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<font color="#002864" size="1" face="Verdana">http://www.mises.org/fullstory.asp?control=1463</font>
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<font face="Verdana" size="2"><font color="#002864" size="5"><strong>Who Made the Fannie and Freddie Threat?</strong></font>
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<font face="Verdana, Helvetica" size="4">By Frank Shostak</font>
<font face="Verdana, Helvetica" size="2">[Posted March 5, 2004]
<img alt src="http://www.mises.org/images3/madscientist.gif" align="right" border="0" width="119" height="160">On
Tuesday February 24, 2004, the chairman of the Federal Reserve, Alan
Greenspan, in his testimony to
the Senate Banking committee issued a warning that Fannie Mae and Freddie
Mac—the two giant mortgage buyers—have grown so large that they pose a
threat to the entire financial system. To reduce this threat the Fed chairman
recommends that Congress cap their size. In this regard, in Q4 the assets of
Fannie Mae stood at over $1 trillion.</font>
<p align="center"><img alt src="http://www.mises.org/images3/Shostak/03-03-2004/1.gif" border="0" width="313" height="269">
<font face="Verdana, Helvetica" size="2">According to Greenspan, because
the public regards these institutions as having the full support of the
government, they can borrow in the market at a subsidized interest rate, so to
speak. This in turn enables them to pay higher prices to originators of
mortgages than potential competitors can pay. In short, both Fannie Mae and
Freddie Mac are monopolizing the mortgage market.</font>
<font face="Verdana, Helvetica" size="2">Fannie Mae's outstanding mortgage
backed securities (MBS) stood at $1.3 trillion in Q4. The yearly rate of
growth of Fannie Mae's outstanding MBS jumped to 26.3% in Q4 from 22% in the
previous quarter.</font>
<p align="center"><img alt src="http://www.mises.org/images3/Shostak/03-03-2004/2.gif" border="0" width="314" height="269">
<font face="Verdana, Helvetica" size="2">The fact that a large portion of
mortgages is currently concentrated in few hands poses a greater risk to the
financial system, so it is held, than if ownership was widely diffused. Hence,
according to Greenspan, if the real estate market should suddenly weaken this
could pose a serious threat to the financial system and to the economy.</font>
<font face="Verdana, Helvetica" size="2">Furthermore, according to
Greenspan, because of their size both Fannie Mae and Freddie Mac know that the
government will not allow them to go belly up. It is this that makes them less
prudent in accumulating massive amount of debts and assets: the moral hazard
at work. </font>
<font face="Verdana, Helvetica" size="2">But this is not only applicable to
Fannie and Freddie, it is also applicable to most large U.S. banks. In fact
the entire banking system is built around the ongoing support provided by the
Fed's monetary pumping. So why single out Fannie and Freddie? Now, even if we
didn't have such institutions as Fannie and Freddie, due to the Fed's loose
monetary policies we would still have undesired symptoms regarding the housing
market.</font>
<font face="Verdana, Helvetica" size="2">Curiously, while identifying
government sponsored enterprises as a major risk factor behind a possible real
estate market plunge, Alan Greenspan had nothing to say about the role of the
Fed in all it.</font>
<font face="Verdana, Helvetica" size="2">As a result of loose monetary
policy, which aims to"protect" the financial system, financial
institutions always receive the new money first. Obviously this gives rise to
an expansion of activities of the earlier receivers of money. An early
receiver of money can afford, so to speak, to become more of a risk taker and
undertake various risky activities.</font>
<font face="Verdana, Helvetica" size="2">In reality however, the new money
leads to an exchange of nothing for something. It leads to the enrichment of
the earlier receivers and to the impoverishment of the late or nonreceivers of
the new money. Money and credit out of thin air leads to a redistribution of
real wealth.</font>
<font face="Verdana, Helvetica" size="2">There is no doubt that the
spreading of risk across an economy as a whole is much better than having it
concentrated in a few large institutions like Fannie and Freddie. So when
Greenspan complains about this state of affairs he shouldn't blame the GSE's
for it but rather the Fed's loose monetary policies which prevents an even
distribution of risk.</font>
<font face="Verdana, Helvetica" size="2">In fact, the uneven risk spread is
the structural manifestation of the loose monetary policies of the Fed. This
is because the first receivers of money can undertake larger risks while the
late receivers, on account of their resulting impoverishment, can only afford
to take less risk. This is the source of the 'skew' that leads to the
resulting imbalance.</font>
<font face="Verdana, Helvetica" size="2">Greenspan is absolutely correct
that once the size of Fannie's and Freddie's assets and debts become too large
there is the risk of a financial accident. However, this accident never
emerges out of the blue, but rather as a response to and effect of the erosion
of the pool of real savings brought about by the loose monetary policies of
the central bank. The erosion of the pool of funding undermines real growth
and the formation of real wealth, which in turn triggers the burst of the
bubble. With real wealth falling people's capacity to support their
liabilities diminishes.</font>
<font face="Verdana, Helvetica" size="2">Can then a stricter regulation of
GSE's, as suggested by Greenspan, eliminate the risk of a plunge in the real
estate market? As long as the Fed continues with its loose monetary policies,
it will not be possible to eliminate this risk. Once loose monetary policy is
activated it immediately sets in motion the process of a false economic boom,
or financial bubble, which sooner or later must be liquidated because it is
unsustainable. The longer the false boom, the more liquidations will be
required. Loose monetary policy gives rise to various higher risk activities
that prior to this policy would never have been considered. Hence, once the
flow of money slows down the existence of these activities is threatened.</font>
<font face="Verdana, Helvetica" size="2">It is for this reason that the Fed
continues to maintain its low interest rate stance: in order to keep various
artificial forms of life going. However, this policy cannot be pursued
successfully for an indefinite period. At some stage the Fed becomes nervous
about the size of the false creature it has created.</font>
<font face="Verdana, Helvetica" size="2">Consequently, the attempt to rein
into the size of the monster leads to an economic bust. Now, contrary to
conventional wisdom the bursting of the bubble is the beginning of economic
healing. It arrests the bleeding of real wealth generators and puts things
into a proper perspective.</font>
<font face="Verdana, Helvetica" size="2">It seems to us however, that
Greenspan is already preparing the public for the likely bust of the housing
market. This in turn means that he is likely to fight off the burst of the
housing bubble by an aggressive monetary pumping. However, if the pool of
funding is already in trouble, which is most likely the case, given the
present level of indebtedness in the economy and shrinking savings, then
monetary pumping won't be able to"revive" the economy.</font>
<font face="Verdana, Helvetica" size="2">There is a strong likelihood that
the U.S. housing market bubble has already reached dangerous dimensions. The
trend adjusted house price index has been following an explosive growth path.
After falling to -44 in Q2 1997 the trend adjusted house price index jumped to
+60 in Q4 2003.</font>
<p align="center"><img alt src="http://www.mises.org/images3/Shostak/03-03-2004/3.gif" border="0" width="341" height="303">
<font face="Verdana, Helvetica" size="2">There are a lot of similarities in
this regard with Japan in the 1980's and early 1990. During that period the
trend-adjusted price index followed an accelerating growth path. A major
reversal in this growth path took place after 1990 with the trend adjusted
house price index plunging to -350 in Q3 2003 against a peak of +640 in Q3
1990.</font>
<p align="center"><img alt src="http://www.mises.org/images3/Shostak/03-03-2004/4.gif" border="0" width="351" height="306">
<font face="Verdana, Helvetica" size="2">It seems to us therefore that the
Fed is barking up the wrong tree. It is not possible to fix the housing market
problem by fixing symptoms. What is needed is to restrain the Fed from its
reckless monetary policies, which structurally distort the economic
environment and give birth to various ugly symptoms.</font>
<font face="Verdana" size="2">_____________________________</font>
<font face="Verdana, Helvetica" size="2">Frank Shostak is an adjunct scholar
of the Mises Institute and a frequent contributor to Mises.org. He maintains
weekly data on the AMS for subscribers through Man
Financial, Australia. Send him MAIL and
see his outstanding Mises.org Daily
Articles Archive. Shostak wishes to express thanks to Michael Ryan
for his useful comments. Comment on this article on the Mises
Economics Blog.</font>
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