A Simple Misunderstanding

That friendly couple in Washington DC, Freddie Mac and Fannie Mae, have become household words lately. The way people talk, you would think they are part of the Gummint. That is because they have the word "Federal" in their names, just like "Federal" Reserve.

Freddie and Fannie, though, like the Fed, are NOT part of the Gummint. They are GSEs -- Government Sponsored Enterprises -- that are private corporations operating under the regulation of the Office of Federal Housing Enterprise Oversight (OFHEO). OFHEO, you might want to know, is the organization that publishes phony statistics on how well the nation's real estate industry is doing.

Anyway, the game is this. Sharkey the Lender loans Average Joe the money to buy or refinance his house. Joe gives Sharkey a Mortgage Deed as collateral. Sharkey sells the Mortgage Deed to Fannie or Freddie, who then package it with other Mortgage Deeds in a bundle -- a mortgage backed security -- and sell shares of it to investors.

OFHEO has required that Fannie and Freddie maintain a cash reserve, of roughly $82 billion between the two, because sometimes people stop paying on their loan and the house has to be foreclosed and sold to make sure the investors get their money back. Most of the time, the price Freddie or Fannie get for the house is less than what is owed. Then they have to pony up the balance out of their cash reserve.

Things are not too good in the mortgage securities business right now because a lot of people are finding out that they can't make their payments, and Freddie and Fannie have had to make things right with the investors. In fact, things are so bad, that Fannie lost $2.1 billion and Freddie lost $3.1 billion in the last quarter of 2007.

Today it was announced (the rumor was circulating for a while, since there was pressure from both Congress and the President to make the move) that OFHEO will allow Freddie and Fannie to reduce their reserves by about 10%, allowing them to put themselves at risk for approximately $200 billion in additional home loans. The current $82 billion was there to guarantee about $2.7 trillion in loans. God help the American taxpayer if they have to pay out more than the $82 billion.

HEY!! WAIT A MINUTE!! Didn't Big Ben last week just say that the Fed was going to loan an additional $200 billion to the mortgage industry to keep it afloat, and they could use their shaky loans including Fannie and Freddie debt as collateral? Anybody still know how to use a calculator? Count on fingers and toes, even?

This follows another move by Congress, which allowed Fannie to begin loaning on higher priced housing; the limits were raised from $417,000 to $730,000, which meant that a 20% down buyer of a $912,500 house could now have the loan held and guaranteed by Fannie Mae instead of a private sub-prime securities bundler. Congress shamelessly did that to bail out its fat-cat contributors who were facing resets in their adjustable jumbo loans. They did it while mouthing platitudes about helping the poor.

Remember Econ 101. Investors expect to be paid more if they take bigger risks. If real estate prices are falling, and interest rates are falling, and Fannie and Freddie have obligations that are going to come due because of bad lending policies in the past, who will buy shares in Fannie and Freddie if the risk is seen to be increasing and the rate of return is going down?

As late as September of last year, Big Ben was saying that increasing the risk to Fannie and Freddie was not a good idea, and OFHEO was strongly resisting the idea of having them enlarge their portfolio. As late as last week, the chairman of Fannie said that any move to increase Fannie's capital could harm its shareholders, but today we see Fannie being told to do just that.

That the politicians are pandering to the fear in their constituencies by playing with the market is clear. That they have no concept of basic economic principles is also clear. That they control the nation's purse is downright diarrhea-causing.

Some folks point to the great accomplishments of FDR in taming the Great Depression by interfering in the market. What they fail to understand is that the Great Depression was not cured by the New Deal. The Great Depression officially ended on September 1, 1939, after which time America's factories and farms went back into full production.

There is only one solution to the economic mess that America finds itself in. That solution is the complete restructuring of the tax system; the removal of all taxes on production and replacement with a national consumption tax. In a sense, it would mean economic war with the rest of the world, since they would either have to play along, or see their goods priced out of reach of Americans.

The current financial debacle was not caused by deficiencies in the marketplace but by the marketplace reacting in a healthy manner to the situation it found itself in. We will not kill the cancer by handcuffing the doctors. We must excise the beast that actually caused the disease.