Ethics Newsline®

Fannie Mae, Freddie Mac, and Locust Ethics

Jul 14th, 2008 • Posted in: Commentary

by Rushworth M. Kidder

Admittedly, it’s a complex story. Last week’s plunge in the market values of Fannie Mae and Freddie Mac, the two institutions guaranteeing home mortgages in the United States, now will be used as evidence for any number of arguments. Should there be tighter regulation of the mortgage business? Were the rating agencies largely to blame? Were there too many dangerous innovations such as collateralized debt obligations? Would lobbying reforms have prevented the favored treatment granted these quasi-governmental giants? Most important, should Congress now use public funds to save Fannie and Freddie, or are these two behemoths, as London’s Financial Times opined over the weekend, nothing but “socialist turkeys coming home to roost in the U.S., home of free-market capitalism”?

Good questions, all, and worthy of expert debate. But unless we also see this debacle as a fundamentally ethical issue, we won’t extract its most useful lessons. Simply put, what brought Fannie and Freddie to their knees were millions of little gray lies. These petty fudgings misstated potential homeowners’ levels of income and overlooked un-credit-worthy histories. They happened over a decade. They occurred during conversations between potential borrowers and some mortgage lenders. They were often well meaning, sometimes noble, and invariably part of a bullish trend. And while, like lone locusts in a plague, no single lie was particularly significant, taken together they darkened the entire financial sky.

Like locusts, too, these exaggerations aren’t very complicated beasts. In fact, their simplicity made them look innocuous, for three reasons:

They seemed morally justifiable. Home ownership, after all, long has been touted as an unmitigated good. The more homeowners, the better, especially in a rising market where a home is the largest asset for most families. To deny a family access to this investment vehicle seemed unfair, elitist, almost unpatriotic. Wasn’t there, in fact, a moral imperative for banks to engage in community lending rather than to practice old-style “redlining” of neighborhoods and denial of credit to deserving people?
They seemed financially reasonable. What if some lenders accepted their customers’ self-reported income levels at face value without confirmation? Wasn’t that a form of trust? What if, in conversation, lenders encouraged buyers to embellish what they reported they could earn in the coming months, thereby qualifying themselves for larger loans? Wasn’t that smart financial counsel? Who could fault lenders for explaining that inflation probably would raise their clients’ incomes in the future, while mortgage payments would hold steady? And who could deny that buyers were invariably grateful to learn they could afford to borrow more than they thought?
They seemed so inconsequential. Yes, these little lies would lead some families to slide into bankruptcy. But if most others did not, each default would be balanced by scores of well-performing loans. Wasn’t that, after all, the same model used so successfully by high-end venture capitalists and down-market credit-card vendors? Hadn’t they learned to thrive by taking risks and counting on a certain number of failures as the price of success?

In other words, the little tricks all seemed so reasonable — except that they hinged on a high tolerance for deception. Which is why, at bottom, regulation alone won’t set the mortgage market right. Unless the ethical mindset changes — unless lenders impose strict self-discipline on those in their fraternity who tolerate this pettifogging — the regulations will be either so incremental as to invite clever weaseling or so draconian as to stifle economic activity. And unless borrowers recognize that lying has real consequences, they won’t easily be regulated into higher ethical standards.

This won’t be easy. As a culture, we’ve long winked at little white lies on the grounds that they’re victimless crimes, isolated and harmless. But Fannie and Freddie may force us to rethink our winking. They remind us that when little white lies grow gray and concentrated, they turn black as a cloud of locusts, making us all victims as they devour everything in their path.