Much of the blame for the demise of the financial system as we knew it can be placed on the doorsteps of Fannie Mae and Freddie Mac. Both of them are shareholder-owned companies with political missions, such as keeping mortgage interest rates low and encouraging affordable housing. So why did they collapse and why did the government have to take them over? In a September, 2008, article The American Enterprise Institute tells the tale: The Last Trillion-Dollar Commitment
The government takeover of Fannie Mae and Freddie Mac was necessary because of their massive losses on more than $1 trillion of subprime and Alt-A investments, almost all of which were added to their single-family book of business between 2005 and 2007. The most plausible explanation for the sudden adoption of this disastrous course–disastrous for them and for the U.S. financial markets–is their desire to continue to retain the support of Congress after their accounting scandals in 2003 and 2004 and the challenges to their business model that ensued. Although the strategy worked–Congress did not adopt strong government-sponsored enterprise (GSE) reform legislation until the Republicans demanded it as the price for Senate passage of a housing bill in July 2008–it led inevitably to the government takeover and the enormous junk loan losses still to come.
The collision of politics and sound business practice resulted in the present financial carnage:
As GSEs, Fannie and Freddie were serving two masters in two different ways. The first was an inherent conflict between their government mission and their private ownership. The government mission required them to keep mortgage interest rates low and to increase their support for affordable housing. Their shareholder ownership, however, required them to fight increases in their capital requirements and regulation that would raise their costs and reduce their risk-taking and profitability. But there were two other parties–Congress and the taxpayers–that also had a stake in the choices that Fannie and Freddie made. Congress got some benefits in the form of political support from the GSEs’ ability to hold down mortgage rates, but it garnered even more political benefits from GSE support for affordable housing. The taxpayers got highly attenuated benefits from both affordable housing and lower mortgage rates but ultimately faced enormous liabilities associated with GSE risk-taking. This Outlook tells the disheartening story of how the GSEs sold out the taxpayers by taking huge risks on substandard mortgages, primarily to retain congressional support for the weak regulation and special benefits that fueled their high profits and profligate executive compensation. As if that were not enough, in the process, the GSEs’ operations promoted a risky subprime mortgage binge in the United States that has caused a worldwide financial crisis.
The special relationship with Congress was the GSEs’ undoing because it allowed them to escape the market discipline–the wariness of lenders–that keeps corporate managements from taking unacceptable risks.
There’s much more at the link, including the history of Fannie Mae and Freddie Mac and the political purposes their creation was meant to fulfill.
The article concludes,
Unfortunately, the sad saga of Fannie and Freddie is not over. Some of their supporters in Congress prefer to blame the Fannie and Freddie mess on deregulation or private market failure, perhaps hoping to use such false diagnoses to lay the groundwork for reviving the GSEs for extra constitutional expenditure and political benefit in the future. As the future of the GSEs is debated over the coming months and years, it will be important to remember how and why Fannie and Freddie failed. The primary policy objective should be to prevent a repeat of this disaster by preventing the restoration of the GSE model.
It seems to me that there are similarities with the saga of Fannie Mae and the current federal takeover of General Motors. While GM is not a government-sponsored enterprise in terms of Congressional legislation, it has a lot in common with it, in that the government is essentially managing the company through the appointment of its officers, finances it and has announced GM’s mission to produce environmentally-friendly cars, a political purpose. This doesn’t bode well for taxpayers, if the history related in this article is any guide.