The quasi-governmental institutions Fannie Mae and Freddie Mac guaranteed  mortgages, which Wall Street happily securitized once the credit rating agencies- which had been given a legally protected oligopoly by the government-declared them to be safe investments.  Government owned banks and municipalities across the world bought mortgage- backed securities like never before.

The central position of Fannie Mae and Freddie Mac reinforced confidence that the government would intervene if the housing market ran into trouble. The Fed’s safety net and the FDIC made banks dare to take big risks because they could privatize any gains but socialize any losses.

When home prices began to fall and the market no longer wanted mortgage-backed securities, the financial authorities stepped in and decreed that the banks had to write down the value of such securities radically, giving rise to several waves of panic selling. And when nobody wanted to finance the special companies anymore, the banks had to take them over, which put such a burden on their balance sheets that regulations forced them to pile up capital rather than make loans.  President Bush and other leading policy makers whipped up a panic to push through the laws they wanted. And just as the financial markets were more worried than ever because they did not know where the big risks were, the authorities banned shorting, thus depriving the markets of liquidity and information when they needed it most.

If this is laissez faire, then I would like to know what government intervention looks like.

If politicians, central bankers, and bureaucrats had intentionally tried to create a crisis, they would have been hard put to find more effective actions.  At each stage, the government inflated the bubble at least as eagerly as the most enthusiastic of Wall Street traders. The only difference was that the government’s pump was so much bigger.

From “Financial Fiasco” by Johan Norberg

HKO comments- yet the media has thoroughly convinced the ignorant and the gullible that this was a failure of capitalism.

In several past postings reviewing the recent financial meltdown, I have noted the pivotal role played by Fannie Mae.

A toxic mix of arrogance and incompetence infected Wall Street.  Bad political, monetary, and tax policy inflated the housing market bubble.  But without the assurances of Fannie Mae, the ratings agencies and market makers would not have  been able to give the mortgage backed securities at the center of the crisis the ratings they clearly did not deserve.

Fannie Mae was exempt from regulation by the FDIC, the SEC and SIPC.  It’ s sole overseer was Congress.  When Congress was presented with evidence that Fannie Mae was taking excessive risks and needed restraint in 2005 and 2006, the bearers of caution were beat down by Barney Frank and many others  and the proposal was unable to even make it out of committee. On almost straight party lines the Democrats refused to restrain the agency. Fannie Mae, with a monopoly granted by the government lobbied hard to prevent any interference by the Congress.

The largest recipients of Fannie Mae campaign funds was Hillary Clinton, Christopher Dodd (Senate Banking Committee Chairman) and Barak Obama.

While understandable outrage was leveled at the Wall Street Firms and AIG for the bailouts the real outrage was the bailout of Fannie Mae.  Now President Obama has pledged unlimited support for the agency.

When private enterprise fails capital exits the enterprise; when a government enterprise fails it attracts additional capital.  Private mistakes go bankrupt, government mistakes get institutionalized.

One of the most intriguing concepts of economics is the concept of “moral hazard.”  It is a corollary to a more obvious principle that everything has a cost. An understanding of it is critical for those whose world view is a never-ending series of crisis that demand a government solution.

Insurance, for example, encourages the risk it is designed to protect us from.  Seat belts may make us more reckless drivers.  I may be more inclined to eat the high fat burger with cheese if I think I am protected by Lipitor.  Free health care may make us less healthy and more obese.

But nowhere is the cost of moral hazard more significant and more obvious than in our financial system.

We insure bank depositors to bring stability to our financial system, but such insurance means that the depositors are freed from the responsibility of even caring about the bank’s stability.  It also increases the bank’s proclivity for risk taking. They get to pocket profits and get bailed out of losses. We privatize the profits and socialize the risk.

FDIC protection started out at $10,000, and soon went to $40,000. Jimmy Carter raised it to $100,000 and some partially faulted this move with creating the savings and loan fiasco about ten years later.  In the midst of our recent crisis the limit was raised to $250,000 to avoid another bank run.  Given our historical correlation of increasing FDIC protection limits with worsening crisis, I wonder if in our effort to avert the current crisis whether we have simply sown the seeds of the next one.

Those who fault the absence of regulation for our current crisis should look further at the moral hazard created by the very protections embodied in our current regulations.

Regulations written in response to our last crisis do not seem to protect us from the next one.  Rules written as a result of the dot.com bubble did not protect us from the ensuing housing bubble.  In fact our regulators and our government was more of a willing participant via Fannie Mae and Freddie Mac.

In the absence of FDIC insurance perhaps the consumer and society would be better served by an “independent” rating such as the AM Best rating service is for life insurance companies or an equivalent of Moody’s or S&P for small banks.  I do stress the independence which had been seriously compromised in the past.

There will never be enough regulators to counter the number of people who seek loopholes, ply lobbyists, create new products or who otherwise seek to game the system.

Even if we were able to staff enough bureaucracies to squeeze excess risk and abuse out of our financial system, it would likely restrict growth so severely that we may long for the days of a few bubbles and the ensuing market correction.

Facing record deficits this administration needs economics growth desperately. The union card check bill, the budget deficit, the uncertainty of cap and trade, higher taxes on the wealthy and private businesses, and the cost of the health care proposals severely threaten business growth.

But the biggest hindrance may be both an increase in moral hazard that increases the likelihood of the next bubble, and overly restrictive regulations that retard the growth we need to recover from the last one.