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December 5, 2007

Lawrence Summers: This Is Where Fannie and Freddie Step In

Larry Summers looks at three questions arising from the current financial crises, and in response to the third says it's time for Fannie Mae and Freddie Mac to step in and help solve the problems we are having in mortgage markets:

This is where Fannie and Freddie step in, by Lawrence Summers, Commentary, Financial Times (free): ...Financial crises differ in detail but, ... they follow a common arc.

First there is a period of overconfidence... Second, there is a surprise that leads investors to seek greater safety. In the current case it was the discovery of huge problems in the subprime sector and the resulting loss of confidence in the ratings agencies. Third, as investors rush for the exits, ... risk analysis shifts from fundamentals to investor behaviour. As some investors liquidate their assets, prices fall; others are in turn forced to liquidate, further driving prices down. The anticipation of cascading liquidations leads to more liquidations creating price movements that seemed inconceivable only a few weeks before. The reduced availability of credit then has a negative effect on the real economy. Eventually ... there is enough price adjustment that extraordinary fear gives way to ordinary greed and the process of repair begins.

Only time will tell where we are in this cycle. There have been some signs of returning normalcy over the past week, but we cannot judge whether they represent a false spring or the end of a crisis phase. ... The impact on consumer confidence and spending ... remains unknown.

While it is too soon to draw policy lessons, we can highlight questions the crisis points ... out.

First, this crisis has been propelled by a loss of confidence in ratings agencies... There is room for debate over whether the errors ... stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for their ratings and can shop for the highest rating. But there is no room for doubt that ... the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings? ... What, if any, legislative response is appropriate to address the ratings concerns?

Second, how should policymakers address crises centred on non-financial institutions? ... The problem this time is not that banks lack capital or cannot fund themselves. It is that the solvency of a range of non-banks is in question... Is it wise to push banks to become public financial utilities in times of crisis? Should there be more lending and/or regulation of the non-bank financial institutions?

Third, what is the role for public authorities in supporting the flow of credit to the housing sector? ... I am among the many with serious doubts about the wisdom of the government quasi-guarantees that supported the government-sponsored entities, Fannie Mae ... and Freddie Mac ... But surely if there is ever a moment when they should expand their activities it is now, when mortgage liquidity is drying up. No doubt, credit standards in the subprime market were too low for too long. Now, as borrowers face higher costs as their adjustable rate mortgages are reset, is not the time for the authorities to get religion and discourage the provision of credit.

This crisis could have a silver lining if it leads to the careful reflection on these vital questions.

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