REVIEW & OUTLOOK

DECEMBER 1, 2009

Systemic Risk and Fannie Mae

The education of Joe Stiglitz and Peter Orszag

As Congress lumbers toward creating a systemic-risk regulator, it's worth a look back—to 2002, when an economist named Stiglitz and a duo named Orszag wrote a paper with the droll title, "Implications of the New Fannie Mae and Freddie Mac Risk-Based Capital Standard".

We won't keep you in suspense. The paper, written the year after Joseph Stiglitz won the Nobel Prize for economics, concludes that "on the basis of historical experience, the risk to the government from a potential default on GSE debt is effectively zero." Their analysis has recently been making the rounds on the Web to a chorus of chortles.

But the real lesson of the paper is not that Mr. Stiglitz, or Peter Orszag, the current White House budget director, and his brother Jonathan are dupes or rubes. The paper is notable because it represents the almost universally held view of the two government-sponsored mortgage giants at the time and for years afterward.

These pages began writing about the systemic risk posed by Fannie and Freddie at around the same time, but until the very end we were in the distinct minority. Fan and Fred's own regulator assured the world that they were well-capitalized almost until they were put into conservatorship in September 2008.

The Stiglitz-Orszag paper's method was to put the companies through "millions of potential future scenarios," and then to judge the likelihood of default. The assumptions in the test were said to be "severe." Even so, the probability of a default was found to be "so small that it is difficult to detect." Some $111 billion in taxpayer-funded bailouts later, with perhaps hundreds of billions to go, the risks have been detected.

To be fair, the Orszags and Mr. Stiglitz acknowledged that "the extremely rare events located in the tail of a distribution are often quite difficult to analyze accurately." Even so, they noted that White House budget gnomes had tested Fan and Fred's capital against "the financial and economic conditions of the Great Depression." The result: "[G]iven 1990 levels of capital, both Fannie Mae and Freddie Mac had sufficient capital to survive."

In reality, it took barely a year of financial distress for Fan and Fred to burn through their capital and wind up in taxpayer laps. Professor Stiglitz says of his paper today, "I'd like to think that if we'd done the same stress test in 2007 . . . we would have said, 'You ought to be worried.'" Taxpayers would like to think so too.

The crucial point is that assessing systemic risk is difficult to impossible—and the likelihood of coming to a reliable consensus about it is even lower. Both Orszags and Mr. Stiglitz were officials in the Clinton Administration and saw the debates about Fan and Fred that the Clinton Treasury began in the late 1990s, only to get clobbered by the companies' lobbying machine. Yet the three amigos still saw fit to put their names to a paper dismissing any risk of failure.

Why should anyone think that regulators—or economists—will predict the next systemic debacle any better? We only know better about the past. When the next problem erupts, as in 2002, smart people will be on both sides of the argument. And when large, systemically important companies are threatened with curbs on their business, they will pay Nobel laureates to write studies that explain away the dangers, and hire lobbyists to block any reform. A future Treasury secretary may also dismiss critics of a future Fannie Mae, or Goldman Sachs, as "ideologues," as Hank Paulson did in 2007-2008.

The very existence of a systemic risk regulator, or council of regulators, will assist the largest and riskiest firms by creating an illusion of stability in a world made less stable by the implicit guarantee that this regulator would convey. It would be an accident waiting to happen, and one made inevitable by the institution created to prevent it.

Look no further than the eminent Mr. Stiglitz or the brilliant Orszag brothers for how hard it is to detect systemic risk, much less to do anything about it.

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