James d. Gwartney

The Aral Sea Over Time
Misdirection of investment and failure to keep up with dynamic change eventually led
to the demise of socialism in most of these countries.
Video:
The Global Village
Recent U.S. experience with government allocation of credit for housing finance also
provides insight into how political allocation of capital works. The Federal National Mortgage
Association and Federal Home Loan Mortgage Corporation, commonly known as Fannie Mae
and Freddie Mac, were chartered by Congress as government-sponsored corporations in 1968
and 1970, respectively. It was thought that they would improve the operation of the capital

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market and make home financing more affordable. Even though Fannie Mae and Freddie Mac
were privately owned businesses, investors perceived that the bonds they issued to raise their
funds were less risky because they were backed by the government. As a result, Fannie Mae
and Freddie Mac were able to borrow funds at approximately half of a percentage point
cheaper than private firms. This gave them a huge advantage over their rivals and they were
highly profitable for many years.
But the government sponsorship also made Fannie Mae and Freddie Mac highly
political. The president appointed several members to their boards of directors. Top
management of Fannie Mae and Freddie Mac provided key congressional leaders with large
political contributions. They also often hired away congressional staffers into high paying jobs,
who then lobbied their former government bosses. Their lobbying activities were legendary.
Between 1998 and 2008, Fannie Mae spent $79.5 million and Freddie Mac spent $94.9 million
lobbying Congress for special favors and continuation of their privileged status.
(32)
Fannie Mae and Freddie Mac did not originate mortgages
(?)
; that is, they did not
directly lend money to people buying houses. Instead, they purchased the mortgages in the
secondary market, a market where mortgages originated by banks and other lenders are
purchased. Because they had cheaper access to funds, they could purchase lots of mortgages
and by the mid-1990s, these two government-sponsored enterprises held approximately 40
percent of all home mortgages. Their dominance of the secondary market was even greater.
During the decade prior to their insolvency
(?)
in 2008, Fannie Mae and Freddie Mac purchased
more than 80 percent of the mortgages sold by banks and other mortgage originators.
While Fannie Mae and Freddie Mac lobbied for and received favors from Congress,
members of Congress used them to achieve political objectives, including making mortgage
funds for housing purchases more readily available to low and middle-income borrowers.
Responding to earlier congressional directives, the Department of Housing and Urban
Development mandated that, by 1996, 40 percent of the mortgages financed by Fannie Mae
and Freddie Mac must go to households with incomes below the median. This figure was
increased to 50 percent by 2000 and to 56 percent by 2008. In order to meet these mandates,
Fannie Mae and Freddie Mac began accepting more mortgages with little or no down
payment
(?)
. They also substantially increased the share of mortgages granted to borrowers

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with a poor credit history, known as subprime borrowers. Because of their dominance of the
secondary market, their lending practices exerted a huge impact on the lending standards
accepted by mortgage originators. Recognizing that riskier loans could be passed on to Fannie
Mae and Freddie Mac, the originators had less incentive to scrutinize the credit worthiness of
borrowers or worry much about their ability to repay the funds. After all, sale of the mortgage
to Fannie Mae and Freddie Mac would transfer the risk to them as well.
As Exhibit 6 shows, subprime mortgages (including those extended with incomplete
documentation) soared from 4.5 percent of the new mortgages in 1994 to 13.2 percent in 2000
and to 33.6 percent of the total share of mortgage originations by 2006. During the same time
frame, conventional loans, for which borrowers are required to make at least a 20 percent
down payment, fell from two-thirds of the total to only one-third. The default and foreclosure