The paradox of government guarantees, like those provided by Fannie Mae and Freddie Mac in housing, is that they encourage lenders to take on too much risk – knowing that the risk will fall to the taxpayer, not the lender – but in a crisis they limit risk, by reassuring lenders that the taxpayer stands behind the loan.
Robert Van Order, finance and economics professor at George Washington University, makes this point in The New York Times March 8. Van Order was chief economist at Freddie Mac from 1987 to 2002.
From the article:
The main alternative to banks is “private-label” securitization. Developed as a substitute for Fannie and Freddie, it promoted the riskiest mortgages (Fannie and Freddie have consistently had default rates less than half those of private label securities), and it was the source of the panic and subsequent credit crunch when there was a run on the shadow banking system that issued deposit-like instruments (e.g., repurchase agreements and commercial paper securitization) to fund private-label securities.
Neither Fannie and Freddie nor insured banks were sources of systemic risk because of their guarantees. That is the paradox of guarantees. They produce incentives to take on too much risk, as they did with Fannie and Freddie after 2004 and with the savings and loans in the 1980s, but they also limit systemic risk and panic. It’s hard to have one without the other.