...on some things, I've got the brains of a slug. Economics would be one of them. I know bloggers are supposed to have at least rudimentary knowledge of everything they post about, but it seems to me that one of the assets of the form is it allows you to interact with people who are smarter than you. We have some sharp-ass commenters on this board, and a couple who I've noticed who are really sharp on the econ end of things.
So here's the deal: I've been following this business with Fannie Mae and Freddie Mac. There's one thing I don't understand here--Isn't it inherently dangerous to have half the mortgages in country controlled by two entities? If it is in fact dangerous, have there been criticism that suggest other ways of doing business? If so, what are some of those other ways?
And now I throw it out to you, my illustrious commenters
The Beautiful Struggle: A Father, Two Sons, and an Unlikely Road to Manhood 
Don't worry too much; half of the commenters and bloggers who profess understanding of economics actually have a very thin understanding.
"Isn't it inherently dangerous to have half the mortgages in country controlled by two entities? If it is in fact dangerous, have there been criticism that suggest other ways of doing business? If so, what are some of those other ways?"
Well, I'm only an econ undergrad, but I'll give you my best.
25% market share each for the two biggest players in an industry isn't that high to me, we've seen much bigger shares in industries such as automotive, telephone, aviation, lightbulbs, computers, etc.
When the top two giants of an industry are being brought to their knees, it means that the whole industry has some structural problems that need to be smacked out of it.
It is important to remember that Fannie and Freddie did not make, back, underwrite, or insure subprime loans. To be a subprime loan was to be by definition a loan Fannie and Freddie wouldn't touch. Fannie and Freddie own your grandma's run of the mill 30 year fixed at 6.25% 150k mortgage. The problem is that credit markets are so bad, that your grandma is broke.
Now, Fannie and Freddie did some irresponsible things, the biggest of which is massively under-capitalizing. Here's the gist of how they work. Fannie and Freddie would buy your grandma's 6.25% mortgage, and sell it (pooled with others that paid, for example, 6.25%) and then sell a bond, which paid 3% a year. Fannie and Freddie pocket the other 3.25%. Fannie and Freddie got alot of money because everyone assumed they were backed by the federal government, and so they could offer lower-interest bonds...with bigger profit margins. Big profit means lots of capital, means rapid expansion.
Now, that's all well and good, except that sometimes people don't pay their mortgages back. So Fannie and Freddie need to have some cash on hand to pay the bonds when the mortgage payments don't add up. The problem here is that since they're government created entities, they haven't been governed by the same market forces that would make a private bank keep big reserves. If Bear Stearns doesn't keep enough cash on hand to cover its securities, its stock will get shorted, and the executives will get the message not to be so aggressive with the shareholders' money. Or it will fail.
Fannie and Freddie, however, have a direct line to the US treasury, and can borrow up to (I think) 22.5 Billion from the Treasury when they need to. 22.5 Bn on 5 trillion (with a t) of debt isn't very much at all, but the implication to the market is huge. "They can borrow from the Treasury" vastly makes it easier for them to get away with holding tiny sums of capital, because if push comes to shove, the US Government will back those bonds.
Because it is now very bad out there, and alot of people are having trouble making mortgage payments, push has come to shove, and those tiny capital holdings have been drained. Fannie and Freddie probably aren't insolvent, their total assets exceed total liabilities, but they are not liquid. The market isn't interested in buying mortgages at the moment, so Fannie and Freddie can't sell their assets to pay the bonds, and now we are footing the bill.
As a follow up, let me explain what a liquidity crisis is, as opposed to a solvency crisis, and why the first is pretty bad, and the second is much worse.
A liquidity crisis happens when you have people demanding money you owe them (bank depositors, bond holders, etc), and you don't have cash to pay them. It becomes a "crisis" when you can't sell your assets in order to pay them off. This is what happened to Bear Stearns. They had a whole bunch of hedge funds demand their money back, and they didn't have enough cash on hand. They went to sell some of their mortgage backed steaming piles of garbage, and nobody wanted to buy (or let Bear use them as collateral on a loan). So even though on paper the mortgages were worth quite a bit, since Bear couldn't get the money quickly, they went belly up.
One reason the Fed exists is to prevent liquidity crises. Banks can go to the open market window and borrow money without collateral. Doing so however is a public admission that your bank is in SERIOUS trouble, which is why it rarely happens.
Solvency crises are similar to a liquidity crisis, but worse. In a solvency crisis, your assets are worth less than your debts, and you're screwed. You generally can't borrow out of a solvency crisis (for lack of assets to use as collateral) and you definitely can't sell out of one. IndyMac Bank had a solvency crisis, and was shut down
Peter's comment is pretty good. Let me just add that Fannie and Freddie were created to meet the policy goal of having more Americans own their own home. At this, they were fabulously successful.
How did that work? With Fannie and Freddie came loan standardization. I'm not sure if it was causal, my history isn't that good. But when someone got a home loan in the 50's it was made locally and held locally by local banks.
Loan standardization was a Very Good Thing, since it meant that loans that met some simple, objective standards as to amount, down payment, etc. could be resold to someone in another state, and bundled together. That meant money could move from neighborhood to neighborhood, city to city, or coast to coast as needed. So more people could get loans.
We're in a mess now because some people (Very Serious People wearing Very Conservative Suits), took that to the extreme, with subprime loans. When the person originating the loan isn't going to be holding the loan, and isn't going to be on the hook if the loan goes bad, well, there's an incentive to make the loan, because of fees, and very little incentive to not make bad loans. The paperwork needs to "look right", it doesn't actually have to be, you know, factual.
Bad loans, undercapitalization, and an economic downturn make this all go kablooey.
I realize I forgot to give you my "prescription" as it were. Had
Fannie and Freddie not been government backed, they would have been forced to hold more in reserves, and would have faced more competition, not becoming as big.
A big part of the problem was the government pushing the idea that everyone should own a house, and using Fannie and Freddie to back that idea with bad lending practices. Had they not had a line to the Treasury, there would have been less capital in the housing market, and the bubble might not have been as bad. Privatizing only works when the firms face the RISK on the private market, as well as the reward. Privatizing the profit only is just cronyism.
"Isn't it inherently dangerous to have half the mortgages in country controlled by two entities?"
Inherently, I think, is too strong a word. If the two companies were simply world-class corporations that outcompeted the other mortgage lenders on the free market, there wouldn't be anything inherently dangerous. Also, even if these companies were to go out of business, it's not as though all these loans would suddenly collapse and millions would lose their homes - rather, the loans would simply be sold as part of the liquidation process, with the homeowner barely having to lift a finger.
The problem isn't so much who controls the loans, as much as the quality of the loans given out.
The government encouraged Fannie and Freddie to pursue ridiculously risky business practices by giving out way too many loans at way too low interest rates, with the implicit promise of a government bailout if things went bad. This guarantee gave Fannie and Freddie an artificial competitive advantage that allowed them to swallow up so much of the market.
"If it is in fact dangerous, have there been criticism that suggest other ways of doing business? If so, what are some of those other ways?"
Sure. Christopher Westley has a pretty good article (http://www.mises.org/story/3053) over at Mises explaining how Fannie and Freddie should simply be liquidated, and in the future, the government should simply stay the hell out of the housing market. Home prices would fall, and we might well suffer the brunt of a recession, but the Austrians have good arguments as to why a recession is inevitable and that simply getting out of the way ensure that it will be shorter. (See Austrian Business Cycle Theory for more on this.)
Thanks guys. This is great. So I take it most of you reject the idea of the GSEs outright? Should we just not have them?
"So I take it most of you reject the idea of the GSEs outright? Should we just not have them?"
Speaking for myself, yes. The Government isn't good at running businesses because it cannot fail. A normal business will either be efficient or it will fail. If you prop it up and remove the failure element, it will almost surely be inefficient, because the executives won't be doing their damndest to avoid that sword of Damocles which hangs over every private company.
"So I take it most of you reject the idea of the GSEs outright? Should we just not have them?"
Most of the points Peter made are good, and I tend to feel Fannie and Freddie, in their current form, are a problem. However, Doctor Jay also made good points about their success at their stated objective.
Perhaps a better plan would have been to ensure they either died off or went fully private as they acheived their goal. Letting them linger indefinitely, with the ridiculous advantage of (implied) government backing and special rules, harmed the market.
"So I take it most of you reject the idea of the GSEs outright? Should we just not have them?"
Yeah, basically. GSE's can work if you can manage to get ownership and control in the same place (see: Dubai, South Korea) but most of the time the incentives are all screwed up. It's even worse in a democracy, because then the goals of the GSE start to include various political goals as well economic ones, which is a surefire way to hurt taxpayers.
Man, I was going to comment on Margaret Weiss but I'll get to that in a minute. First, check out this Freakonomics blog post on widespread financial illiteracy among Americans:
http://freakonomics.blogs.nytimes.com/2008/07/21/are-we-a-nation-of-financial-illiterates/
You are probably more knowledgeable than the majority of people out there. And rather than relying on the strength of my dusty econ degree, let me point to this excellent short and clear piece on Fannie and Freddie by Larry Summers, former Treasury Secretary and Harvard President:
http://creativecapitalism.typepad.com/creative_capitalism/2008/07/our-creative-mo.html
Also no econ expert, but an episode of This American Life from a few months back devoted its whole hour to the crisis, and I learned a helluva a lot. That seemed true. I think it's $1.99 on ITunes.
Ta-Nehisi: I am not an expert, and I have forgotten where I read this (but I did read it somewhere; anything in it which is my thinking is a mistake), so take it with a grain of salt, but:
I gather mortgages are sort of troublesome, as a way to make money. Little and tiny: no scale. Take 20 years (or whatever) to pay off: no quick return on investment. Plus, figuring out who will default on them has to be done on a case-by-case basis, and you're exposed to that risk for 20 years. Little, poky, troublesome things. Left to itself, the market for them would be much smaller, and mortgage rates would be higher.
By guaranteeing mortgages that meet defined standards, the GSEs help make them a lot less risky for investors. By pooling them and selling them, they overcome their tininess. Generally, they turn mortgages, which are sort of annoying little investments, into much more attractive investments (partly by guaranteeing them, which affects risk, but partly by overcoming their problems of scale and lack of immediate payoff), which (in turn) means that more people are interested in them, which means that there's more money ready to be lent, and thus that mortgage rates are lower.
I think this is a fine thing to do. I just think that if we're going to do it, we should nationalize the GSEs.
Two things, the This American Life episode (which is great) can be streamed free from thislife.org . Second, Hilzoy, your comment makes quite a bit of sense until you say we should nationalize. You don't give any reasons why we should nationalize. Most consumer finance encounters similar problems to those you describe (e.g. car loans, which are shorter, but even smaller). Why would a nationalized company do any better than a fully private company? Privatizing has many advantages, in my opinion, and relatively few disadvantages.
Advantages:
No risk to taxpayers if any particular company goes under.
A large number of firms, so that a failure by any particular one is not devastating, and is possible (Gov't firms can't fail.)
Market based risk pricing. Private firms don't try to jigger the market towards one asset (homeownership) the way politicians do. Fannie and Freddie did exactly what the Government thought it wanted, which was to get ANYONE into a home they owned. Unfortunately, that was not such a great plan, since it pumped in so much capital that a small asset bubble got much bigger.
Now the Disadvantages:
The profits are private. I'm a free marketeer and don't mind this, but some people want this to be a potential source of government revenue. Yes, they can turn a profit here most of the time.
We can't advance policy through them. Take that as you will.
These are my thoughts.
Peter: my basic thought is: (a) this is a good thing for government to do; (b) if we do it that way, we should, um, actually nationalize, so that instead of allowing private investors to make the profit off our willingness to back the GSEs, we get it.
Basically, I think: either nationalize or privatize. This intermediate thing makes no sense to me: it uses the implicit guarantee of the government, but allows other people to get rich off it. Of the two, since I support the basic idea and think it would be better done by government (since it seems to me to correct a market failure, and to do so in ways that largely rely on government backing), I go with nationalization.
Hilzoy,
I agree that the intermediate here is worse than the extremes, but disagree that mortgages are non-standard due to market failure. Fannie and Freddie constituted half of the market. The reason mortgages were nonstandard pre-Fannie was a lack of information transmission and a less advanced banking system. Private insurers, banks, financiers, and investors can handle the bundling of mortgages and the setting of standards all on their own. Even highly variable credit card debt is now easily sold to third parties which can collect on it.
To your 2nd point there, it currently relies on government backing, and this is a bad thing. It artificially lowers the capital cost of home buying, and therefore artificially raises prices. House prices should be based on the relative demand and supply for houses, with the capital costs being the same (risk adjusted) as any other industry and market.
I do not believe this