"Did Fannie and Freddie Cause the Mortgage Crisis?"

Jim Hamilton argues that Fannie and Freddie are partly to blame for "causing the underlying problem we face today":

Did Fannie and Freddie cause the mortgage crisis?, by Jim Hamilton: Some thoughts about the role played by the GSEs in the run-up in mortgage debt and house prices.

Paul Krugman ably lays out the case for why it's conceivable that Fannie and Freddie could have made a contribution...

Fannie and Freddie had purchased $4.9 trillion of the mortgages outstanding as of the end of 2007, 70% of which the GSEs had packaged and sold to investors with a guarantee of payment, and the remainder of which Fannie and Freddie kept for their own portfolios. The fraction of outstanding home mortgage debt that was either held or guaranteed by the GSEs (known as their "total book of business") rose from 6% in 1971 to 51% in 2003. Book of business relative to annual GDP went from 1.6% to 33%.

Sum of retained mortgage portfolio and mortgage backed securities outstanding for Fannie and Freddie (from OFHEO 2008 Report to Congress) divided by (1) total 1- to 4-family home mortgage debt outstanding (from Census for 1971-2003 and FRB for 2004-2007) and (2) annual nominal GDP.

The fact that the volume of mortgages held outright or guaranteed by Fannie or Freddie grew so much faster than either total mortgages or GDP over this period would seem to establish a prima facie case that the enterprises contributed to the phenomenal growth of mortgage debt over this period. Krugman nevertheless concludes that the GSEs aren't responsible for our current mess. ...

For my part, I have two questions for those who take the position that the GSEs played no significant role in causing our current mortgage problems. First, what economic justification is there for the dramatic increase in the share of loans guaranteed or held by the GSEs between 1980 and 2003 that is seen in the first graph presented above? What sense did it make to increase the ratio of such loans to GDP by a factor of 12 over this period?

Second, what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

Is that the answer to the second question? I'm not sure. But if anybody has a better answer, I'd still like to hear it.

In the mean time, I very much agree with Krugman that the most egregious problems were not caused by anything Fannie or Freddie themselves did. But I disagree that their actions played no role in causing the underlying problem we face today.

Justin Fox has a nice summary of some of the main events in the 1980s and 1990s in terms of mortgage share:

Fannie Mae started life in 1938 as a government agency, the Federal National Mortgage Association, and was privatized in 1968. Congress created Freddie — the Federal Home Loan Mortgage Corp. — in 1970 to give it some competition. For years the two companies operated on the fringes of the mortgage market, which was dominated by savings & loan companies. But after the S&L collapse of the 1980s, Fannie and Freddie swept in to take over. The widespread assumption that government would step in if they faltered allowed them to borrow money at only slightly higher rates than the U.S. Treasury, which meant they could outbid all competitors in the secondary mortgage market. Before long 60% of all mortgages made in the U.S. were passing through their hands, and their share would have been even higher if they weren't banned from buying loans above a certain size ($417,000 in 2007) and generally required to stay away from exotic loans and borrowers with poor credit. For a time in the mid-1990s, before the wave of bank megamergers that brought us the likes of Citigroup and J.P. Morgan Chase, Fannie Mae was the biggest financial institution, by assets, in the country.

Fannie and Freddie did get lots of flak, mostly from people on the political right, for taking risks for which taxpayers might eventually have to foot the bill (and, from other quarters, for its top executives' outsized pay packages). Both companies also got tangled in accounting scandals in 2003 and 2004. But more shocking was what followed from 2004 through 2006: The two mortgage giants got muscled aside by Wall Street firms willing to underwrite bigger, riskier mortgages than Fannie and Freddie were allowed to touch. Their joint market share fell to only about 25% in 2006.

In other words, Fannie and Freddie were mostly bystanders to the worst excesses of the housing bubble. Since it popped, they and the more explicitly government-backed team of the Federal Housing Administration and Ginnie Mae (which buys FHA-insured loans) have been crucial to keeping the mortgage and housing markets going. In January, Congress raised Fannie's and Freddie's loan limit temporarily to as much as $729,750 to aid struggling high-priced housing markets on the coasts.

With house prices falling in most of the country, though, even the relatively safe loans acquired by Fannie and Freddie are starting to turn sour at much higher-than-expected rates.

Update: Paul Krugman:

Why Fannie and Freddie got so big, by Paul Krugman:...Jim Hamilton asks why Fannie and Freddie grew so much in the years before the surge in subprime lending. Justin Fox had already suggested that Fannie/Freddie were taking the place of the savings and loans, after the crisis of the 1980s. Well, if I’m reading this data (xls) right, that’s pretty much the whole story. This graph shows the share of savings institutions and “agency and government-sponsored enterprises-backed mortgage pools” in total mortgage holdings:

The big switch

Now here’s the thing: S&Ls are private, profit-making institutions whose debt (in the form of deposits) is guaranteed by the federal government. Fannie and Freddie are private, profit-making institutions whose debt is implicitly guaranteed by the federal government. It’s not clear to me that the switch shown here led to any net socialization of risk.

The S&L story, of course, ended in catastrophe, because deregulation led to an explosion of bad lending. That didn’t happen with Fannie and Freddie, at least not to anything like the same extent.

What did happen was an explosion of risky lending by other parties, which crowded out the GSEs; you can see that at the end of the figure (which runs up to 2006). So I stand by my view that Fannie and Freddie aren’t the big story in this crisis.

Here's another graph with a bit more detail from the post from last year Jim Hamilton references above. Note the spike in asset backed securities at the end that matches the decline in lending from GSEs:

Comments

[save_the_rustbelt]

This is like a stampede, which steer do you blame?

We just need to certain this is fixed so the cattle cannot run away again.

[kthomas]

Greenspan tops my list. Right after that, greedy people. General, I know, but it covers a lot of bases.

As for the Fanny bailout....just more socialized capitalism (socialized losses, really) from the so-called "free markets" crowd.

There;s nothing more ironic than a potzel like Paulson going before Congress and asking for more reulatory powers.

[Cynthia]

Justin Fox writes,

"But after the S&L collapse of the 1980s, Fannie and Freddie swipt in to take over."

But now it's anyone's guess as to WHAT will sweep in to take over Fannie and Freddie...

[James McCarthy]

As I said on Seeking Alpha:

The GSEs did not force the rating agencies to mis-rate risk, did not force mortgage bankers and investment bankers to originate garbage in return for huge bonuses, did not force securitizers to spin tales of structuring the risk out of investments, did not force fund managers to buy toxic waste that they little understood, did not force regulators to dismiss concerns with blind faith in the marketplace and distribution of risk. What the GSEs did was expose the taxpayers to this mess even as they avoided most of the sub-prime waste. Perhaps it would have been better if they were still government entities and the taxpayers were clearly on the hook. But to avoid charges of "socialism" we moved them into government sponsored SIVs and paid foreign investors a premium to help us pretend that the weren't really backed by the Treasury (but wink, wink don't worry).

[Ex-Worker]

Isn't the answer more obvious? Please criticize.

By subsidizing the "good" mortgages with the guarantee and financing cost of the US treasury, we freed up significant risk capital to chase all the dumb mortgages and related securities that wall street cooked up over the last 7 years.

[Barkley Rosser]

Paulson is very close to the Chinese. As Brad Setser has pointed out, they are sitting on a half trillion FM assets of various sorts. They bought them on the theory of that implicit guarantee. I have no doubt that they have been on the phone to both Paulson and Bernanke, and given the parlous foreign indebtedness situation of the US, those gentlemen have had to offer a respectful ear.

I do not see much point in trying to pin down to one person or entity the "blame" for the housing bubble. Too big and too broad for anyone, even Big Al or the FMs, even if they all contributed to it. So did many others.

[donna]

I blame "Greed is Good". As soon as the rich decided they needed WAY more money than everyone else, and poor people were poor because they deserved to be poor and not because they didn't have any money, it all went to heck.

The main reason I no longer believe in libertarian philosophy is because people are stupid greedy evil bastards who must be contained.

[ken melvin]

'Twas a catastrophe looking for a way to happen. Too many wanting to either get rich or retire rich and the only investment was housing. Strange this lot who want to buy everything cheap, including labor, and, all the while, have the value of their homes and that of the houses in which they have invested go ever up.

[don]

As Ex-Worker points out, the question is whether the GSEs added fuel to the fire. PK questions this, but I wonder if, absent the GSEs, so much foreign capital (especially from central bank currency interventions) would have found its way to the U.S. housing market. That is, just because GSEs replaced S&Ls does not mean the S&Ls would have been that much more prominent if there had never been GSEs, as PK seems to imply.

[hari]

"This is not just a subprime mortgage crisis; this is a crisis of an entire subprime financial system", says Roubini.

Freddie and Fannie are insolvent, he claims, and Treasury bailout plan is socialism for the rich, the well connected and Wall Street...profits are privatized and losses are socialized, he claims.

Securitization, slice and dice and transfer of toxic credit risk and piling fees upon fees rather than earning income from holding credit risk...this business model is bust, according to Roubini.

However, as I indicated in the links this morning, it seems Paulson is more worried about debt securities issued by F&F and held by Chinese/BoC and Japan (three megabanks) as of March 2008. I had no idea almost 3% of Japan's GDP or $150bn is exposed to US Treasury market (than agency market).

[Bruce Wilder]

str: "This is like a stampede, which steer do you blame?"

Outstanding metaphor. The obvious answer is, the guy, who opened the gate in the fence. But, most economists seem to have a lot of trouble acknowledging that there is a fence, let alone a gatekeeper. They are so busy imagining an ideal marketplace, that they forget to imagine the organization, public and private, that exists to structure the marketplace.

Obviously, when Fannie Mae was privatized and Freddie created, there were some ideas about how they would function. That kind of economic engineering goes on all the time, but there's no memory for it in the economics profession. When the S&L's were de-regulated in response to the massive dis-intermediation triggered by the Volcker Squeeze, it was pretty obvious what would happen. But, economics don't think about policy having consequences, until after the consequences are realized; then, there were plenty of people to explain about how the Federal guarantee of deposits interacted with laissez faire to create a monster -- oh so helpful after-the-disaster analysis. But, ask about the implications for the distribution of income and wealth, and the event is completely forgotten; gov't policy does affect income distribution much, except tax policy affect after-tax income maybe, plus social security and the minimum wage.

Krugman has written a book about the implictions of 35 years of Republican parasitism on the New Deal, and it still seems like each new denouement is something he's learning about for the first time.

[hari]

Recall, Mark Thoma, said Roubini was the first to forecast the subprime credit crunch before last Aug.

I'm afraid Paul may have to eat his words on F&F and current market retrenchment....the unfolding story is already seriously affecting EU markets in Spain, Italy, UK and Portugal.

[Winslow R.]

"Krugman has written a book about the implictions of 35 years of Republican parasitism on the New Deal, and it still seems like each new denouement is something he's learning about for the first time. "

Krugman must be acting the teacher. The analysis and proposed solutions is coming sooooo slow.

I'd take from this 'lesson' that

1) socialized/privatized lending caused less misallocation than privatized lending.

2) privatized lending can lead to collapse as in S&L crisis.

I'd like to see Krugman suggest gains should be socialized and losses privatized. How? Socialize access to the lender of last resort while making those who borrow responsible for losses.

Turn the current model on its head.

[Bruce Wilder]

Barkley Rosser: "I do not see much point in trying to pin down to one person or entity the "blame" for the housing bubble."

With respect (and I mean it, Barkley's contributions here are terrific), this an illustration of the attitude I complain of, above.

This is not the economic equivalent of a natural disaster. There is no economic equivalent of natural disaster. The economy is all artifactual; this is an engineered disaster, the consequence of policy.

I would readily acknowledge that it is a policy shaped over time by large-scale political/social movements, which apply pressure over long periods of time, and are imperfectly resisted by other political/social movements. That's the reality of political economy. But, the reality of political economy should not be an excuse to fail to do the analysis, to fail to point fingers at the policy desiderata of the conservative movement (or, the facilitating corruption and impotence of the dwindling cadre of New Deal Democrats). Politics is about choice and consequences; choices were made, and there were consequences.

Economics ought to be able to do the analysis to draw a reasonably plausible line, connecting policy choices and policy consequences, and between intention and result.

And, don't even start with the idea that no one wanted or intended these consequences. (That's like saying no wants a war, wars are so terrible. I only wish humanity was so pure.) Some reactionay conservatives are genuinely stupid -- I'll give you that; but others are awfully rich, for seeming more stupid than it is possible for a functioning human being to be. And, too many progressive politicians use pragmatism as an excuse to collect a few bucks.

There are huge transfers of income and wealth accomplished by the changes in banking policy taken as a whole. There were a lot of years, while Fannie & Freddie were growing, and the structure of mortgage securitization was being built up, that the banks were making money furiously, and bank failures dwindled to nothingness (which is just not possible in a fair, realistic and competitive banking market).

Fannie & Freddie were seduced, not just in replacing the S&L's, but in underwriting the growth of the giant mortgage aggregators, like Countrywide and WaMu -- underwriting what were borderline criminal enterprises, to not mince words. There was a time, when Fannie & Freddie existed to facilitate small local and regional banks -- the Podunk Nationals and Mainstreet State banks -- in local lending. They were run as a patronage mill for the Democratic Party by ex-New Dealers, who were out to do well by doing good. States could regulate the business practices of Podunk and Mainstreet, because they had to be local. But, all those rules got thrown out, and the world made safe and ruleless for the likes of Angelo Mozilo. And, the old New Dealers passed away and their successors got rich, rich, rich. But, hey, Barkley doesn't want to point the finger of blame. (Sorry, Barkley, but this attitude demands a modicum of ridicule; don't hate me for saying what must be said.)

We really, really need to encompass the implications institutional design, and the economic history, into our policy and political thinking. And, that means being less naive. And, it means pointing the finger of blame enthusiastically.

[hari]

Once again, the dismal science of economics and its implications to political decision-making is raising its ugly hair. And, for those of us past our productive life after more than thirty years of institutional service and whatnot, we know bloody well how difficult it is to make decisions which affect across national sovereignties and, in our globalized world today, gettings even more aggresively institutionalized because of economic and other disparity between nations.

Bruce is ranting, as usual, but there is a lot a substance and common sense as to what political economy is all about. I know what he is talking about which libertarians - not very long ago - didn't even acknowledge in their serious analysis and/or reporting system.

America and its subsequent deregulation of the banking sector, in particular, opened a can of warms which was ok for a few decades, but it's now coming home to disfigure the same old folks who pushed it not only on *boarderless* global financial markets but eventually Globalization itself under WTO regime.

[hari]

spelling - *worms* not warms pls!

[roger]

I blame Thomas Friedman - or, rather, a cause Friedman championed. In the Lexus and the Olive Tree, that primer of neo-liberalism, Friedman devotes much time to how economic policy has been de-politicized. As always, Friedman's language conceals the truth it is trying to tell - economic policy has been taken out of the hands of democratic politics, and left in the hands of an inside-dealing elite. In 1969, how many people knew or cared about the Fed? That was as it should be. The Fed should be only one aspect of state economic policy. But the consensus of the 90s was that the people just got in the way, misunderstanding the things that were good for them, like free trade. Thus, put decision-making in the hands of bureaucrats that the congress and president can then point to as the ultimate decisionmakers - as though our political bodies didn't tie their own hands before our very eyes. All to keep economic policy "non-partisan", ie dominated by an overgrown financial sector as it hadn't been since the 1890s. Back then, muckrackers called it corruption. Now, newspapers call it responsible economic policy, maturity, or putting on the "golden straightjacket" - another Friedmanism.

The idea that an oligarchy consisting of the wealthy and economists cherry picked to benefit the wealthy should quietly determine our economic policy gets us the economic policy we have had: de-industrialization, free trade policies that actually destroy complex path dependent technostructures (it should be called, trading the residual), a laughable tax policy that "rewards" the successful by make the reward a game of Veblen like predatory prestige, etc.

[Winslow R.]

Why structure the financial sector so the Fed must beat it to a pulp in order to slow the general economy?

[Winslow R.]

Why must the Fed give enormous gains to the financial sector in order to lend to the general economy?

[save_the_rustbelt]

Anyone surprised by this news flash?

"The FBI has launched an investigation into possible fraud at
now-defunct IndyMac bank corporation, CNN confirms."

[Bruce Wilder]

hari: "Bruce is ranting, as usual . . ."

Ranting is its own reward.

[Movie Guy]

How does anyone gloss over these facts as among the principal contributing causes of the financial meltdown:

The Long Demise of Glass-Steagall, 1933-1999
Frontline, PBS

1913-2008
Where Credit Is Due: A Timeline of the Mortgage Crisis
By Nomi Prins
July/August 2008 Issue, Mother Jones

Foreclosure Phil
by David Corn
May 28, 2008, Mother Jones

Fannie Mae and Freddie Mac probably wouldn't have been in any trouble had the existing Federal laws and supporting regulations governing operations elsewhere in the financial markets been in place. Instead, they were gutted and new oversight over other financial instruments was avoided at all costs.

This is a no brainer. Bolt the wheel back in place.

[BJ Feng]

Freddie and Fannie were around during Democratic administrations too, where is the finger-pointing? There were many calls during the late 90's to make Freddie and Fannie hold more capital as reserve, but Franklin Raines, the former CEO, was a Democratic favorite and close enough to Dems that he was in line for a government post had Gore won. Democrats refused to impose greater capital requirements, if you are going to blame regulators, you have to blame everyone.

With respect to the overall housing crisis, once again the whiners here are treating the situation as if it had never happened before in the history of the world. Boom and busts are part of the economic cycle and have been since the beginning of capitalism. What is clear is that no method has been found to eliminate or prevent booms and busts from happening. Today, our booms and busts are actually much more muted and less frequent than in the past. A crisis in the 19th century would have meant GDP falling by 5% or more, sometimes 10-20%! We haven't even experienced a decline in GDP yet!

Due to the nature of fractional reserve banking, we will get credit expansions and credit collapses periodically. The market doesn't guarantee an optimal outcome! In fact, a large part of the market's self-correcting mechanism comes from the pain and fear that loses inflict. Without loses or fear, there would be no reason for investors/speculators to step back, and no incentive to stop excessive risk-taking.

I have yet to see any evidence that government can do better. In fact, the evidence shows that government usually does worse. State run economies also have bad loans and credit crises. China only recently cleaned up their billions of bad bank loans, so that former State banks could be privatized through IPOs. State run banks are notorious for making stupid loans, based on either bribes, or ideology. But since they are government owned, the State simply bails them out again and again. Comparatively, it is rare for a private bank to be bailed out in more market oriented systems.

Regulations cannot stop people from being stupid or from taking risk. Risk means the possibility of a bad result, and only the pain that comes from a bad result can discipline and stop people from acting unwisely.

If we didn't have this crisis, there would be complaints about rising home prices and how the poor are unable to afford them. Now that prices have come down, there are complaints that homeowners are losing money. Incredible the whining and complaining, constant and unending, no matter the situation. It's easy to call for more regulation, but in what form is that regulation to take? What are the unintended consequences? The details of any regulation are the most important, yet nothing but more whining and an unreasonable belief that government can better manage loans when the evidence in China and the former Soviet Union clearly shows otherwise.

[Movie Guy]

BJ Feng,

You appear to not be familiar with the banking laws that were gutted. Otherwise, your remarks indicate a considerable lapse in memory or judgment.

[anne]

"There were many calls during the late 90's to make Freddie and Fannie hold more capital as reserve...."

Reference this, though I find no problems with the extent of reserves carried. The only complaints I know of about Fannie Mae and Freddie Mac during the 1990s were from Republicans who wanted to limited them severely for the sake of competing mortgage banks which were wildly more lax in lending. Fannie and Freddie were not a problem.

[merkury]

"In other words, Fannie and Freddie were mostly bystanders to the worst excesses of the housing bubble. "

It's a moot point because foreclosures are happening in prime mortgages as well. It's really the risk they took by being over levered 60 to 1. That's what's really causing all this angst.

[Michael McKinlay]

Of course Fannie and Freddie aren't responsible for the mortgage crisis.

What economists and those that know won't say is who is because they are intimidated ... by the Federal Reserve!

We all know the real culprit, at least 90% of it, was caused by the privately owned and operated Federal Reserve. It was the Federal Reserve that chose not to police or regulate the financial sector so that their owners, the private banks with their investment, insurance and brokerage arms could conjure up exotic instruments that had no economic value but would boost their bottom lines. We also know that the Fed held interest rates too low for too long to give financial institutions a wider spread and help Bush get reelected.

Everybody knows the Federal Reserve is the culprit, EVERYBODY, yet we do this dance around the truth.

[gordon]

It was only a few months ago that the major theme of economic comment on the subprime crisis was the need to protect the "real economy" from its effects. I note the virtual disappearance of that theme from current commentary, in favour of expedients for maintaining the existing institutional and regulatory structures. I find this very worrying, because at the same time there appears to be a consensus that the existing strucures are not viable.

[gordon]

M.McKinlay might be interested in this post from Jesse's Cafe Americain, which broadens the blame beyond the Federal Reserve to economists in general. A good, old-fashioned rant which (noting my previous comment) I would have modified to include a complaint about finance-speak taking over from economics-speak. We need economists to stay focussed on the economy, not get distracted and lost in a maze of financial manipulations. Economists should stay with the real economy.

[BJ Feng]

I will agree with Michael in that the FED should get the majority of blame if any. I don't think the FED had the authority to regulate Fannie and Freddie, thus the recent hearings to give that power, but they were responsible for the loose monetary conditions that fueled the housing bubble. For a time, mortgages below 5% were available! That's because the FED Funds rate was 1% for quite a time, and it took years for the FED to gradually raise FED Funds above inflation. When you have negative real rates, there is a great incentive to borrow. I remember when money market rates were at 0.6%, it was impossible for anyone with savings to keep up with inflation without taking risk.

I don't know how the FED has managed to avoid more criticism, but it's a symptom of the current mentality where no pain is allowed and the government must accommodate every cough and ache least we feel the slightest discomfort. We have historically low unemployment and mortgage rates, yet somehow Americans are suffering with the huge burden of a 5.5% mortgage. Never mind that mortgages were routinely 8% in the 80's, no, 5.5% is still too high. And since there are foreclosures now, speculators and foolish home buyers alike have to be helped lest they feel some loss. This surely will teach them not to overextend and buy a home they can't afford. Humm, maybe the whiners should also receive a share of the blame?

And to Movie Guy, which regulation that was gutted could have stopped the housing bubble? Which regulation makes people keep their money in a 0.6% money market fund or CD paying 1.5% instead of buying a home they've wanted, financed at a nearly zero real rate? You're right, I must of forgotten about it.

[Movie Guy]

BJ Feng - "And to Movie Guy, which regulation that was gutted could have stopped the housing bubble? Which regulation makes people keep their money in a 0.6% money market fund or CD paying 1.5% instead of buying a home they've wanted, financed at a nearly zero real rate? You're right, I must of forgotten about it."

Work on your reading skills.

This is what I said: "Movie Guy says...
BJ Feng,

You appear to not be familiar with the banking laws that were gutted. Otherwise, your remarks indicate a considerable lapse in memory or judgment."

All you need to do is read the timeline identified in the link that I posted above. The information is there. And there is more.

...

[VA Refinance]

Give them some of the blame! but we can certainly spread the wealth of blame to many others.