Understanding the GSEs

If you want a great example of how conservatives don’t know anything about anything, look no further than Iain Murray’s enthusiastic recommendation of this Wall Street Journal opinion piece pinning the blame for everything on Chris Dodd:

In February 2004, while Republican colleagues warned of the systemic risks posed by Fannie Mae and Freddie Mac, Mr. Dodd pronounced the mortgage market “one of the great success stories of all time.” A year later, the Connecticut Democrat voted against a reform that would have limited the size of Fan and Fred’s mortgage portfolios.

As a heuristic, you might wonder why this piece of finance and business journalism didn’t make it into the WSJ news pages.

Meanwhile, it seems to me that the Republicans were right on the merits of this controversy and that Dodd was wrong. In fact, all before this crisis I generally agreed with the conservative view on the so-called “government-sponsored entities.” As such, I actually understand what that view was! The view was that the implied government guarantee to Fannie and Freddie might cause them to take unduly large risks, and that the very scale of those risks would mean that in the event of a crash we actually would need to bail them out despite the lack of explicit guarantee. Thus, the idea of limiting the size of the Fannie/Freddie portfolios. The point was that if the Fannie/Freddie portfolios could be kept small, then perhaps the GSEs wouldn’t be “too big to fail” and we could afford to avoid bailing them out. And if we did wind up needing to bail them out, we wouldn’t be on the hook for such an enormous amount of money.


These were sensible concerns and I hope that when we come through this current crisis we won’t repeat the mistakes that were made when Fannie and Freddie were privatized in the first place. That said, this has nothing to do with the current crisis in the financial system. In case you, Murray, John McCain, or the WSJ opinion section hasn’t noticed, it’s not as if we’ve managed to get away with not bailing out non-GSE firms. Instead, the magnitude of the crash has been so giant that we’re now partially nationalizing the entire banking system. Fannie and Freddie being somewhat smaller wouldn’t have changed anything. At all. Capping their portfolios was a good idea for avoiding a potential problem that, as it happens, wound up not being relevant because something much worse happened instead. It’s a red herring. You might as well blame the crisis on ethanol subsidies or sugar tariffs or the stupid structure we use to allocate airport runway space or any number of other things that happen to be bad policies but that fixing would in no sense have prevented the current crisis.