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The reason the case is weak is that anyone with half a brain could read Fannie’s financial disclosures and determine they were doing subprime. Contra to Joe’s false claim that“Fannie and Freddie got into subprime mortgages, with great trepidation, only in 2005 and 2006,” the companies were both clear before then that they were involved in subprime. Since fact-checking doesn’t seem to be very important with Joe, you can start with my analysis.

The disagreements between Nocera and AEI’s Peter Wallison focus on the GSEs’ mandated housing goals. This is unfortunate and, even more importantly, besides the point. While I find the evidence that the housing goals helped to increase GSE credit risk convincing, I would be the first to say that such evidence is far from conclusive. But so what. Being leveraged over 200-to-1, as was the GSE guarantee business, is a recipe for disaster regardless of credit quality. As even Democrat Phil Angelides admits in today’s WSJ, Fannie and Freddie “had a flawed business model in which profits were privatized and losses socialized.” That’s the real problem. If Nocera wants to argue that Fannie Mae was no worse than Bear Stearns, then I can live with that as long as we also apply the fate of Bear to Fannie.

One has to give Nocera some credit. By painting the narrative as Fannie vs. Wall Street, when instead they were close partners, he has helped to preserve the current GSE model. By focusing on “the role of government” in housing, he moves the debate away from the reckless immoral behavior of Fannie and Freddie. He can claim this is about social policy and paint himself as a caring progressive, despite the massive regressive theft that Fannie and Freddie have actually been.

While I agree that having a better picture of the role of the GSE housing goals would be helpful, such an analysis should not delay the obvious: the hybrid GSE model is a failure. Let’s either have them be part of the government or truly be private (and suffer the fate of private failures). Whether Fannie and Freddie rank in one’s top 5 or top 20 causes of the crisis, they should have been ended a long time ago.

Courtesy of the Cato Institute

Advocates of the new agency argue that regulators put too much emphasis on banks’ safety and soundness at the expense of consumer protection, so the two functions had to be separated. But after more than 300 bank failures and trillions of dollars of assistance to the financial sector, it would seem there was not enough emphasis on safety and soundness.

The crisis was not caused by failures of consumer protection. It was caused by a housing bubble driven by easy credit. Under the guise of consumer protection, bank regulators spent much of the last decade urging banks to expand mortgage credit. Researchers such as Jeff Gunther of the Dallas Federal Reserve have found that the banks that did so became less sound.

Separating soundness from consumer protection has been tried with Fannie Mae and Freddie Mac. From 1992 to 2008, the Department of Housing and Urban Development enforced their housing goals, while the Office of Federal Housing Enterprise Oversight monitored their financial health. Unsurprisingly, HUD pushed Fannie and Freddie to take on ever more unsafe risk. The result has been a taxpayer-funded bailout that will cost hundreds of billions.

Even outgoing Rep. Barney Frank recognized the dangers of separating these functions. In 2008, he wrote legislation that combined them under a single new regulator for Fannie and Freddie. Oddly enough, Frank (D., Mass.) now argues that these functions must be separated for banks.

This is in keeping with the special treatment Fannie and Freddie always seem to receive. Despite the purported benefits of the consumer protection agency, Fannie and Freddie are explicitly exempt from its oversight. So is Wall Street, whose oversight stays with the unreliable Securities and Exchange Commission. And so are all the cheerleaders of the housing bubble, the real estate agents and builders who touted housing as a bulletproof investment.

In other words, almost everyone who had anything to do with the financial crisis is not affected by the new agency. It’s as if Congress sold exemptions to the highest bidders.

In fact, the intent of the agency is not to prevent future financial crises or protect taxpayers, but to extend the reach of trial lawyers and regulators to financial products offered by non-banks, such as check cashers and payday lenders. And whatever your opinion of such companies, we can agree they weren’t behind the financial crisis. Furthermore, they are already subject to regulation by the Federal Trade Commission.

Unfortunately, the new agency is a distraction from the real flaws of our financial system. Instead of increasing so-called consumer protection, Congress should have prohibited the government from pushing risky lending and reined in the easy-money Fed policies that inflated the housing bubble. That would help correct the problems Dodd-Frank ignores.

Courtesy of the Cato Institute

Much is made of the Fed’s “dual mandate” of promoting price stability and full employment, but a read of the Fed’s responsibilities, in Section 2A of the Federal Reserve Act, requires the Fed to maintain “growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Encouraging a bubble in the housing market is the exact opposite of the Fed’s mandate. Yet from 2002 to 2005, the real federal funds rate was negative. Paying people to borrow money for three years is a recipe for disaster.

Beyond the Fed’s role in creating the housing bubble was its response to the crisis. The Fed’s role as lender of last resort is to provide liquidity to banks experiencing short term financing needs. No degree of liquidity, however, can cover up a firm’s insolvency. The basic problem at firms such as Bear Stearns, Lehman Brothers, AIG and Fannie Mae was that their liabilities were greater than their assets. This is not a liquidity problem, but one of solvency. Using the Fed balance sheet to absorb the losses that should have been borne by creditors and shareholders is not conducting monetary policy. It is fiscal policy, on a massive scale.

The Fed’s purchase of $1 trillion in mortgage-backed securities is no different than the original proposed purpose of the TARP. And while I opposed the TARP, one can at least say it was passed by Congress, where we could observe each member’s vote and hold them accountable. The Fed has engaged in the same actions, yet being unelected bureaucrats who regularly claim “independence”, are beyond public accountability. At a basic level, if the TARP is fiscal policy when passed by Congress, how can the same actions count as monetary policy when performed by the Fed? They do not and cannot. Defenders of the Fed constantly invoke another Great Depression or that it would have been worse. Maybe they’ve missed just exactly how bad it is and has been. To say we avoided another Great Depression is empty conjecture. We had a nasty housing boom and bust. Bailing out AIG wasn’t going to change that. It is long past time for the Fed to return to a focus solely on price stability and end its excursions into fiscal policy and the constant inflating of asset bubbles.

Courtesy of the Cato Institute

This is not really surprising considering we’re at the start of another election season when politicians are scrambling for goodies to sell for votes. Under the slogan of preserving the American Dream, the Obama election campaign is promising to resurrect the old policy of extending implicit government backing to Fannie and Freddie — if the President is re-elected.

The Obama Administration has outlined major policy initiatives to preserve a role for the same mortgage-lending giants that have had to be bailed out repeatedly since 2008 at taxpayer cost of $130 billion to date. The latest proposal would allow homeowners with underwater mortgages backed by Fannie and Freddie to refinance. This would be expected to transfer money from taxpayers to homeowners and, by increasing expected taxpayer burdens, is likely to delay economic recovery in consumer spending.

It is worth noting that the Administration’s recent report on housing policy begins by blaming the private sector for initiating riskier lending practices: To wit:

Initially, Fannie Mae and Freddie Mac were largely on the sidelines while private markets generated increasingly risky mortgages. Between 2001 and 2005, private-label securitizations of Alt-A and subprime mortgages grew fivefold, yet Fannie Mae and Freddie Mac continued to primarily guarantee fully documented, high-quality mortgages.

This reveals a fundamental misunderstanding of how private markets work — one that needs to be exorcised before we can move to better policies. The Administration’s statement assumes that private lenders’ business decisions and risk-taking activities occur in a vacuum. On the contrary, the very existence of Fannie and Freddie to subsidize and support home lending probably triggered private risk taking at the margin in that sector.

The long-standing and profitable operation of housing GSEs — their purchases of home-loans financed out of bond sales to the public at cheap rates because of the implicit government backing they enjoyed — generated a long-sustained upward spiral in home prices, reduced aggregate risk perceptions in home finance among private lenders, and attracted capital including foreign savings. That made Fannie and Freddie a part of the constellation of government policies that promoted a steep home price bubble — that eventually burst to deliver the Great Recession.

The correct policy prescription under a buoyant housing market would have been to withdraw the GSEs from the market, and transition to a self sustaining home finance sector. Such a policy, had it commenced during the early 2000s, could have injected caution and countered the growing perception of a risk-free bonanza in home lending that fed the housing price bubble. Instead, Fannie and Freddie’s appetite to preserve market share and profits was only whetted — as the historical record of their massive portfolio expansion by purchasing subprime loans clearly shows.

The Administration is now proposing to “wind down Fannie and Freddie on a responsible timeline,” (that is, remove the old names), to “address fundamental flaws in the mortgage market to protect borrowers, help ensure transparency for investors, and increase the role of private capital,” (that is, increase lending regulations that stifle the private market), and “target the government’s vital support for affordable housing in a more effective and transparent manner” (that is, create new government sponsored home-lending institutions and increase its role in home-finance).

Instead of admitting that the lesson of the housing debacle is that some segments of the population do not deserve and cannot sustain home purchases financed through government subsidized mortgages, the Obama administration’s proposals, including this latest one, seek to “serve the needs of families, lenders, and investors” (but not taxpayers, of course) to “makes us all better off” (again, taxpayers excluded).

Sometimes, when a company fails for reasons unconnected to its business model, its operators attempt to preserve it via cosmetic changes — a new name, new location, or different front-office personnel. Accenture, the business consulting firm — formerly a part of Arthur Andersen that was tainted in the Enron scandal — is now thriving. So is “Sunshine Financial,” the formerly failed “People’s First” home lending business in Florida. Look for something similar to happen to Fannie and Freddie — even though that “business model” has clearly failed.

Courtesy of the Cato Institute

The government did it — cause the economic meltdown. Of course, there were other factors. But in Reckless Endangerment, reporter Gretchen Morgenson and analyst Joshua Rosner point the biggest finger at Fannie Mae and Freddie Mac. These so-called government-sponsored enterprises (GSEs) used any means — fair or foul — to create a housing bubble. When it popped, economy-wide havoc resulted.

Although the financial meltdown lies three years in the past, we continue to pay a high price for past follies. The housing market continues to look for its bottom as the GSEs, now under direct government control, continue to lose money. Bailouts have become the new norm. America faces rising spending, continuing deficits and mounting debt.

It is time to respect George Santayana’s dictum and learn from the past. Reading Reckless Endangerment is a good place to start.

Ms. Morgenson and Mr. Rosner have done what is uncommon: produce a book that is substantive but also readable, even entertaining. The result is a Washington “whodunit” story — the authors report not only what happened, but who did what. They explain: “the American economy was almost wrecked by a crowd of self-interested, politically influential, and arrogant people who have not been held accountable for their actions.”

The sordid tale begins in 1994, with President Bill Clinton and his National Partners in Homeownership. U.S. politicians long have sought to win votes with homebuying subsidies, but Mr. Clinton took the strategy to new levels. “It was unheard-of for regulators to team up this closely with those they were charged with policing,” observe the authors.

Few paid attention to the dangerous incentives created. When Massachusetts Democrat Rep. Barney Frank, long one of Fannie Mae’s Capitol Hill champions, was asked about the risks of inflating the housing market, he responded: “We’ll deal with that problem if it happens.”

The result, as they say, is history. Write Ms. Morgenson and Mr. Rosner: “By 2008, the American economy was in tatters, jobs were disappearing, and the nation’s middle class was imperiled by free-falling home prices and hard-hit retirement accounts. Perhaps most shocking, homeownership was no longer the route to a secure spot in middle-class America. For millions of families, especially those in the lower economic segments of the population, borrowing to buy a home had put them squarely on the road to personal and financial ruin.”

The chief miscreant in Reckless Endangerment is James A. Johnson, chief executive officer of Fannie Mae. His objectives were money and power. He was determined, ruthless and manipulative.

The story of how Mr. Johnson bought politicians, neutralized academics and acquired partners — through generous campaign contributions, professional fees and shared profits — vividly demonstrates how Washington works. Few people have gained so much benefit by causing so much harm.

One of Mr. Johnson’s most successful ploys was to ensure that Fannie Mae was regulated by the Office of Federal Housing Enterprise Oversight rather than the Treasury Department and to keep the OFHEO — located within the Department of Housing and Urban Development — weak and underfunded. This, write the authors, “allowed Fannie to shift the power of oversight to congressional subcommittees, run by members who could be easily swayed by the company’s lobbying efforts and campaign contributions.”

For years, Fannie Mae, joined by Freddie Mac, launched nuclear strikes against any individual or institution criticizing the two institutions’ increasingly risky activities. One of the heroines of the story is June O’Neill, head of the Congressional Budget Office, who refused to back down from a critical review of Fannie and Freddie.

The villains, alas, are far more numerous. The GSEs more easily made friends among Democrats, like Mr. Frank. But House Speaker Newt Gingrich and Missouri Republican Sen. Christopher Bond were two notable Republican allies.

Others to blame include Angelo Mozilo, head of Country-wide Financial, which wildly and dishonestly degraded lending standards, Goldman Sachs, which steered investors into the subprime market while reducing its own exposure, and rating agencies, which followed fees rather than facts to stamp triple A on securities filled with junk mortgages.

At least this depressing tale would have been redeemed by justice being done. But no. Tragically, “the cast of characters that helped create the mess continues to hold high positions or are holding jobs of even greater power,” note Ms. Morgenson and Mr. Rosner.

That’s bad enough. However, Reckless Endangerment ends on an even more pessimistic note. The authors write: “Will a debacle like the credit crisis of 2008 ever happen again? Most certainly, because Congress decided against fixing the problem of too-big-to-fail institutions when it had its chance.”

Those most deeply involved in nearly wrecking the American economy ended up writing “reform” legislation that did not even mention the two GSEs that did so much to spark the crisis. Such is the way of Washington.

Books often are called “must-read.” But Reckless Endangerment really is “must-read” for anyone who wants to understand the crash of 2008 and why more government-created economic crises are likely in the future.

Courtesy of the Cato Institute

The responsibility for the massive failures of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, at the center of American housing finance and the private securitization system that supports housing finance, falls directly on regulators and indirectly on their political overseers. Private and GSE prudential regulators were given politically determined social lending goals that ultimately trumped prudential regulation, forcing the GSEs to fund subprime lending in competition with private label securitizers. The result was the extension of lower and lower quality loans, creating a race-to-the-bottom between the GSEs and private mortgage providers, all while regulators and politicians looked on approvingly. The financial crisis resulted when many of those loans turned sour in the latter part of the last decade.

We find no evidence that the United States housing market has unique characteristics requiring a hybrid GSE system, thus we conclude that the system and the political risks it is subject to are unnecessary. Any U.S. housing finance policy that does not safeguard prudential regulation from political influence by separating housing subsidy from finance and eliminating government- induced distortions will result in another systemic failure. To re-privatize the GSEs while maintaining their political goals, or to create new, specially chartered enterprises that pursue those goals, would exacerbate systemic risk.

Courtesy of the Cato Institute

The most important driver of housing demand is income, which is driven by jobs. While the rest of the country suffers from an unemployment rate of around 9 percent, the Washington area has a rate of 5.4 percent. Wages are also about 9 percent higher in D.C. relative to the nation. Central to these numbers is the increase of government workers. Whereas the civilian U.S. labor force has been shrinking since 2008, government employment in D.C. has been growing. When government constitutes a fourth of your labor force, as it does in greater Washington, its actions become a driver of housing demand.

It is the interaction of demand and supply that determines prices. If D.C. were Houston, with little zoning, then despite the increase in government jobs, prices would likely be falling. Quite simply, with the exception of outer Virginia counties, it is quite difficult to bring new supply onto market in the D.C. area. Both Houston and D.C. have about 5 million residents, yet in 2010 over 27,000 housing permits were issued in Houston, compared with around 13,000 in the D.C. metro area. This is a trend that held even more so during the boom: in 2006, Houston issued three times the building permits as D.C.

While supply constraints can put a floor under prices, they come with a very real cost in affordability. The most recent median existing sales price for D.C. metro is close to $300,000, but only about $150,000 in Houston. This difference is not simply driven by income, as the D.C. metro median household income of $56,000 is only slightly above Houston’s $54,000. Wharton’s Residential Land Use Regulation Index shows Maryland, whose Prince George’s and Montgomery Countries constitute a large segment of the D.C. metro area, being one of the most highly regulated states in terms of land use. Virginia falls in the middle of the pack.

So while government has been both a stabilizer for D.C. in terms of housing demand and supply, its impact has come at considerable cost, much of which has been borne by those on the lower half of the income distribution.

Courtesy of the Cato Institute

The federal government’s largest housing construction program for the poor has squandered hundreds of millions of dollars on stalled or abandoned projects and routinely failed to crack down on derelict developers or the local housing agencies that funded them.

Nationwide, nearly 700 projects awarded $400 million have been idling for years, a Washington Post investigation found. Some have languished for a decade or longer even as much of the country struggles with record-high foreclosures and a dramatic loss of affordable housing.

The U.S. Department of Housing and Urban Development, which oversees the nation’s housing fund, has largely looked the other way: It does not track the pace of construction and often fails to spot defunct deals, instead trusting local agencies to police projects.

The result is a trail of failed developments in every corner of the country. Fields where apartment complexes were promised are empty and neglected. Houses that were supposed to be renovated are boarded up and crumbling, eyesores in decaying neighborhoods… .

The Post examined every major project currently funded under the HUD program, analyzing a database of 5,100 projects worth $3.2 billion, studying more than 600 satellite images and collecting information from 165 housing agencies nationwide.

The yearlong investigation uncovered a dysfunctional system that delivers billions of dollars to local housing agencies with few rules, safeguards or even a reliable way to track projects. The lapses have led to widespread misspending and delays in a two-decade-old program meant to deliver decent housing to the working poor.

The Post found breakdowns at every level.

And so on for three full pages.

It was reminiscent of another Sunday story two months ago that I wrote about under the title “A Routine, Run-of-the-Mill Half-Billion-Dollar Corruption Story.” The Post teased that one as “A D.C. lawyer and her associates secured $500 million in federal contracts to benefit Alaska native corporations. Less than one percent made it back to Alaska,” and reporter Robert O’Harrow Jr. found:

For years as a lawyer in Washington, Paralee White had helped small and disadvantaged firms break into the federal contracting market.

Then she decided to help herself.

She started a business and was soon making more than $500,000 a year through a contracting program intended to help poor Alaska natives, even though she isn’t an Alaska native.

White also helped her family. She hired her sister and brother, paying them as much as $280,000 a year. She helped her sister’s boyfriend set up his own firm in partnership with Alaska natives. He made more than $500,000 a year.

White’s story offers a look at how Washington insiders can make fortunes from government programs intended to benefit small, disadvantaged and minority entrepreneurs. It also illustrates how government officials who are supposed to keep tabs on these programs often fail to do so.

Outrage ensued, right? Angry editorials, congressional hearings? Not much, even though it was hardly the first time that the problems with the Alaska Native Corporations program had been noted. There was a Senate hearing, with the reassuring title of “Promise Fulfilled: The Role of the SBA 8(a) Program in Enhancing Economic Development in Indian Country,” where “Alaska Natives and a Small Business Administration official defended federal contracting preferences for Indian and Native firms.” No critics were invited to the hearing. After all, “The purpose of the hearing is to allow the SBA, ANCS, NHOs, Indian tribes, shareholders and other stakeholders the opportunity to demonstrate the importance and legitimacy of the program to Native communities in fulfilling self-determination and self-sufficiency,” as 49-year senator Daniel Inouye (D-HI) and Alaska’s own Sen. Mark Begich wrote in a letter to whippersnapper senator Daniel Akaka (D-HI), who has served in Congress for only 34 of his 86 years and chairs the Senate Indian Affairs Committee.

Meanwhile, there were a couple of other intriguing points in Sunday’s Post. In a column on “four days of hearings about the hiring scandals hobbling D.C. Mayor Vincent C. Gray,” Robert McCartney wrote:

The main thing learned in the hearings so far is that Gray showed bad judgment in allowing the Sorority to guide so much of the hiring for patronage jobs just below the cabinet rank. Although all three advisers were longtime personnel executives, they blundered repeatedly by overpaying people, doing inadequate vetting and hiring children of officials (including those of Green and Hall).

With Green’s testimony Friday, all three have now appeared before Cheh’s committee investigating the scandal. The results have been distasteful for anyone who’d like public servants to be straight forward and transparent, especially when speaking under oath.

And an article on Amtrak’s annual billion-dollar deficits included this gem:

Critics in Congress also have questioned Amtrak’s management, asking, for example, how an employee with a $21,000 salary earned $149,000 in overtime last fiscal year.

Newspapers are full of stories about serious men and clowns running for president, about who’s up and who’s down in political maneuvering, about Charlie Sheen and Lindsay Lohan. All fine topics indeed. But if journalists spent even 10 percent of their time digging into how the federal government is spending $3,600,000,000,000 this year, who knows how many stories of waste and deadweight loss we’d find? Of course, the newspapers would probably go out of business, because such stories are expensive to do and they don’t bring in the eyeballs like horse-race and celebrity stories.

I generally don’t think that “waste, fraud, and abuse” is the key to cutting federal spending; you have to go after the big programs, like transfer payments and military spending. But as Everett Dirksen almost said, $500 million here, $500 million there, pretty soon you’re talking real money. And there are reasons that government programs are often characterized by waste, fraud, and abuse. Politicians tend to respond to interest groups who stand to receive benefits from any particular program rather than to the average citizen who will pay very little for each program. Policymakers have less incentive to control costs and improve efficiency than do people in the private sector with their own money (or their boss’s money) at risk. As government gets bigger, it becomes less and less possible to have meaningful oversight and transparency — though we can hope that new technologies may help somewhat on the transparency side.

And for those who like big government, I have to say: This is the business you have chosen. If you want the federal government to tax (and borrow) and transfer $3.6 trillion a year, if you want it to build housing for the poor and give special benefits to Alaska Natives, if you want it to supply Americans with health care and school lunches and retirement security and local bike paths, then you have to accept that such programs come with incentive problems, politicization, corruption, and waste. Maybe it’s worth the cost.

Courtesy of the Cato Institute

While the American taxpayer will be required to fund a bailout of the two companies that will be measured in the hundreds of billions of dollars, the current state of affairs presents an opportunity to reform the two companies and the manner in which the residential mortgage market is structured. Few scholars, however, have provided a framework in which to conceptualize the possibilities for reform.

This analysis employs regulatory theory to construct such a framework. A critical insight of this body of literature is that regulatory privilege should be presumed to be inconsistent with a competitive market, unless proven otherwise. The federal government’s special treatment of Fannie and Freddie is an extraordinary regulatory privilege in terms of its absolute value, its impact on its competitors, and its cost to the federal government. Regulatory theory thereby clarifies how Fannie and Freddie have relied upon their hybrid public/private structure to obtain and protect economic rents at the expense of taxpayers as well as Fannie and Freddie’s competitors.

Once analyzed in the context of regulatory theory, Fannie and Freddie’s future seems clear. They should be privatized so that they can compete on an even playing field with other financial institutions, and their public functions should be assumed by pure government actors. While this is a radical solution and one that would have been considered politically naive until the recent credit crisis, it is now a serious option that should garner additional attention once its rationale is set forth.

Courtesy of the Cato Institute