June 12, 2011
Capture Theory and the Financial Crisis
Capture Theory and the Financial Crisis—Posner
The phenomenon of regulatory capture—the transformation of a regulatory agency into an anticompetitive tool of the regulated industry—is real, but I think Fannie Mae and Freddie Mac are more accurately regarded as examples, though no less unlovely, of something else: a capitalist-socialist hybrid. They were not regulatory agencies; until they collapsed during the financial crisis of 2008 and were taken over by the federal government, they were private corporations that had been chartered by Congress to promote home ownership. Their status as GSEs (government-sponsored enterprises) created an expectation that the government would guarantee their debts. This expectation enabled them to borrow at lower interest rates than other private corporations. They were supposed to promote home ownership by buying or guaranteeing home mortgages. They did that; they also pioneered mortgage securitization—in effect turning mortgages into bonds, which are more liquid than mortgages and so could be sold all over the world, bringing more capital into the U.S. residential real estate market, thus promoting home ownership, just as Congress wanted. Because of the low interest rates they paid, Fannie and Freddie were immensely profitable until the financial crisis brought them down.
As Becker points out, Fannie and Freddie were effective in obtaining congressional and presidential assistance to ward off threats to their activities and their profits. But I don't think that that assistance, unseemly as it was, and perhaps corrupt as well, was the basic problem of Fannie and Freddie, or the cause of their collapse; nor do I think their collapse was of any great consequence for the nation.
I don't think there was ever a good reason to promote home ownership over renting (so I would favor the abolition of the deductibility of mortgage interest from federal income tax). It ties up a lot of the capital of individuals and reduces labor mobility. Maybe it makes for more responsible citizens by giving people a property interest, but there must be better candidates for federal largesse. And even if there were a good reason for government to promote home ownership, federal chartering of mortgage institutions would not be a sensible means of implementation. Are the external benefits of home ownership, if any, so great that the mortgage-interest tax deduction is not subsidy enough? True, the lower the interest rates that Fannie and Freddie paid to borrow money, the riskier the mortgage loans they would agree to underwrite by buying or guaranteeing the loans, but home ownership is not promoted in any meaningful sense by the granting of mortgages to people likely to default.
Conservative critics led by Peter Wallison of the American Enterprise Institute lay on Fannie and Freddie a significant measure of blame for the housing bubble of the early 2000s and the ensuing financial crisis of September 2008. But these critics have not persuaded me. Private banks like Morgan Stanley and Goldman Sachs and Countrywide bought mortgages, securitized them, and sold interests in them (these firms also bought mortgage-backed securities created by other financial firms)—a sequence wholly separate from the activities of Fannie and Freddie. It was an immensely profitable activity, so there is no reason to think that had there been no Fannie and Freddie the volume of mortgage-backed securities would have been less than it was. Whether a market has X firms or X – 1 firm is unlikely to affect the volume of market activity. I don't think Fannie and Freddie took more risks than their competitors; the difference is that they were more deeply committed to the housing market (that was their mission) than most other firms, so less likely to survive a housing bubble.
The financial crisis might actually have been worse without Fannie and Freddie. They collapsed and were simply taken over by the federal government. Had their debts instead been debts of Morgan and Goldman and other private banks, those banks might have collapsed and been taken over by the federal government as well, providing daunting challenges to the government's ability to run the banking system. The cost to society of the government's taking over Fannie and Freddie is hard to estimate. The takeover resulted in a transfer payment to creditors of Fannie and Freddie from (ultimately) the federal taxpayer. Had there been no Fannie or Freddie, other mortgage companies would have had more debt, and the owners of that debt would also have been bailed out by the federal government, in all likelihood.
Congress would do well to abolish Fannie and Freddie. But it won't. The constellation of political forces that supports subsidizing home ownership is too strong.
But if Fannie and Freddie are not at the root of the financial collapse and ensuing depression (as I insist we should call it, eschewing the tepid euphemism "recession"), this is not to exonerate the government. I would go so far as to contend that the government is entirely to blame for the crisis (see my book The Crisis of Capitalist Democracy [Harvard University Press, 2010]). The housing bubble was enabled to expand to bursting point by unsound interest rate policies followed by the Federal Reserve in the early 2000s, under the chairmanship of Alan Greenspan. Interest rates were kept too low, and because a house is a product bought mainly with debt, low interest rates reduce the cost of acquiring a house. The result was a surge in demand for housing, forcing up price because the housing stock cannot be rapidly expanded. (The Fed controls only short-term interest rates directly, but short-term interest rates influence long-term rates; moreover, interest rates on adjustable-rate mortgages are in fact short term, and those mortgages became immensely popular during the bubble, as they facilitated speculation on rising house prices.) House prices rose so steeply that the increases became self-sustaining (that's the bubble phenomenon). The Fed and the other banking agencies were oblivious to the bubble, and the Fed (by then under Bernanke) made a disastrous error by allowing Lehman Brothers to fail after having led the banking industry to believe that the Fed would not permit a major bank failure—whereupon the industry lost all confidence in government policy. And finally financial deregulation had gone too far, enabling—and by virtue of competitive pressure compelling—banks and other financial firms to take risks that were excessive from a social though not private standpoint.
But the role of Fannie Mae and Freddie Mac in all this probably was minor.
"Capture" of Regulators by Fannie Mae and Freddie Mac-Becker
Political economists describe the process whereby government officials end up being the servants rather than the masters of the firms they are regulating as the "capture" by the industry of their regulators. When regulators are captured, much of what they do is motivated, consciously or not, by a desire to help the companies they are regulating, even when the social goals that the regulators should pursue are very different.
A famous illustration of capture is given by the way airlines were regulated under the Civil Aeronautics Board (CAB) from 1940 to 1978. Large airlines of those times, like American and Delta, naturally had a strong incentive to try to keep new airlines from entering the industry. As a compliant ally of the airline industry, the CAB did not approve one new interstate airline during this almost 40-year period. Many airlines entered the industry when President Carter abolished the CAB, and some of the old standbys, such as Pan Am and Eastern, ceased operations because they could not adjust to a competitive environment.
An economically disastrous example of the capture theory is provided by the disgraceful regulation of the two mortgages housing behemoths, Fannie Mae and Freddie Mac, before and leading up to the financial crisis. In their fascinating recent book, Reckless Endangerment, Gretchen Morgenson and Joshua Rosner explore in great detail how Fannie Mae used political connections and intimidation of anyone who stood in their way to gain a highly dominant position in the residential mortgage market. The authors' show that various government officials, including congressmen and presidential cabinet members, closed their eyes to what these two government-supported enterprises (GSE) were doing. They allowed them to take on enormous risks, while publicly defending their behavior as not being highly risky.
Fannie Mae was created in 1938 as a government enterprise that purchased mortgages from banks that loaned money to homebuyers. It eventually became a private investment company regulated by the government, where investors expected that the government would help out if these companies got into trouble. By the beginning of the crisis in 2008, Fannie and Freddie held or guaranteed about half of the United States' $12 trillion of assets in the residential mortgage market. In September 2008, both Fannie and Freddie were taken over by the federal government when they became insolvent. The loss to taxpayers is likely to be in the hundreds of billions of dollars because many of the mortgages are subprime and of little value.
Reckless Endangerment shows how the chief executive officers of Fannie Mae furthered the reach and reduced the regulatory control over their company by assiduously courting congressmen, Fed officials, the Congressional Budget Office, high-level officials of the U.S. Treasury, the Secretary of Housing and Urban Development, and major economists. The prominent and well informed congressman, Barney Frank, gets especially sharp criticism for his continual support of Fannie and Freddie while he was initially a member, and later chairman, of the House Financial Services Committee, the powerful committee charged with oversight of the housing and financial sectors. Barney Frank remained an unwavering supporter of Fannie and Freddie until 2010, when he admitted that they should have been more closely regulated. In a bit of irony, he is a principal author of the 2010 Dodd-Frank act that attempts to reform the financial sector mainly by giving even greater discretion to the regulators.
Fannie and Freddie had so much money and political power at their disposal that it became risky for anyone to oppose what they wanted: large increases in their holdings of subprime and other mortgages, with no questions asked. Different government agencies that were supposed to either regulate or oversee these GSEs ended up as advocates instead. Well-known economists wrote favorable articles downplaying the riskiness of the holdings of Fannie and Freddie. These articles were sometimes published in journals or other publications sponsored by these companies.
A few government officials were brave enough to risk the wrath of Fannie and Freddie. The authors give particular praise to June O'Neill (I am proud to say she is a former student of mine), who was then head of the Congressional Budget Office. A member of her staff wrote a report that was critical of the degree of risk to taxpayers from the assets held by Fannie and Freddie. These companies tried to get June to suppress the report- she refused- and then a few members of the House of Representatives in cahoots with Fannie and Freddie subjected her to vicious attacks when she steadfastly defended the report in testimony before Congress.
The Fed also comes in for sharp criticism by the authors. One example discussed was a Boston Fed publication in October 1992 claiming that minorities were widely discriminated against in gaining access to mortgage credit. The media, many regulators, and some economists widely praised this study as offering definitive evidence of extensive discrimination against minorities in the credit market. Fannie Mae's head, the politically astute James A. Johnson, seized on this reaction to promote a large increase in mortgages to poor residents of African-American and Hispanic communities with bad credit histories.
Since I had written a book on discrimination against minorities in the economy, I was curious to see how the authors reached such definite conclusions about mortgage discrimination. I became convinced after reading their study that it was deeply flawed, and failed to show what they claimed about discrimination in the market for mortgages. The theory of discrimination against minorities implies that minority applicants for mortgages would need to have better credit records and higher employment stability than comparable whites in order to obtain mortgages. This suggests that default rates would be lower and profitability higher on loans to minorities.
The study's authors presented no evidence to support these implications of discrimination theory. All the circumstantial evidence, and some real evidence, showed just the opposite. I published my criticisms in a column for Business Week in 1993 (reprinted on pp. 119-120 in The Economics of Life, a collection of my Business Week articles). The Boston Fed and their supporters tried defending this article against my attack and those by others, but their arguments were weak. Nevertheless, the view persisted that the Fed had "proved" widespread discrimination in the credit market against minorities, and this helped justify an expansion of mortgage loans to families with low incomes and poor employment records.
The Fannie and Freddie story does not demonstrate that government officials, congressmen, economists, and others who sang their praises were corrupt, although undoubtedly some were. But rather that powerful companies and industries can bring massive resources to bear in promoting their interests through lobbying, congressional testimony, financial support to help political candidates win elections, attacks on critics, hiring experts to promote their views, and in many other ways. The result is, as Simon Newcomb, an outstanding American economist and astronomer of the 19th century, said a long time ago, "one cent per year out of each inhabitant would make an annual income of $500,000. By expending a fraction of {their} profit, the proposers of policy A could make the country respond with appeals in their favor…Thus year after year every man in public life would hear what would seem to be the unanimous voice of public opinion on the side opposed to the public interests" (p. 459 of his 1885 Principles of Political Economy).
I am not claiming that the reckless behavior of Fannie Mae and Freddie Mac was solely, or even mainly, responsible for the financial crisis. Enormous blame must go to the commercial and investment bankers who took on vastly excessive risks that endangered their companies and the economy. Nevertheless, that officials charged with overseeing Fannie and Freddie protected the interests of the companies instead of the interests of taxpayers and the general public does not only offer resounding support for the capture theory. For this capture of regulators also inflicted great harm on taxpayers, the American and world economies, and many of the families who exposed their life savings to undue risks in the mortgage market.