Too big not to fail: the rise and fall of Fannie Mae

By Lorenzo

The debate over the role (if any) of the Community Reinvestment Act (CRA) in the sub-prime crisis, and thus the Global Financial Crisis (GFC), often seems to be a stand-in for other issues. In particular, to what extent was either financial meltdown the consequences of government regulation (or the lack thereof).

The answer to the former question is: almost entirely, if by government regulation one includes the full gamut of government interventions and political game-playing. In a market economy, failures of regulation and government intervention always manifest as market outcomes. By the simple expedient of declaring such government interventions and regulations irrelevant or unimportant, said market outcomes can then be pointed to as “proof” of market failure.

But that is ideology blocking analysis. Corporations are pavlovian profit monsters–they will go where profits lead them. They act according to the incentives offered them, within the range of managerial competence. (Hence markets as economic selection processes.)

In the case of the US finance industry, particularly the US housing finance industry, various government interventions profoundly shaped the incentives facing participants in the market, with part of the problem being those being regulated having rather too much influence over how they were regulated.

With no entity playing the political game more relentlessly, narrowly effectively or ultimately self-destructedly than the Federal National Mortgage Association (FNMA) or Fannie Mae. As long-time Wall Street Journal journalist James R. Hagerty sets out in his highly readable history of Fannie Mae, The Fateful History of Fannie Mae: New Deal Birth to Mortgage Crisis Fall.

Supporting housing finance
Fannie Mae started operating in 1938, a late New Deal initiative. While fairly small in its early days, it grew until it became one of the biggest financial institutions in the world. For its first 30 years, it had a monopoly over the US secondary mortgage market. As an Australian reading the book, the idea that housing finance needed government support seems a little bizarre. We have a home-ownership rate slightly above the US’s (ex-communist countries generally top the rankings), but did not need to create anything like Fannie Mae or Freddie Mac, or the other US government founded/supported finance entities, to do it.

But such efforts suited some very politically effective interests, such as realtors. The implicit or explicit taxpayer guarantee allowed more funds to be pushed into housing at lower cost. At one point, Hagerty quotes Adam Smith‘s scepticism about government-sponsored companies:

These companies, though they may, perhaps, have been useful for the first introduction of some branches of commerce, by making at their own expense an experiment which the state might not think it prudent to make, have in the long run proved, universally, either burdensome or useless.

Fannie Mae provides a dramatic example of Adam having a point. The US$187bn the taxpayer’s invested in bailing out Fannie Mae and Freddie Mac may have been more than returned, but their role in fuelling destructive, massively over-leveraged, housing price booms imposed a much greater social cost than that.

Having previously read Fragile by Design, Hagerty’s book also put the CRA into a much more useful context, even though it plays a small role in his book. There was a long history of US federal government action to support housing finance. The CRA was a way of extending that pattern of action to urban minorities. The problem with the CRA was not the Act itself, but the way it then came to feed back into, and amplified, already existing patterns, which were also amplifying for other reasons. It was a building block in the edifice that created the sub-prime crisis, no more than that (but also no less).

Hagerty takes us through the history of Fannie Mae, with an enduring feature being attempts to either regulate it more closely, or to fully privatise it, being fought off by Fannie Mae. Fannie Mae wanted to keep its government guarantee (an implicit guarantee, once it became a company with shareholders), because that lowered the cost of its capital, but without tighter prudential regulation, because that would have reduced its ability to leverage off its government guarantee. Fannie Mae’s leadership played the political game increasingly effectively, including using such tactics as hiring as many lobbying firms as practicable, so they could not be hired to lobby against it.

To a large degree, Fannie Mae got the regulatory framework it wanted, though part of the trade-off became to expand its support for housing finance. As a result, the prudential rules covering it became increasingly vulnerable to catastrophic failure, if there was a large enough rise in interest rates or fall in house prices. Which, of course, there duly was.

Government guarantees to financial entities require matching prudential regulation if catastrophe is not to be avoided. But Fannie Mae was too politically useful; which it leveraged ruthlessly, to avoid inconvenient prudential regulation to match its government guarantee. Fannie Mae became too good at selling itself as the perfect (off-budget) housing finance problem solver.

As the various housing bubbles across the US started to deflate, a desperate housing industry lobbied hard for Congress to “do something”. And there was Fannie Mae and Freddie Mac, available to “do something” off-budget. So, as the housing bubbles deflated, Fannie Mae and Freddie Mac increased their exposure. But this was the end run of a long process of ever-lower standards of lending without compensating increases in prudential requirements.  The necessary corollary to government guarantees if said guarantees were not to make the financial system more vulnerable rather than less.

Pay and …
And then it all collapsed, wiping out Fannie Mae and Freddie Mac’s share values and requiring a $US187bn bailout of the two government-sponsored-enterprises (GSEs). It was as if nothing had been learnt from the Savings & Loans crisis. Which, in effect, it had not.

What Calomiris & Haber call the game of bank bargains has been perennially played in the US to suit narrow interests and not broad ones. As in this case, with the taxpayers left holding the bag (again) as helping the housing industry by “off-budget” measures suddenly went dramatically on-budget.

It is useless to complain that the politics was “corrupted”, as if that is the only problem: we have to deal with politics as it is, not as it might be. There is certainly a role for seeking to have better functioning institutions, for informed debate, for exposure. But to change nothing about the political institutions and framings of debate, and then expect the players to reliably and continually act differently, is naive at best.

It was not as if the housing booms themselves were not also significantly responses to regulation. Land rationing was a major driver of where the US housing booms did (or did not) occur. For any asset, if quantity responses are dampened, then price responses become more intense. That is, if supply is constrained (such as by land rationing), then the price of a class of assets (such as land-approved-for-housing) will become more susceptible to demand shocks (both upwards and downwards). Or, in this case, upwards then downwards. Especially if a government guarantee is leveraged into pumping more and cheaper finance into purchasing said asset.

So, local governments were rationing land (driving up house values and property tax revenue), Congress wanted off-budget help to the housing industry and home-owners (both middle class and those aspiring to be so), driving up the funds being pumped into supply-constrained markets, banks wanted to benefit from the too-big-to-fail subsidy, and prudential regulators either did not want to pick unfortunate fights or were overwhelmed by the superior lobbying power of those that they were attempting to regulate. With no-one playing the political game more effectively, or more ultimately disastrously, than Fannie Mae. Which became too politically big not to fail.

… then repeat
But Fannie Mae and Freddie Mac have been bailed out, not killed off. The too-big-to-fail subsidy is now absolutely established, as are the GSE‘s government guarantees. Blaming “Wall St” or “easy money”, or whatever, means that the game of helping a powerful industry off-budget–in part by not forcing sufficient prudential requirements to match the government guarantees–continues to be played. After all, the imbalance is very much based on providing (positive) externalities to those who usefully notice and passing the costs on to those who do not.

The Savings & Loans Crisis was Mark 1. The Sub-Prime Crisis was Mark 2. The pieces are being set in place to have Mark 3. With “corporate greed” the perennial theatrical villain, so that the real players can continue to play their political games, and taxpayers and home-owners can be set to take the fall, yet again.

But Hagerty’s book–clearly based on talking to everyone who matters and reading every report–provides a well-written, clear and informative history of past, present and (sadly) likely future.


  1. kvd
    Posted June 9, 2014 at 1:06 pm | Permalink

    Economists are a subset of historians. It irks when they pronounce so solemly “well, of course this led to that”. It reminds me of the complete but impotent fury I felt whenever I read the Institute of Chartered Accountants’ emails referring to the GFC as the ‘Global Economic Downturn’; I’m sure this was a deliberate choice of obtuse terminology – designed to obscure their own less than exemplarary contribution to same.

    Whatever. One hundred books are written by one hundred pundits; and one will inevitably be nearer the mark than most. In hindsight.

  2. Posted June 9, 2014 at 4:13 pm | Permalink

    [email protected] So, there is nothing to be said about social causation?

  3. kvd
    Posted June 9, 2014 at 4:38 pm | Permalink

    [email protected] volumes, I expect. Unstated, but inferred by your first graphic, is that however icky the bailouts were, they have mostly been paid back in full. So – bad – but not Bad bad?

    Anyway, while I respect the analysis that B followed A, we are now living in C and, I expect, are more worried about D.

  4. kvd
    Posted June 10, 2014 at 2:54 am | Permalink

    Apologies Lorenzo. The good mood I was in yesterday was shattered by HJ’s incessant and unproductive contributions on another thread. I was irritated and, ungratiously, posted here instead.

    As always, I appreciate your sound and calm analysis and willingness to engage in debate.

  5. John Turner
    Posted June 10, 2014 at 7:04 am | Permalink

    George Monbiot’s Guardian article early last week had a simple and sensible explanation of the role of both government and money in the GFC and all housing value inflation – the failure tax away the surplus funds in the hands of the wealthy who use those funds to buy up properties in completion with those who need those properties to live in. He has an excellent illustration in the “privatisation” of council housing in the UK in the time of the Thatcher Government. The son of a former minister bought up 40 housing units in one area for about 4 million pounds. The properties are now worth 12 million and the rent charged in total is 60,000 pounds per month.

    A/P Bill Black was an investigator in the Savings and Loans era in the USA and his analyses of both the S and L and the GFC lay the blame on the absence of effective application of regulation in both situations.

  6. Posted June 10, 2014 at 8:37 am | Permalink

    I enjoy watching shows like Air Crash Investigations in part because they attribute causation expansively and usually ideology plays no part in it. I recall one old investigator saying that in all his years of air crash investigation, he hasn’t yet investigated one that had a single cause. Contrast that with political warriors such as Lorenzo, who is now apparently reading books specifically chosen for their conclusions – “It was the guvmint wot did it!” and delights in telling us how his bias has been confirmed.

    Step out into the fresh air and expand your horizons, Lorenzo; you have nothing to lose but your prejudices.

  7. Posted June 10, 2014 at 4:31 pm | Permalink

    Fannie Mae’s leadership played the political game increasingly effectively, including using such tactics as hiring as many lobbying firms as practicable, so they could not be hired to lobby against it.

    It seems there is a significant problem with a lack of government integrity at the heart of the matter. Arguments over economics or ideal levels of regulation are rather mute if a government is incapable of governing for the greater good.

  8. Posted June 10, 2014 at 4:33 pm | Permalink

    kvd: thanks 🙂 And I sympathise. The cost the taxpayers was not the worst effect, though I agree that the reimbursements obviously lessened the fiscal costs.

    [email protected] And why are there such capital gains to be made in the UK housing market? Because of you-have-to-get-official-approval land rationing which makes land so approved wildly more valuable than land not so approved. Germany provides an instructive counter-example.

    Also, one reason why Canada was largely untouched is that, apart from Vancouver, there is little land-rationing in its housing markets.

    But I agree about inadequate prudential regulation to match the government guarantees. The interesting question then becomes why were the guarantees handed out but the prudential regulation not ratcheted up to match?

    [email protected] Canada had no banking or mortgage crisis, but its banks and mortgage-brokers are presumably as interested in profit-making as US banks and mortgage-brokers. So, what was different?

    The question becomes, why were government guarantees provided but prudential regulation not applied to match it?

    It was not too much/too little regulation, but wildly unbalanced regulation. So, why did that happen? And what can we learn from it?

  9. Posted June 10, 2014 at 4:37 pm | Permalink

    [email protected] Also, taxes on land values encourage governments to do more land-rationing.

  10. Posted June 10, 2014 at 4:40 pm | Permalink

    [email protected] Yes, Congress wanting to have it cake and eat it too is a bit of a problem. But the US system does rather encourage narrow political bargains rather than broad ones, a particular problem for matters of financial regulation.

  11. Mel
    Posted June 18, 2014 at 10:34 am | Permalink


    [email protected] Canada had no banking or mortgage crisis, but its banks and mortgage-brokers are presumably as interested in profit-making as US banks and mortgage-brokers. So, what was different?

    Financial institution culture for one thing, altho I’m not saying this was decisive in this case. But I will certainly always remember how Four Corners ran a program from America less than six months before the subprime crisis blew up that pointed out the vast extent to which bank and non-bank lenders without any prompting form Fannie or Freddie or the CRA were making irresponsible loans on a vast scale, including loans dubbed NINJA- “No Income No Job No Assets”.

    Freddie and Fannie had a much lower default rate than rate than the general rate and it is abundantly obvious that if both they and the CRA hadn’t existed the bank and non-bank lenders who were loaning money to anyone with a pulse would have soaked up those loans like tissue paper absorbing water.

    An amusing aside is that the AEI stooge Wallison, who you’ve favourably mentioned on this site as an expert in the past, repeatedly criticised Fannie and Freddie for not lending enough b4 the crisis. Later, as a republican senator, he wrote a widely debunked dissent to to FCIC that blamed everything on Fannie and Freddie.

    Barry Ritholtz makes far more sense than AEI hacks like Calomiris.

    As a lefty I frequently leave the left wing fishbowl; I think you’d be a superior thinker if you did the same a little more often.

  12. Posted June 18, 2014 at 4:52 pm | Permalink

    [email protected] Fannie and Freddie did not cause the crisis. Their problem really came when the “marched boldly into the breach” and took up the slack; so their failure represented a later round of the crisis. (There is an argument about whether they affected the overall structure of the market: even if true, that was only possible because of deeper regulatory failures.)

    The CRA did not cause the crisis, but it was a useful building block in the banking coalition that was ultimately responsible.

    (BTW Wallison was never a Senator.)

    Financial deregulation did not cause the crisis–Australia and New Zealand have both been major financial liberalisers. As I understand it, Canada never had a particularly heavy regulatory regime in the first place.

    The problem was unbalanced regulation. If governments are going to hand out implicit or explicit guarantees, then they need to impose commensurate prudential regulation. That is what Australia does.

    If they are not willing to impose the requisite prudential regulation, then they should not hand out or imply such guarantees. (As I understand it, the Canadian system is more like that.)

    The problem in the US is that they neither picked workable option A nor workable option B. Instead, they picked utterly unworkable option C — guarantees without adequate prudential regulation. You set up a series of one-way bets, then financial crisis is likely to ensue, because people will keep making those bets. That is what happened in the Savings & Loans Crisis, it is what happened in the Sub-Prime Crisis. (In both cases, there was reckless lending encouraged by the one-way bet framework.)

    If the debate never moves beyond:
    Government, bad! v. De-regulation, bad!
    Then it will never get better.

    Calomiris & Haber’s point is not the one you seem to be taking them to be making, since you do not seem to be able to get out of the above dichotomy. Their point is there always has to be a regulatory framework, that is the nature of banking, The need is to have a broad bank bargain (so, for example, balancing guarantees and prudential regulation), not a narrow one (e.g. guarantees without adequate prudential regulation).

    The US keeps making narrow bank bargains. So, sooner or later, there is a crisis and folk not part of the bargain get screwed. It has happened twice, big time, in the last 30 years. Despite all the fuss over Dodd-Frank, they are marching down that same path again.

    The Wallison v Frank debate in the Atlantic is, on both sides, a great deal more heat than light.

  13. Mel
    Posted June 18, 2014 at 6:57 pm | Permalink


    “The problem was unbalanced regulation.”

    Actually there were numerous problems that contributed to the GFC and it is wrong to focus on one chosen because it reflects one’s ideological inclinations. I am equally peeved, if it more so, when a fellow lefty says the GFC was solely caused by neoliberalism.

    One silly thing the government (in most/all states?) did was to limit the liability of mortgage holders so that they could simply walk away from their obligations. Maybe the crisis could have been averted if this, dare I say, privilege, was removed.

    What I would love to see is a flow diagram that maps out the crisis with every causal factor included that is written by a group of apolitical technicians who have had that section of the brain responsible for ideology removed. Yeah, I know, I’m dreamin’.

  14. Posted June 21, 2014 at 11:49 am | Permalink

    [email protected] Since I am pointing to a structural issue, it is not sufficient to explain why the crisis happened at a specific time in a specific way; that will be due to contingent factors. And yes, the mortgage rules in many US states are fairly unbelievable.

    But the question that should be being focused on is how to have, as far as practicable, a crisis-free banking system that still provides good levels of credit. And that is very much a structural issue, where learning comes from comparing the performance of different jurisdictions.

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