Whence Systemic Risk?

William Poole’s departure from the St. Louis Fed calls to mind a speech he gave in 2003 on Fannie Mae, Freddie Mac and systemic risk. In Poole’s view, the concentration of mortgage risk in the two institutions was per se dangerous. I think it is fair to say that Poole’s view was at least partly grounded in the idea that the implicit subsidy the two institutions received created alarming moral hazard issues. It was (is) a view shared by many fine economists, including Dwight Jaffee and Larry White, both of whose work I admire.

My view–and it is one that has led me to feel lonely at times in the company of other economists–is that the benefits of the GSE subsidies outweigh their costs, and that the GSE subsidies are not materially larger than those received by, say, Citigroup. Indeed, the pool of financial institutions with an implicit guarantee has recently moved beyond GSEs and commercial banks to include investment banks.

I think it is worth noting that Fannie and Freddie’s core business–prime mortgages–is doing ok. To the extent the companies are having trouble, it is because they were pushed into buying subprime and Alt-A loans by a set of misguided regulations known as affordable housing goals. I don’t know whether it is a coincidence or not, but Fannie and Freddie market share of mortgages declined dramatically between 2002 and 2007; they gave up their market share to private label institutions. So if Poole was correct, systemic risk should have declined between 2002 and 2007. The prediction didn’t work out too well.

I should disclose that I worked at Freddie for 15 months in 2002 and 2003. While I learned a lot there and met some wonderful people who remain my friends, I pretty much knew I wanted to leave the place within a month of arriving. How this biases my views on GSEs is not entirely clear to me. But I do sometimes wonder if some of the GSE’s most vociferous opponents, such as the American Enterprise Institute and the Wall Street Journal Editorial page, just can’t stand the idea that government created institutions have spread the benefits of capital markets to a broad swath of ordinary people in a very responsible way.