Shorts and Fannies: A Brief History

An explainer on Fannie Mae, short selling and government economic regulation.

Robert Kuttner | July 22, 2008


Americans who are not financial experts have been scratching their heads lately, trying to understand just what short-selling is and why it threatens banks; and what exactly Fannie Mae is, and how it might be dragging down a housing sector that it is supposed to help.

A brief history lesson is in order. Fannie Mae, (nee the Federal National Mortgage Association or FNMA) was once an irreproachable government agency -- its troubles began only after it was privatized and wise-guy executives started paying themselves multi-million dollar bonuses for taking excessive risks. And reformers have been trying to get rid of short-selling since before Franklin Delano Roosevelt.

This is a little technical, but stay with me. It's a good story.

For a year now, the Bush administration has been pursuing emergency regulatory interventions in practice that it does not accept in theory. Since mid-2007, the ad hoc rescue operations conducted by Treasury Secretary Hank Paulson with the help of Federal Reserve Chairman Ben Bernanke have included:

An emergency takeover of Bear Stearns by JP Morgan Chase, at fire-sale prices, putting $30 billion of taxpayer money at risk.
Offering a general line of credit to large investment banks that previously enjoyed no special government guarantee or supervision.
Putting government capital at the disposal of Fannie Mae, leading to outcries from across the political spectrum.
Invited banks to exchange dubious paper for government-guaranteed Treasury bills, in order to recapitalize banks and move markets in risky securities that nobody else wanted to buy.
All of this was done under the Federal Reserve's emergency authority which was enacted during the Roosevelt administration. None of it had congressional authorization, nor did the Bush administration announce an explicit reversal of the general policy of financial deregulation. All the moves had the same, panicky, ad hoc character.

In the last couple of weeks, a new and alarming element deepened the crisis -- runs on banks. This seems improbable, since depositors have nothing to fear because their money is insured by the Federal Deposit Insurance Corporation -- a core invention of the New Deal that was not repealed during the orgy of deregulation. But these runs were something new -- panicky flights by shareholders.

As details of the crisis unfolded, it became clear that bank balance sheets were seriously weakened. First of all, the balance sheets were full of dubious securities that suddenly nobody wanted to buy. These included not only subprime paper, but other exotic forms of securitized credit. It was this credit crunch that caused the Fed to pump so much emergency liquidity (money) into the banking system.

Second, much of the banks' fee and interest income had been based on underwriting or trading these very same securities. If this lucrative line of business suddenly was kaput, banks had trouble not only on their balance sheets, but with their earnings.

As these twin vulnerabilities became apparent and bank losses mounted, shareholders fled. Since early 2007, the broad stock market has lost about 20 percent. But the index of bank stocks has declined almost by half. Cleveland-based National City Bank's stock was down 90 percent. Washington Mutual fell 76 percent. The stock of the Swiss-based global giant UBS lost 70 percent.

One other factor deepened the crisis -- the proliferation and abuse of "short selling." In selling a stock short, an investor who thinks a stock price is headed downward borrows the shares from a broker, delivers them to a purchaser, buys back the identical number of shares on the open market after the price has fallen, and then pockets the difference. This is how some investors make money in a falling market. The practice of short selling doesn't do much damage in a normal market, but organized on a large scale it can turn a bear market into a full blown crash.

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