“Alan Greenspan had this view that the light hand of regulation was best,” said Vincent R. Reinhart, a former Federal Reserve economist and now a scholar at the American Enterprise Institute.
When housing prices commenced plummeting, the ugly truth emerged that many banks did not understand the details of the mortgage-backed investments they owned. Ignorance proved expensive.
As one bank after another announced losses that now exceed $400 billion and that some estimate will ultimately cross the trillion-dollar mark, money ran screaming from the field, leaving Fannie and Freddie pretty much the only players.
A general fear of debt took hold. Banks that had offered loans to students under a federally guaranteed program suddenly could not sell investments linked to those outstanding debts, meaning they could not raise cash for the next crop of loans. Dozens of banks pulled out of the program.
“What’s happened kind of speaks for itself,” said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. “You had this effort to weaken the government’s role. There was this conscious effort to turn things over to the private sector, and it failed.”
But there is a parallel narrative, the story that critics and competitors of Fannie and Freddie have told for years: how the two companies exploited their pedigree as entities backed by the government to secure an unfair advantage over the private sector.
They swelled into highly leveraged behemoths, it was said, on the implicit guarantee that the government would step in and rescue them if they ever got into trouble. This allowed them to borrow money more cheaply than their competitors could, enabling them to make loans more cheaply.
That secured more business and rewarded their shareholders, along with their handsomely compensated executives. It emboldened them to trade in highly risky investments.
“They were using their privileged position as favored children of the government to dominate the market, and taxpayers were on the hook for substantial risk,” said Martin N. Baily, a chairman of the Council of Economic Advisers in the Clinton administration. “You couldn’t possibly say this was a pure unfettered market.”
The government was getting something for its protective largess. It was using Fannie and Freddie to pursue the social goal of broader homeownership, particularly among racial minorities.
“When you’re looking at the upside, here’s the government helping people get mortgages and student loans,” said David R. Henderson, a self-described libertarian economist at the Hoover Institution at Stanford University. “The downside is there might be a bailout and then you pay in taxes. These things don’t come cost-free when government gets involved.”
As the Bush administration readies funds to buy student loans from cash-short banks, and officials plot a potential bailout of Fannie and Freddie that could run into tens of billions of dollars, the government’s outsize role in these two huge areas will not shrink anytime soon.
It seems a strange coda to an era in which markets were sacred, and regulation heresy.
For a generation, American policy makers have lectured the world on the need to unleash the animal instincts of the market. China’s rickety banks should stop lending to protect state factory jobs, Americans said, and focus on the bottom line. Now the Bush administration is reluctantly concluding that Fannie and Freddie might need to be propped up to protect the American homeowner.
During much of Japan’s lost decade of the 1990s, Americans called for an end to its coddling of weak banks. Better to let them keel over, along with the paper tiger companies they sustained. No company was “too big to fail,” Washington said.
Yet here, in the aftermath of a financial crisis brought on by what were once called American virtues — financial engineering and risk management — Washington may bail out Fannie and Freddie for the simple reason that they are too big to fail. If they go down, so do whole neighborhoods. So, perhaps, does the global financial system.
“The thing we have to do now is to make sure that Fannie and Freddie remain solvent and continue to make loans,” Mr. Baily said. “We just don’t have any choice.”