Gary Krueger, economics, on the Wall Street crisis

By Hazel Schaeffer

Did the federal takeover of Fannie Mae and Freddie Mac on Sept. 7 come as a shock to you, or was it expected?It was expected . We had known, obviously, that they were in trouble for some time and in July, [Ben] Bernanke [Chairman of the Board of Governors of the Federal Reserve] and the Treasury Secretary [Henry Paulson] basically set the stage for what would be a bail out. They essentially primed Congress to back them when, and if, [the firms] were to go down. They just went down a little sooner than we thought.

Was the failure of Fannie Mae and Freddie Mac a result of or a reason for the mortgage crisis? It’s a result of [it]. Basically, the way I see the mortgage crisis, it was not just Fannie Mae and Freddie Mac. Everybody got invested in the expectation that real estate prices were going to go up, and every mortgage underwriter to some degree was invested in this notion that real estate prices are going to go up and that we can create this class of assets from mortgage-based securities, that we can do all sorts of new and interesting and riskless things with [the securities], and they did it. The federal underwriters were only half of the market, and I do no not think they were the perpetrators of a lot of this risky lending. Once the assumptions imbedded in the behavior were no longer true-that is, real estate showed that it could decline, then they were done for.

Do you think that placing both firms into federal control will help protect mortgage rates?Yeah, they did; it’s measurable. Interest rates fell half a point the day afterwards. I, in fact, started a refinance on my house the day afterwards. Yes, [the takeover will help turn the corner in the mortgage rate crisis]. Have we turned the corner? I don’t know. But they had to do it. It’s half a trillion dollars of wealth out there, something like half the size of the U.S. economy. To let them fail would be catastrophic. A lot of these assets are held by China. They hold the bonds of these guys, and so it would be global financial collapse if we had let them collapse. There’s no way [Paulson] could not do what he did.

Do you think the federal takeover should have happened prior to Sept. 7? I would not second guess Paulson and Bernanke in terms of their timing. They obviously did it for a reason. I guess they saw something that no one else had seen.

How did the two firms develop such a huge influence over the mortgage market, and do you think they had too much power? Fundamentally, you have insurance on one side, so [the firms] are sort of insured by government-an implicit government guarantee, and they are sort of unregulated on the other side. So they are a profit-making company, quasi-private, but they had a guarantee. Essentially, at one level they were the entire market. That sort of situation creates really bad incentives. If I guarantee your losses and then allow you to make profits that are essentially unregulated, then you are going to engage in very risky behavior. Partial deregulation does not work. You either privatize them and let them fail . or you do what they ended up doing, which is, essentially, they nationalized them. You cannot have it half and half.

In a Mac Weekly article last fall, you said that as bad as the economy was that year, “it will probably be slower next year.” How slow is it this year, and how will that affect job prospects for this year’s graduates? We are not sure how slow it is; the economic data are always lagged . We are always looking backwards. A lot of things are much slower, especially in different sectors-finance and real estate are dead. But on the other hand, the export sector and the economies [are not dead]. Agriculture is doing very well. So you see that in the data, the export data are pushing things along.

For our typical students in Economics, the finance sector being dead is bad. It is going to hurt their job prospects. For students going into some sort of manufacturing or export-oriented types of business, it could be better than we might think. The news reports are focusing on the bad, but underneath some of it, there is some good news. Exports grew even though the trade deficit widened last month. Because oil prices have increased so much, the trade deficit looked bad. The weak dollar is helping the export sector.

Anything else you would like to add? It’s an interesting time to take Economics [laughs]. Just look at the headlines today: “Crisis on Wall Street as Lehman Totters, Merrill Seeks Buyer.” You almost never see “The Wall Street Journal” looking like the “Star Tribune.” This is just unprecedented-it could be 1929. The trouble with this crisis is that we really do not know the extent of it. No one really knows how low real estate prices are going to go. We need to track [the securities] better, understand who holds them and what the risks are, and that we did not appreciate until now.

The other level that needs supervision-and the Federal Reserve seems to be taking this on-is tracking these securities. It used to be, when you bought a house and you had a mortgage, [the bank] held it for thirty years, then you paid it off in the last decade. The originators of the mortgage would then sell the mortgage right away to a consolidator, often [Fannie Mae and Freddie Mac]. They would bundle those mortgages and create an asset, a bond that you could trade . They were rated almost [as highly as] treasury bills, because it’s mortgages, it’s houses. People are always going to pay their mortgages, so therefore they are riskless. Well, [apparently only] until the houses fall in value. And the trading of these securities essentially became unregulated, and that was an unknown.

Presumably [the securities] and the loan origination part will be more strictly regulated. They were writing mortgages with no money down, no income verification-nothing. It’s crazy. There was so much froth; real estate is where everyone was just moving money. In a way, we are way over invested in real estate. For, say, the last fifteen, twenty years, we stopped saving because our wealth was going up in stocks and housing. People were using their houses as ATM machines, getting home equity loans, going to France, or whatever. Well, that is over now. We need to start saving again, actually [laughs].

This interview was conducted on Sept. 15