Monday, January 12, 2009

Michael Shermer on the Bailouts

Ever since I have taken up following conspiracy theorists I have been reading a lot of Michael Shermer, he is founder of the the Skeptic Society after all. He recently wrote a pretty decent book on economics, which I got an autographed copy of (and actually made a YouTube video of when the troofers interrupted it). He continues this theme with a editorial in the City Journal.

Though the financial crisis is complex and has many explanations, one of its primary causes involves Fannie Mae and Freddie Mac, the nation’s largest guarantors of home mortgages. Recall that Fannie and Freddie are government-run organizations that do not make loans directly to customers; rather, they buy loans from the banks that make those loans directly. In spring 1999, Fannie and Freddie—under pressure from the Clinton administration—increased their portfolio of loans to lower- and moderate-income borrowers from 44 percent to 50 percent by 2001. That meant granting loans to higher-risk customers.

Now, there’s nothing wrong with corporations’ and institutions’ taking higher risks, so long as they adjust for it by charging more. The higher price acts as a risk signal to both buyers and sellers, thereby dialing up their emotion of risk aversion. That’s what Fannie Mae was already doing, in fact: when it purchased loans that banks made to high-risk customers, it bought only those that charged 3 to 4 percentage points higher than conventional loans. But under the new program, Fannie would buy high-risk mortgages that were only 1 point above a conventional 30-year fixed-rate mortgage (and that added point would be dropped after two years of steady payments). In other words, the normal risk signal sent to high-risk customers—you can have the loan, but it’s going to cost you a lot more—was removed.

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