Shorts and Fannies: A Brief History

Americans who are not financial experts have been scratching their heads lately, trying to understand just what short-selling is and why it threatens banks, and what exactly Fannie Mae is, and how it might be dragging down a housing sector that it is supposed to help.

A brief history lesson is in order. Fannie Mae, (nee the Federal National Mortgage Association or FNMA) was once an irreproachable government agency -- its troubles began only after it was privatized and wise-guy executives started paying themselves multi-million dollar bonuses for taking excessive risks. And reformers have been trying to get rid of short-selling since before Franklin Delano Roosevelt.

This is a little technical, but stay with me. It's a good story.

For a year now, the Bush administration has been pursuing emergency regulatory interventions in practice that it does not accept in theory. Since mid-2007, the ad-hoc rescue operations conducted by Treasury Secretary Hank Paulson with the help of Federal Reserve Chairman Ben Bernanke have included:

  • An emergency takeover of Bear Stearns by JP Morgan Chase, at fire-sale prices, putting $30 billion of taxpayer money at risk.
  • Offering a general line of credit to large investment banks that previously enjoyed no special government guarantee or supervision.
  • Putting government capital at the disposal of Fannie Mae, leading to outcries from across the political spectrum.
  • Invited banks to exchange dubious paper for government-guaranteed Treasury bills, in order to recapitalize banks and move markets in risky securities that nobody else wanted to buy.

All of this was done under the Federal Reserve's emergency authority which was enacted during the Roosevelt administration. None of it had congressional authorization, nor did the Bush administration announce an explicit reversal of the general policy of financial deregulation. All the moves had the same, panicky, ad-hoc character.

In the last couple of weeks, a new and alarming element deepened the crisis -- runs on banks. This seems improbable, since depositors have nothing to fear because their money is insured by the Federal Deposit Insurance Corporation -- a core invention of the New Deal that was not repealed during the orgy of deregulation. But these runs were something new -- panicky flights by shareholders.

As details of the crisis unfolded, it became clear that bank balance sheets were seriously weakened. First of all, the balance sheets were full of dubious securities that suddenly nobody wanted to buy. These included not only sub-prime paper, but other exotic forms of securitized credit as well. It was this credit crunch that caused the Fed to pump so much emergency liquidity (money) into the banking system.

Second, much of the banks' fee and interest income had been based on underwriting or trading these very same securities. If this lucrative line of business suddenly was kaput, banks had trouble not only on their balance sheets, but with their earnings.

As these twin vulnerabilities became apparent and bank losses mounted, shareholders fled. Since early 2007, the broad stock market has lost about 20 percent. But the index of bank stocks has declined almost by half. Cleveland-based National City Bank's stock was down 90 percent. Washington Mutual fell 76 percent. The stock of the Swiss-based global giant UBS lost 70 percent.

One other factor deepened the crisis -- the proliferation and abuse of "short-selling." In selling a stock short, an investor who thinks a stock price is headed downward borrows the shares from a broker, delivers them to a purchaser, buys back the identical number of shares on the open market after the price has fallen, and then pockets the difference. This is how some investors make money in a falling market. The practice of short-selling doesn't do much damage in a normal market, but organized on a large scale it can turn a bear market into a full blown crash.

This summer, short sellers (many of them hedge funds) smelled blood in the financial waters. Many short sellers invented or passed along rumors that exaggerated the weak condition of several large banks. Executives of Bear Stearns blamed their demise on rumor mongers and short sellers. The venerable firm of Lehman Brothers seemed headed for insolvency, pulled down by short sellers' rumors that turned out to be untrue. The same psychology of short selling threatened Fannie Mae.

The legal status of such rumor-mongering is ambiguous. Short-selling is permissible, but deliberately manipulating markets is a felony. Deciding when passing along a juicy rumor becomes deliberate market manipulation is a Talmudic endeavor, and rarely clear-cut enough to win a conviction.

But last week, one of the most ideologically conservative Securities and Exchange Commissions ever did something startling. Faced with organized short-selling raids that were depressing the stocks of major financial institutions and threatening their very solvency, the SEC rushed out an emergency order on July 15, warning that it would be on the lookout for short-selling abuses against the shares of 19 flagship financial firms, and would vigorously go after violators.

The order expressly prohibited new short sales of shares unless the seller had already borrowed the stock, and the Commission explicitly warned about manipulative short-selling of the shares of such wounded giants as Lehman Brothers, Merrill Lynch, Citigroup, Fannie Mae, and Bank of America. SEC Chairman Christopher Cox, one of the most anti-regulation ideologues ever to chair the commission, boasted, "For the entirety of its 74-year history until 2008, the Commission has never brought an enforcement action of this kind."

For generations, conventional financial economists and their Wall Street allies have defended short-selling as helping to lubricate the efficient functioning of markets. Reformers have been trying to ban short-selling as harmful mischief since the late 1920s. Roosevelt recognized the hazards of short-selling, and sought to ban it outright. One of the many abuses of the 1920s had been market manipulation via short-selling, known as "bear raids."

The Securities Exchange Act of 1934, policing the conduct of stock exchanges and creating the Securities and Exchange Commission, was the object of fierce battles between progressives and conservatives in the Congress and the country. FDR's draft bill included a flat ban on short-selling, as well as other abuses that came back to haunt financial markets in the past two decades -- excessive leverage, conflicts of interest, and favored treatment of insiders. But by the time the Wall Street lobbies got finished with the bill -- enlisting small town bankers and national networks of retail stock brokers as their allies--all these teeth had been removed.

It is a mark of just how dire current conditions are that in 2008 a panicky and conservative SEC that doesn't much believe in regulation embraced an ad hoc remedy that eluded even Roosevelt. And the fact that Wall Street, at the nadir of its disgrace in 1933, still had the clout to block these reforms, suggests something of the residual power that an Obama administration would be up against.

As for Fannie Mae, it was invented, also by Roosevelt, as the Federal National Mortgage Administration. Before the Roosevelt era, virtually all mortgages were short term loans of five years or less, typically interest-only, with the principal due and payable at the end. If the homeowner could not roll over the loan, he lost the house. As foreclosures skyrocketed, the New Deal invented the modern, long-term, self-amortizing mortgage. The government insured such mortgages so that lenders would accept them, and devised FNMA to create a "secondary market" to purchase mortgages from lenders, turn them into government bonds and replenish the bank's money, so that the banker could make more loans.

In 1968, FNMA was privatized as Fannie Mae, mainly to get its large balance sheet off the government's books. It retained its social mission, and an implicit government guarantee. For a couple of decades, Fannie continued to be well behaved. But in the late 1970s other Wall Street firms decided they could imitate what Fannie was doing -- turning mortgages into bonds -- for big profits. Standards gradually declined, until they became the sub-prime mess.

Meanwhile, in the 1990s, the new executives at Fannie Mae decided that they, too, could get rich by gambling with exotic securities. Now Fannie, which is very thinly capitalized relative to its elephantine mortgage portfolio, is also in parlous shape, and many investors are fleeing its stock.

First moral of the story: Some things initiated by government -- like supporting affordable housing -- are better done by government. Second moral: Roosevelt got a lot of things right: the FDIC, FNMA, and trying to ban short-selling. Third moral: Don't offer government guarantees, and then let private speculators run wild. And that's how to cover our collective fannies.

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