Fannie, Freddie, Fraud

Last week, new research from Edward Pinto, a former chief credit officer for Fannie Mae and a housing expert, began to penetrate the media fog. Pinto has documented that as far back as 1993, Fannie and Freddie were buying risky subprime and Alt-A loans, but routinely misrepresenting them as prime.

Let me drive this point home. Without Fannie and Freddie’s certification of millions of bad loans as safe, other banks both domestic and foreign wouldn’t have bought them. More importantly, world financial markets wouldn’t have relied on those packaged loans as collateral and collapsed when they went bad. Fannie and Freddie, both government-sponsored enterprises that are guaranteed and funded by U.S. taxpayers, committed fraud so massive it dwarfs the Enron scandal.

We Austrian economists saw this coming three decades ago. I warned in the 1980s that government involvement in the housing market would inevitably produce catastrophe. Even Republicans attacked me as an enemy of home ownership. The theory, held by many in both parties, was that owning a home made Americans stakeholders in the system and stabilized our economy. Others pushed the envelope further, using Fannie and Freddie as a way to give homes to low-income individuals. All very noble, of course, but it was always doomed. I hate to say I told you so but… well, actually, I don’t.

Our current administration is, of course, sticking to the story line that this “great recession” is a failure of capitalism. This won’t change because so many high-ranking administration officials profited from the mortgage fraud business.

The beginning of the Fannie and Freddie fraud that Pinto documents took place under the watch of Jim Johnson. You may know Johnson as the “trusted adviser” to the president who helped pick his running mate, Joe Biden.

While few know about Johnson’s role in the financial collapse, many know him for his legendary generosity with Fannie’s fake profits. As CEO of Fannie, he bestowed fortunes on his favorite causes, which made him one of the most popular people inside the beltway. Many of my colleagues spoke out against this laundering of the public’s money for personal and political purposes, but were ignored or attacked.

Rep. Barney Frank was the chief defender of Fannie and Freddie, accusing anyone who wanted more oversight of the out-of-control institutions of being heartless, racist or both. While I’m not a huge fan of the Bush administration, the truth is that it made multiple attempts to rein in Fannie and Freddie. Unfortunately, they were successfully parried by Frank.

Over the weekend, administration talking heads were sticking to the line that they have deterred financial disaster with bailouts and stimulus spending.

I was not as worried about the initial financial collapse and resultant recession as I was worried about the so-called fixes. I predicted then that those programs, along with efforts at massive restructuring of the economy, would not only fail to create the jobs and upturn we were promised. I told you they would slow the recovery. I include, incidentally, President Bush’s contribution to our debt and deficit as part of the problem.

Now you can read how this has actually come to pass in a great article by three University of Chicago economists, “Uncertainty and the Slow Recovery,” by Nobel laureate Gary Becker, Steven Davis and Kevin Murphy, in The Wall Street Journal online.

“In terms of U.S. output contractions, the so-called Great Recession was not much more severe than the recessions in 1973-75 and 1981-82.Yet recovery from the latest recession has started out much more slowly. For example, real GDP expanded by 7.7% in 1983 after unemployment peaked at 10.8% in December 1982, whereas GDP grew at an unimpressive annual rate of 2.2% in the third quarter of 2009. Although the fourth quarter is likely to show better numbers — probably much better — there are no signs of an explosive takeoff from the recession.

“We believe two factors are behind this rather tepid rebound. An obvious one is the severe financial crisis that precipitated this recession, with many major financial institutions receiving large bailouts from the federal government. The confidence of bankers and venture capitalists has been shattered, at least for a while, and it will take time for them to recover from the financial turmoil of the past couple of years. The household sector also faces a difficult period of financial retrenchment in the wake of a major collapse in home prices, overextended debt positions for many and high unemployment.

“The second factor is less obvious, but possibly also of great importance. Liberal Democrats won a major victory in the 2008 elections, winning the presidency and large majorities in both the House and Senate. They interpreted this as evidence that a large majority of Americans want major reforms in the economy, health care and many other areas. So in addition to continuing and extending the Bush-initiated bailout of banks, AIG, General Motors, Chrysler and other companies, Congress and President Obama signaled their intentions to introduce major changes in taxes, government spending and regulations — changes that could radically transform the American economy.”

Those changes, the Chicago Boyz say, have inspired hesitation, uncertainty and fear in employers and investors. As a result, they’ve waited on the sidelines to see how things play out. Not very cheering, is it? The result is that while the administration takes credit for “jobs saved,” actual unemployment figures in some areas are at Great Depression levels.

Yes, yes, yes, Obama inherited a mess. The problem with that thinking is that Congress makes policies, not presidents. When government is split, the most a president can do is use the veto, something Bush should have done regularly. For the last two years of his presidency, Democrats had the power of Congress. For two additional years, Congress was split. Democrats who now blame him for the totality of the financial failure are saying, implicitly, that he should have opposed Congress more vigorously, and I don’t think that’s their real message.

Anyway, I’m telling you that I was right about the all the ridiculous big-government solutions for a reason. I am fundamentally an optimist, and I am forecasting remarkable things in the not-so-distant future. I’m not, however, a blinkered Pollyanna like certain high-profile analysts whom we will not name.

My point is this: If someone doesn’t have a history of accurate predictions, he has no right to ask others to believe him when he makes forecasts. And I’m forecasting that the recovery, delayed as it is, will be historically unprecedented. And if you don’t want to believe me, believe Dr. Gary Becker, who has said to me, in both conversation and writing, the same thing. More importantly, he forecasts that the recovery will be driven by the breakthrough technological innovations that we are talking about and investing in now.

For transformational profits,
Patrick Cox

January 14, 2010

The Daily Reckoning