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welcome to knowledge at Wharton this
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week we saw the collapse of some of the
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biggest Financial companies in the
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country and it all began with the
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September 7th announcement that the
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federal government would take over Fanny
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May we're here today with professors
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Richard Herring and Susan do to ask what
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this means and what we can expect next
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in the world and the US financial
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markets welcome pleasure to be here well
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the other day treasury secretary uh
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Paulson said that he thinks this whole
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crisis in the housing market will behind
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us in a number of months rather than
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years do you think that's true and
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what's it going to take to get us behind
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us Professor wer I think it's very
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difficult to say and I think it's uh
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over optimistic to say this will be
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behind us in several months depending of
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course what you mean by that the housing
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market crisis which is underlying the
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financial crisis is not likely to be
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resolved in a couple of months it's
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ongoing for a year or perhaps more in
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part that's because there is a whole set
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of mortgages which are going to have a
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peak in foreclosure after the next set
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of months and that's the option arms
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which are just coming due now so we
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haven't hit bottom yet when do you think
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we might see a turnaround
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again I think it's very hard to say
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there is a huge excess supply of housing
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uh we have stopped building it by and
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large but um it's increasing because of
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foreclosures and uh until you really
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clear the housing market I don't think
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uh you're going to see a bottom to any
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of this um they're Prime mortgages that
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are getting higher foreclosure rates
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even at this stage in fact there are
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more Prime mortgages in foreclosure than
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subprime just big surprise the beginning
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we thought oh it's highly risky well I
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think it's it's a mistake that's been
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made all along um you could ask why the
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the managers of be Sterns and Layman did
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not recapitalize earlier and frankly
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they thought it was going to be a
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two-month crisis three-month crisis it's
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over it's now more than a year and uh I
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think there's no reason to believe that
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it it won't last at least another year
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let's look at the Fanning Freddy
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takeover uh for starters though it may
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be mood at this point point was this the
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right thing was there any alternative to
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the government taking over well I don't
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think there was any alternative uh
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there's Reliance on the debt uh
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throughout the world there are um
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governments who are treating that debt
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as treasury debt I think it would have
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had spill over in terms of risk uh there
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was a an implicit guarantee on the debt
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side if the federal government had
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walked away from that it would have
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raised questions over the uh the the
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cost of that debt going forward leaving
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a side spillover for treasury the cost
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of that debt was already increasing and
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the one thing that we do not need is a
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sudden dramatic increase in the cost of
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Mortgage Debt and Fanny and Freddy are
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70% of the market it really gets to the
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heart of the ambiguity of the
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organization um it it all goes back in
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history I guess to um the Johnson
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Administration um May was a government
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entity um Johnson didn't like having it
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on the budget so he spun it off to try
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to um pay for guns and butter and they
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created Freddy Mack as sort of
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competition but you had this very odd
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animal that was government sponsored but
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privately owned and so it had this dual
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m mission that uh really was not
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sustainable in the Long Haul and uh
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there's a sense in which you could argue
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that Fanny and Freddy were and the way
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they were regulated had a lot to do with
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the whole subprime crisis because the
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demand for um subprime securitizations
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came largely in terms of AAA Securities
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and uh in some of the subprime
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securitizations as much as thir as 80%
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of the pool ended up as being AAA well
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who bought most of those they were
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mostly bought by Fanny and Freddy why
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did they do that well because HUD had
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put goals for affordable housing on them
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that required them to buy much more in
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the way of uh affordable housing uh than
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was being produced and so they were able
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to meet that requirement by buying these
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AAA tranches now apparently they didn't
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do their homework to see that AAA wasn't
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really AAA when it came to Securities
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like this um but it fed the market it
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was sort of demand from that end that
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made it such a profitable line of
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activity and probably led to a lot more
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underwriting of these kinds of of uh
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loans than we might otherwise have seen
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now uh on the other hand they have both
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been public quasi public uh private
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entities or whatever you call them for
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30 years or 40 years almost uh and it's
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worked pretty well up until now is it
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was it really a problem inside Fanny and
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Freddy or was it something that was
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changing in the markets that swept over
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over them as well well Fanny and Freddy
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uh certainly embedded aided and embedded
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the crisis but the Crisis began
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elsewhere and people are um not aware
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that we had another subprime crisis we
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had a subprime crisis in 2000 uh which
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was much smaller because subprime was a
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much smaller share of the market but in
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some areas some parts of the country was
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pretty significant right here in
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Philadelphia we had 20% of our mortgages
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go into default which ultimately is
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about what we're going to see in the
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subprime Market Nationwide and of course
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subprime is now five times what it was
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then my point being at that point uh
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Fanny fredd had nothing to do with the
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subprime market and the subprime market
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Grew From 2000 uh to 2004 and now I'm
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thinking really nonprime some Prime in
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all day to 38% of the market uh as they
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did that they outcompeted FHA FHA share
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fell uh from about 20% uh to about 5%
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Fanny and Freddy's share held steady uh
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what what was happening in that period
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one thing that was happening very
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clearly is that uh subprime as they took
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over the market a big substantial
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portion of the market lowered lending
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standards substantially and this was
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without the assistance of Fanny and
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Freddy that is originally these MBS were
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structured by Wall Street sold
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throughout the world uh AAA tranches all
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the way down down to the toxic waste of
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course all of it is now toxic uh this
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was without Fanny and Freddy's
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assistance what happened and Fanny
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Freddy were not purchasing uh subprime
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until
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2004 in terms of their um investment uh
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sometime in 2003 they were given the
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go-ahead to do so uh they had a
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regulator their regulator clearly um uh
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there was discussion of this HUD and the
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regulator discussed whether this was a
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good idea or not and they approved of it
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a big question of course here is um do
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we need more regulation do we need less
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regulation do we need more competition
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or do we need and do we need better
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regulation well we certainly need better
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regulation and better competition well
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let's start with what should happen to
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these entities going forward now they're
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in a conservatorship which is a kind of
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limbo nobody expects that to last
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forever what should happen next um I
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guess I would slightly disagree with the
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fact that they've worked perfectly well
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for 30 to 40 years what we've been faced
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with is this very odd sort of animal
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that has an implicit government
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guarantee and it it reinforces the point
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Susan made earlier that it was treated
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by and large as if it were government
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debt uh even to the extent that the
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banking Regulators were putting Capital
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charges against it as if it were
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government debt and that's why you see
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so many angry small banks that bought
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preferred shares in Fanny that are going
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to uh suffer major losses um because the
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capital charge against it was treated as
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if it were a claim on the US government
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uh now both the US government and Fanny
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and Freddy claimed that the guarantee
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did not convey a subsidy the subsidy was
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perfectly obvious in the market and it
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distorted quite frankly um the
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competition in the market um but the
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point uh you're making is what should
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you do now that you've got them in
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conservatorship um I think there are
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three possibilities I would rule out
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maintaining them as gsse I think we've
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proven that model is is deeply flawed
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and
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dangerous um anything that's too big to
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fail is basically too big and so you
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need to make them smaller well you could
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liquidate it you could privatize it or
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you could nationalize it and we've
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basically nationalized it now um that's
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not really consistent with American ways
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of doing things and there are really
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lots of other substitutes for this kind
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of guarantee the private sector is
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perfectly capable of providing mortgage
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Finance in normal times so once things
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are restored to normality uh I think the
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right thing to do is to liquidate if you
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don't do that then you should probably
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split it up and privatize it but I have
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pretty grave reservations about that
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because I think there will be a tendency
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for them like the baby bells to to form
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again and become too big to fail and
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they'll have sort of a quazi government
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status um I see no real in real uh need
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to have it the model is deeply flawed in
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another way too because what it's doing
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is encouraging leverage if the
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government really wants to help
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lowincome uh buyers and you know there's
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certainly a case to be made that they
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should you don't make them more
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leveraged what we had was a number of
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people who simply could not sustain home
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ownership given the leverage they had
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and the kind of volatility they had in
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their sources of income what you really
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need to do is have a grant program that
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will match down payments or give down
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payments to firsttime
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borrowers uh Congress won't like that
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because a fanny and Freddy were an
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enormous source of lobbying funding for
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them all and B it's going to have to go
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on the government budget and we're going
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to have to to trade that off against all
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the other things we want to do but if
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it's worth doing it's worth doing in a
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way that we can monitor and and talk
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about it sensibly rather than pretending
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it's a uh free gift and Professor Walker
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what do you think should happen to them
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well I think it's going to be a long
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time for us to consider the pros and
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cons of different Alternatives I don't
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think that um we know the answer I think
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there are uh serious questions about all
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the different options on the table I
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think there U one thing that for my mind
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two things that are absolutely necessary
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one thing I think there is consensus on
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and that is we continue to have
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securitization in the United States that
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we do have a market where we can have a
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30-year mortgage that is
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securitized uh as opposed to what many
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other countries have which is a Reliance
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on a short-term variable rate mortgage
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which is subject to uh subjects
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homeowners to mortgage payment shock so
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that's on the table the second is in a
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world of securitization there has to be
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discipline and the discipline has to
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come from Market forces or from
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regulation but let me point out that
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it's not the only way to get 30 rate
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fixed rate mortgages uh the Danes have
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gotten along perfectly well for 150
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years with covered bonds and the Germans
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have too uh now there's what are those
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can you just explain that um yeah it's
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where the um bank will put together um a
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bond that essentially pools the
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mortgages and uh sells it in the
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long-term Market uh and it's guaranteed
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by the bank um there are proposals for
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doing more of that inside the us at this
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time the FDIC is very concerned about it
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because they're afraid it's going to
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take the good assets off of bank balance
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sheets and leave them with a bigger hole
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in in uh frail Banks but in normal times
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uh that seems to be a perfectly good way
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to provide what I think Susan has
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rightly pointed out is one of the the
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real strengths of the US uh mortgage
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system and it's a good deal simpler it
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it it has much less complexity um fewer
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fees for investment Banks to be sure um
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but it's proven to be very stable over
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literally more than a
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century
