Spongy Conduits

In 1995 Marvin Phaup, a Deputy Assistant Director in the Congressional Budget Office, wrote a damning report about the potential lethal risks to the U.S. economy in Government Sponsored Enterprises, specifically Fannie Mae and Freddie Mac, due to the combination of their being backed with the full faith and credit of the United States and legislation passed in 1992 during the Clinton administration that lowered their capital reserve requirements.  By lowering reserves well below any prudent guidelines required of other lenders, the onus fell on the taxpayer to pick up losses. 

The perceived security of U.S. government guarantees allowed Fannie Mae to make far riskier loans and attract investors to supply the money than otherwise would have been  possible.  The advantage generated savings and benefits to Fannie Mae of around $7 billion per year.  Mr. Phaup’s analysis of how these savings were (and weren’t) passed on to the lower and middle income borrowers inspired him to name these GSEs “spongy conduits” because of the billions that wound up in the pockets of investors and senior executives of the organizations, particularly James Johnson, the brilliant CEO of Fannie.  Over $2 billion of the annual benefit was absorbed into the organization, not passed along as lower costs to borrowers.

James Johnson, once a roommate of Bill Clinton’s at a Martha’s Vineyard strategy session in 1969 for the Eugene McCarthy campaign, was a skilled manipulator of regulators and legislators, a lightning fast and brutal negotiator.  He forged symbiotic relationships with key Democrats  like Barney Frank to keep the lens from focusing on what was going on behind the black curtain; Mr. Johnson personally made millions, placing him in the upper echelons of executive compensation.  His well funded marketing and lobbying organization sold the myth of Fannie Mae’s noble mission to put more Americans into homes.    Johnson spread a lot of money around to secure the support of politicians and advocacy organizations like ACORN.  He and Bill Clinton fashioned the National Partners in Homeownership in 1994, and we were set on the path that greatly damaged our economy 14 years later.

Fannie Mae cranked up its formidable lobbying and public relations machine at the first hint of a threat to the channel of taxpayer guaranteed money.  Mr. Phaup was maligned, even spreading rumors of mental illness, when he (and then CBO head, June O’Neill) couldn’t be intimidated into mitigating their report as many other skeptics had backed away during Johnson’s lucrative reign.  When unable to alter the report, Fannie leveraged its cronies in congress and the main stream media to suppress the report’s significance.

In 1999, it got worse. A “beaming” President Clinton signed into law the Gramm-Leach-Bliley legislation that finished off the 1933 Glass-Steagall Act, which had protected consumers and investors from fraudulent bankers for over six decades: the much criticized deregulation of banks and investment houses that blurred the lines and gutted the rules.  The bill was backed by financial luminaries like Alan Greenspan, longtime head of the Federal Reserve, and Lawrence Summers, then Treasury Secretary and later senior financial advisor to Barack Obama.  The Bush administration bought into the fairy tale of home ownership for those who couldn’t afford them and the train rolled on undeterred.

A blog post is too limited to explore the multiplicity of greed from homeowners to mortgage brokers to bankers to investors to politicians with the labyrinths of Credit Default Swaps and Collateralized Debt Obligations.   I suggest reading Gretchen Morgenson’s and Joshua Rosner’s “Reckless Endangerment” and Michael Lewis’ “The Big Short” for a much more comprehensive viewing.

The point of a synopsis of the roots of our ongoing problems is Mr. Phaup’s superb “spongy conduits” metaphor.  Big government and its unwieldy, huge bureaucracy full of self serving czars and drones are spongy conduits by their very nature.  The current occupant of the White House is a particularly wearying exemplar (see Norman Podhordetz’s WSJ  current editorial), but the truth remains: only limiting the money and power that government accrues and misuses can control the creature.

Canada saved its economy with severe austerity measures in the last decade by doing deep government cuts and layoffs.  Government jobs shrunk, entitlements dwindled and the unemployment rate, even with shedding many public jobs, dropped.  Now Canadian currency has rebounded from an almost 30% discount to the American dollar to parity and even a premium.  Texas is a domestic example of what a partnership between limited government and private business can achieve for economic growth and job creation.

It’s not that government makes plenty of mistakes (which it does) or even that it’s full of corruption and greed (which it is), the benchmark is the entity itself: its size and power.

George Washington wrote in a letter to General Phillip Schulyer during the earliest part of the war for American independence.
“We must do our best with Mankind as it is, not as we wish it to be.”