Lazear Talks Fannie, Freddie, and Change for 2009

Ed Lazear is the Chairman of the President’s Council of Economic Advisors (CEA).  He is a Professor of Economics and Senior Fellow at the Hoover Institution (Stanford University), now on leave.

He is one of the White House’s key decision makers involved in last week’s take-over by the Federal Government of the Federal Home Loan Mortgage Corporation (FHLMC) (NYSE: FRE), popularly known as Freddy Mac, and The Federal National Mortgage Association (FNMA) (NYSE: FNM), commonly known as Fannie Mae.

These colossal publicly-traded mortgage companies have together lent over $5 billion to Americans to enable them to buy and own their own houses. Every other American’s home is financed by these two behemoths.  And they are in deep trouble.

HUMAN EVENTS met with Mr. Lazear in Tokyo several days ago for a private interview after he presented his professional views on improving the U.S. health care system to the Mont Pelerin Society, the global organization of Noble-Prize-Winning Economists and other distinguished professors and free-enterprise think-tank leaders.

Ed began by talking about the current mortgage debacle and housing crisis.  “The bailout was a done deal a year ago.  But we were still shocked when we finally got to take a look at their books.  Freddy Mac was a dark hole.  It was much worse than we thought when we saw their numbers.”

He revealed that Freddy and Fannie “had moved away from their core business of making classic home loans and had entered the hedge fund business in search of higher profits.  At one time they even owned oil futures!”  

Fannie Mae was created in 1938 as a government agency under FDR’s “New Deal” to provide liquidity to the mortgage market. Until 1970, Fannie Mae held a virtual monopoly on the secondary mortgage market in the United States when Freddy Mac, also created by Act of Congress, entered the marketplace.  

On September 7, 2008, James Lockhart, director of the Federal Housing Finance Agency (FHFA), announced that Fannie Mae and Freddie Mac were being placed into conservatorship of the FHFA, the most sweeping government intervention in private financial markets since the Great Depression.

Lazear noted that “clearly, the independent regulator of these two firms was unable to catch the problem itself”.  There was no alternative but to exercise the Federal Government’s right to place the two into conservatorship if the taxpayer’s money was going to be used to bail out the businesses.  Under conservatorship, we can control the future of the organizations and conduct a rapid reorganization and bring in expert new management.”  

Lazear told HUMAN EVENTS that “it also reduces some of the moral hazard.  Old management is now gone, and the common shareholders are not being bailed out.  Their equity has been wiped out anyway.  The stock prices are down 90% since January”.

The “bailout” will take the form of guaranteed loans by the Treasury at 10% interest, and so he expects the government to actually make a profit on its investment as the real estate market recovers.  The numbers are substantial, however.  Analysts estimate that upwards of $100 billion each may be needed.  Still, this is a fraction of the portfolio of home loan assets that the two institutions own and small compared with the roughly $600 billion that China and Tokyo have spent in buying Freddy Mac and Fanny Mae bonds.

Lazear also observed that “the Fed is also now re-examining the rules on lending in the housing market”.  When it was observed that much, if not most, of this problem of making dodgy loans was the result of Congress “encouraging” banks to make “no doc, no equity” loans, especially to poorly-qualified minority buyers in the late 90’s, he tactfully declined to comment.

Lazear expects the housing financial market to begin to recover in 2009.  But his views on the global economic slowdown are not as clear.  “Many people, particularly in Europe, thought that the rest of the world had become ‘decoupled’ from the U.S. market.  People forget that international trade now accounts for over 25% of U.S. GDP, up from only 10-12% a few decades ago.  A slowdown in growth or other financial change in the US economy can have a far greater impact in other countries.”

Turning to the subject of inflation in the United States, Lazear thinks that “this has been principally caused by structural impacts, not monetary policy.  The effects of high energy prices, including oil and natural gas, have rippled through the economy affecting most prices.”

He states that “the main problem on the inflation front is not loose money, but high energy costs.”

Moreover, “the overbuilding of houses has been a relatively recent growing phenomena.  Low interest rates encouraged the annual construction of 2 to 2.1 million housing starts, an excessive supply compared with a demand of 1.5-1.8 million units, just a few years ago.”

Coming back to inflation, he stated that “the core figures are up a little but some others are now dropping.”  He noted that “oil is the overwhelming driver of upward prices.  The growth in oil consumption from 2000 through 2004 was fairly modest.  Since 2004, the demand has actually been dropping, and that is having a dramatic effect in falling oil prices, per barrel.”

However, he observes that unless we increase domestic oil production dramatically, “even if we brought monetary inflation down to zero, we will still see crude oil prices fixed at current high prices.”  

He clearly does not accept the argument that some members of Congress have argued — that the price of oil has been driven up by speculators.  When it was observed that if a speculator is in the market, it takes a willing producer on the other side to do the deal, he agreed: “[S]peculators in the oil market, taking a position against the oil companies, generally lose just as much as they make, but they represent a tiny fraction of overall oil trades.”

As the world absorbs the ongoing shock of the U.S. financial liquidity problem, now being played out in Wall Street, the effects of the clearly coupled U.S-global markets is expected to have an ongoing ripple effect from market to market and country to country. In the past few days alone we’ve witnessed the collapse of Lehman Brothers, the merger of Merrill Lynch into the Bank of America and the AIG debacle. Let’s hope that Chairman Lazear is right in his predictions of a recovering financial system in 2009.