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Moral Hazard


Fannie and Freddie

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"Far from being disciplined in their risk-taking, lenders went wild"

What failed this time were markets.
The lenders who were supposed to regulate mortgage borrowing — and the credit-rating firms who monitored them — failed utterly.
The investors whose job it was to monitor the capital of financial institutions were asleep at the switch.
ROGER LOWENSTEIN, New York Times July 27, 2008

Roger Lowenstein

The entire U.S. policy of promoting homeownership, which during the boom raised the ownership rate from 64 percent to 69 percent, now looks to be a case study in unintended consequences. Encourage more housing than markets will support and you get — voilà! — mortgages that fail. Fannie and Freddie were among the chief implements of the policy. Though judged by Standard & Poor’s to be only a Double A-minus credit, they were able, thanks to the widely held belief (since validated) that the United States would not allow them to fail, to borrow at lower than Triple A rates.

A good first step would be to draw a bright line between Fannie and Freddie’s outstanding obligations, which total $1.5 trillion, and the borrowings they undertake in the future as their current paper matures.

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Banks with federally insured deposits, which are limited in the risks they’re allowed to take and the amount of leverage they can take on — have been pushed aside by unregulated financial players.
We were assured by the likes of Alan Greenspan that this was no problem: the market would enforce disciplined risk-taking
Paul Krugman 28/7 2008

Far from being disciplined in their risk-taking, lenders went wild. Concerns about the ability of borrowers to repay were waved aside; so were questions about whether soaring house prices made sense.

Lenders ignored the warning signs because they were part of a system built around the principle of heads I win, tails someone else loses. Mortgage originators didn’t worry about the solvency of borrowers, because they quickly sold off the loans they made, generally to investors who had no idea what they were buying. Throughout the financial industry, executives received huge bonuses when they seemed to be earning big profits, but didn’t have to give the money back when those profits turned into even bigger losses.

If the government is going to stand behind financial institutions, those institutions had better be carefully regulated — because otherwise the game of heads I win, tails you lose will be played more furiously than ever, at taxpayers’ expense.

And as Upton Sinclair pointed out, it’s hard to get a man to understand something when his salary — or, we might add, his campaign war chest — depends on his not understanding it.

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The biggest political story of 2008 is getting little coverage. It involves the collapse of assumptions that have dominated our economic debate for three decades.
Since the Reagan years, free-market cliches have passed for sophisticated economic analysis.
But in the current crisis, these ideas are falling, one by one

E. J. Dionne Jr. Washington Post, July 11, 2008

Bank for International Settlements annual report
“How,” asks the report, “could a huge shadow banking system emerge without provoking clear statements of official concern?”
How, indeed?

How big are the risks now? The answer is: very large.
As I argued in a speech at a BIS conference last week...
Martin Wolf, Financial Times, July 1 2008