Economy would ultimately be better served by breaking

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economy would ultimately be better served by breaking up the various functions of the GSEs. In a fundamental sense the critics of the GSEs were right: They were a problem. The specific quasi-public/quasi-private structure of the GSEs created incentives for excessive risk- taking, at the ultimate expense of the taxpaying public; and having them around in mortgage markets made it convenient for each successive presidential administration to employ them for boosting short-run consumption and spending that was centered on housing, at the expense of some future administration and again ultimately the taxpayer. The confluence of these two distortions meant that over time, the GSEs morphed into the world’s largest and most leveraged hedge funds, except that only they had government backing. In the end, the GSEs had inadequate capital for the risks that they were taking. But virtually all critics got the immediate source of the problem wrong. What caused the financial downfall of the GSEs was not the interest-rate risk embedded in their portfolios. Instead, the immediate source of the problem was the credit risk that stemmed from the poor quality of mortgages and investments that they took on and guaranteed in the middle of the decade. When the housing market crashed in the U.S., this credit risk materialized and generated the large losses that wiped out the inadequate capital that they had maintained. The force that led to the downfall of the GSEs is not uncommon to economic theory, which would call it a classic “race to the bottom” in bank risk-taking or underwriting standards. The important point is that the GSEs contributed to – and were influenced by – the risk-taking of private financial firms that were competing with them in the same mortgage markets. In effect, a set of privileged institutions – Fannie and Freddie, backed by government guarantees and enjoying a lower cost of funding – entered a financial market (less-than-prime mortgages) hitherto operated by less-privileged institutions (mortgage banks, commercial banks, and investment banks, among others); the less-privileged tried to guard against the entry by lending more aggressively, which prompted the more privileged to respond with aggression too. The sub-prime mortgage mess was in part due to government guarantees for Fannie and Freddie that distorted a level-playing field, resulting in the debacle of mortgage finance.
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75 Chapter 6: In Bed with the Fed Policy, whether it be printing money, guarantees or deficit spending, can prop up asset values for a while. This may even be useful in a liquidity crisis. But a solvency crisis is another thing. The longer policy distorts markets by ignoring fundamentals, the longer those reliant on market signals will sit on their hands. The Fed’s recent decision to continue asset purchases shows there is no exit once this path is chosen. As we approach the second anniversary of the Fannie and Freddie bailouts, are we better off? -
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