living in last year's crisis. But let me dispose of the arguments quickly.

1) Republicans/conservatives. Unsurprisingly, Rush and his boys want to blame "them." "They"are always a fine target, since it can't possibly be "us." In this case, "them" is thhose bleeding heart liberal Democrats who forced everyone, but especially Fannie and Freddie, to make loans to those swarms of "Mexicans" and "uppity N-words" who -- when not stealing our jobs, raping our daughters, and spreading leprosy -- are responsible for all other social ills that keep "real Americans" down.

This conveniently infores that it was beloved fearless leader who conceived and pushed the "ownership society" in the first place. It also ignores all the rhetoric between 2004 and about a year ago how Liberal Democrats who wanted to regulate questionable lending practices were really anti-black and anti-hispanic because they wanted to keep them from enjoying the benefits of the "ownership society."

The other problem with this theory is it rather ignores the inconvenient truths about who made these loans (everyone) and who took these loans (everyone). The Real Americans toting around more credit card debt than they can handle, tapped out on their home equity, and with mortgages "under water" are as much to blame as "they" are. And if it is really only "them," why is it that so many Real Americans who took loans from private companies and fudged their income figures and reached beyond their means are in trouble? O.K., I don't expect rational answers from folks who are basically saying "the Mexicans are our misfortune" and looking for someone to blame. I simply marvel at how such folk can turn on a dime and remain impervious to the evidence of their senses. But I understand that is easier for some than reality.

Let's move on to the more interestng case.

2) Libertarians/U of C school. Here we get to the far more sophisticated folks who would have been happy abolishing Frannie and Freddie back in the day, because all government backed intervention invariably warps the market. Here, the proof is actually a proof, rather than simply pointing to internal contradictions.

The problem for the U of C explanation that we simply failed to deregulate enough lies in at the heart of the current total meltdown, and why U of C accolytes with any intellectual rigor like Alan Greenspan are deeply troubled. It has to do with rational actor theory and risk assesment.

Had we merely had Fannie and Freddie making bad loans, we could have confined the damage to one economic sector. It wasn't. The advent of credit default swaps (CDS) and increasingly complex deriviatives was the ticking time bomb that blew all this up. Why? Because functioning markets depend on information -- particularly the ability of actors to reasonably assess risk.

A functioning market, particularly a complex and interelated market, relies on information so that actors can determine whether or not to engage in transactions. In simple markets, such transparency is generally achieved by pricing mechanisms. Aggregate enough willing buyers and willing sellers and you have some approximation of value. Where risk is involved, rational actors price the risk. Risk-phylic actors take more risk for greater reward. Risk-phobic actors avoid risk and accept the smaller reward. In a functioning market, this evens out over time with individual risk takers achieving great rewards but the majority of risk takers failing, giving rise to risk avoidance strategies and creating a stable yet dynamic market.

But as the market grows more complex, it becomes harder to assess risk. With CDS and derivatives, it became essentially impossible to assess risk. Worse, pricing ceased to be a useful proxy for risk assesment. Herd behavior and other drivers of rational actor theory took over. As risk became harder to assess, rational actors looked to see who else was involved in the transactions as a measure of safety. Because so many actors were involved, each assuming the other actors had superior information the situation became reenforcing.

Other factors contributed to the problem of information and risk assessment. The issue of conflict of interest was handled by disclosure. Those who rated transactions and/or insured transactions and/or advised on transactions were allowed to have financial interests in the outcome -- on a theory that rational actors would evaluate the advise of conflicted actors based on the disclosure and discount if they felt it was tainted. But when all risk assessors became conflicted, it was impossible to genuinely assess risk. Worse, certain risk assessing firms that had no obvious conflicts had non-obvious conflicts, such as receiving business or other rewards for favorable ratings. Finally, the ability to genuinely assess risk became impossible even for risk assessors becuase of the same factors clouding the other assesments -- the inability to determine the true nature of the derivitive and its ultimate value/risk profile.

Now lets thorugh on Frannie and Freddie. If the problem were simply that Fannie and Freddie distorted the market in loans, then rational actors would not have accepted CDS based on their paper. In theory, CDS and derivitives based on questionable loans by Fannie and Freddie were subject to the scrutiny by rational actors such as Lehman Bros and AIG and other investors. But the reality was that there was simply no way to assess the actual value or risk profile of CDS or certain complex financial deriviatives.

To all of this, one can propose several scenarios that would make it "more" the fault of Fannie and Freddie and general government intervention in the marketplace. But for those making the assertion, I would ask for some actual empirical evidence, please. I'd like some actual math that shows how the Fannie and Freddie factors outweighed the other problems of risk assessment in the market.

The issue is telling because it goes to the heart of the question of whether markets alone can produce efficient results and unrelenting prosperity. I have argued (and continue to argue) that there are inherent trade offs between regulation and reliance on unregulated market mechanisms. I believe neither in the efficient calculations of centralized government regulators or the perfect efficiency of the unregulatd market. Rather, I believe that unregulated markets have a natural boom-bust cycle, as profit increases complexity until we reach the Coasian limit on efficiency (usually thought of as the efficiency of the firm, but the logic applies equally well to the market as a whole). At that point, we see retraction, collapse, more panic behavior, until we begin the process over.

By contrast, centralized planing becomes so stifling and divorced from the empirical market (i.e., where real people shop) that it eventually collapses under its own weight. Worse, the dangers of agency capture and public choice theory are real, and I have found no totally satisfactory answer to these. In a market wth profit-driven companies and regulation, it is inevitable that regulators grow closer to incumbents and incumbents learn to manipulate the system to their advantage. Even without this, the cost of regulatory delay s real, and can prevent useful and important innovations from emerging.

So adults in public policy, IMO, chose their poison and accept the consequences, recognizing that the pendulum swings. Because I believe markets are not capable of self-regulating in the manner envisioned by free market proponents, I dislike deregulation for its own sake. Because I distrust regulatory processes, I dislike regulation for its own sake. Whether I prefer to rely on regulation or market forces depends on whether the issue at hand is critical infrastructure and the risk of letting things go unsupervised.

But I find few folks who share this view. My progressive friends, by and large, have little use for greed and corporate profit maximization. They regard regulatory oversight as not merely necessary, but desirable. They blame the problems of regulation on individual corrupt regulators, a view I regard as being as silly as blaming Wall St.'s woes on greedy brokers. My Libertarian and free market friends are quite knowledgeable about the risks of regulation, but unwilling to believe that markets may be inherently non-self-regulating over the long-term. A very few U of C types will accept the concept of the boom-bust cycle and argue that it is better than ceding power to a bureuacracy that must inevitably do more harm than good. Even fewer are content to make a moral argument, that even if regulatory mechanisms are more efficient they are inherently immoral because the power to tax/regulate is the power to destroy and is inconsistent with ideas of human freedom.

But to return to my central thesis. I will submit that the effort to blame government intervention in the market exclusively, rather than to place adequate blame on deregulation and trust in the market to self-regulate, does not stand up to the evidence. Information theory and rationa actor behavior, properly understood in the aggregate, provide a much more comprehensive answer that addresses real world results the government intervention model cannot address.

I caveat this by saying that there is plenty of blame for government intervention, particulrly given the extent of agency capture and the creation of false expectations (the presence of government regulators reassures actors, despite the fact that government regulators are not actually performing their stated functions). There was a lot wrong with Fannie and Freddie, and they played their role in abetting the crisis rather than stabilizing the market. But to assign the entirety of the blame to Fannie and Freddie is absurd. At best, it is an ideological dodge designed to shore up belief in the self-regulating market. At worst, it is cynical scapegoating and an effort to divert the angry mob with pitchforks and torches away from the true architects of disaster.
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