The Government-Created Subprime Crisis

Published on 23rd September 2008

Half the mortgages in the world’s biggest economy have been re-nationalised. That’s right re-nationalised.

Fannie Mae and Freddie Mac, principal players in America’s ‘subprime crisis’, were created by the US government as government enterprises, then semi-privatised, pending supposedly full privatisation in 1996, and re-nationalisation this week.

Confusion about the nature and causes of the crisis and its global implications is extreme. South Africa’s National Credit Regulator, Gabriel Davel, for instance, says our National Credit Act (NCA) ‘protects’ us from the subprime crisis. Apart from the fact that it was implemented after the subprime crisis started, there could be no similar crisis here because the cause is absent. The NCA has, however, precipitated an opposite ‘supraprime’ crisis by depressing credit-intensive markets (mortgages, vehicles, furniture, appliances, clothing etc).

For nearly a century, the supposed citadel of capitalism, America, harboured a dark socialist secret. The US government created Fannie Mae, Freddie Mac and other GSEs with the sole purpose of flooding housing markets with subprime (low-return, high-risk) credit. GSEs are ‘Government Sponsored Enterprises’. That they extended credit recklessly on an unimaginable scale is a consequence not a cause of the subprime problem.

The Federal National Mortgage Association (Fannie Mae) was created in 1938 as part of President Roosevelt’s notoriously socialistic New Deal. Fannie Mae created a ‘secondary mortgage market’ by buying mortgages with taxpayer dollars, consolidating or ‘securitising’ them, and selling them to institutional investors worldwide.

In 1968 President Lyndon Johnson sold Fannie Mae to finance the Vietnam War deficit, but kept the company under strict government control. Although formal government subsidies ceased in 1996, the omnipresent government role left the impression that GSEs are government-backed. That, more than any other factor, explains the seemingly irrational behaviour of subprime mortgage lenders and ‘secondary market’ investors. Former Federal Reserve Governor, Alan Greenspan, observed that ‘The market believes the government guarantee is there’. In Congressional evidence in 2004 he attributed Fannie Mae’s precarious position to the belief that the government would never let it fail. Nobel Laureate, Vernon Smith, called GSEs ‘implicitly taxpayer-backed agencies’, and The Economist referred to ‘the implicit government guarantee’.

The two GSEs enjoy government benefits estimated at $6.5 billion annually, including exemption from the capital requirements of other financial institutions and tax exemption. Concerned about rising housing prices fuelled by easy money, Greenspan warned Congress in 2002 that ‘our extraordinary housing boom cannot continue’.

The Federal Home Loan Mortgage Corporation (Freddie Mac) was created by the US government in 1970 to provide ‘competition’ for Fannie Mae.   The combined assets of the two GSEs grew to 45% more than that of Citicorp, America’s largest bank. Fannie Mae alone financed 55 million homes. Between them they are owed US$5 trillion. During the past two years their share value plummeted by nearly 90%. The IMF estimates resultant knock-on worldwide losses at $1 trillion.

Such numbers are hard to comprehend. A trillion one-dollar notes would be a pile 128,000 kilometres high (a third of the distance to the moon). End-to-end they would stretch nearly to the sun. $1 trillion exceeds the planet’s annual military budgets, 40 years of NASA spending, and the combined annual revenues (not profits) of Wal-Mart, Exxon, General Motors and Ford. It amounts to $3,500 (R28,000) for every American and $25,000 (R200,000) for every South African.

When George Schultz was told they were ‘too big’ for government to allow to let them fail, he said ‘Then make them smaller’. Now that they are re-nationalised, will the US government hold onto them as perpetual monuments to socialism, or will it privatise them properly? Greenspan suggests full nationalisation, refinancing from taxes, unbundling into smaller entities, and sale by public auction.

The IMF’s Jaime Caruana says experts have been ‘humbled’ by the ‘very, very complex’ impact of the crisis on foreign markets. Banks in many countries have written off hundreds of billions of dollars and retrenched thousands of staff. The BBC maintains a subprime crisis ‘timeline’ of losses ‘so far’.

After much speculation, Federal Housing Finance Agency (FHFA) Director, James Lockhart, announced his decision to place the two GSEs into ‘conservatorship’ (nationalisation) under the FHFA. That he is free to do so reflects the extent to which they have been de facto government enterprises.

So, far from the subprime crisis being a ‘market failure’, the opposite is true. George Bush’s Treasury Secretary, Henry Paulson, admitted in the press conference where the take-over was announced that he attributes ‘the need for today's action primarily to the inherent conflict and flawed business model embedded in the GSE structure’.

Governments seldom learn from their mistakes. The basic problem, not yet addressed, is that you travel in the wrong direction if you don’t know where you’re going. The best short-term strategy will reveal itself only when the end objective is clear. How about the goal being the long-overdue separation of economy and state?

Leon Louw 

Executive Director, Free Market Foundation.

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