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Monday, September 22, 2008

It Wasn't Fannie and Freddie

It's time to run this again, and add a bit more to it:

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. ...

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%.

Hamilton1

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...? I'm not sure...

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.

 Paul Krugman, also from the previous post:

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:

INSERT DESCRIPTION
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. ...

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 old post Jim Hamilton references above. Note the spike in asset backed securities at the end that matches the decline in lending from GSEs:

Hamilton2

Richard Green says the unique hybrid nature of Fannie and Freddie - which gives it the implicit guarantee - isn't the problem:

Could we please stop saying that it was the hybrid feature of Fannie/Freddie that caused them to fail? I think we have enough failures across enough different types of financial institutions (Investment Banks, Commercial Banks, Thrifts,Insurance Companies and GSEs), and sufficiently (ahem) large rescue packages for them that we can say that the US financial system has very few purely private financial institutions (sorry Lehman Brothers).

But I want to go back to Krugman's point because it has been overlooked in this debate. If, as the data suggest, "Fannie/Freddie were taking the place of the savings and loans, after the crisis of the 1980s," then there was no change in the level of socialized risk. Since S&Ls also have a guarantee from the government, all that happened is that loans moved from one guarantee under S&Ls to another guarantee under Fannie and Freddie. So this could not have substantially changed the degree to which markets were distorted.

Let me add one more piece that may not be widely recognized. Brad Setser notes that since 2000, much of the new debt guaranteed by Fannie and Freddie has been absorbed by foreign central banks, leaving private citizens in the US with a riskier pool of assets:

Were the Agencies responsible for the current crisis?, Brad Setser: The role of the Agencies in the current crisis is something that has come up in the Presidential campaign. It is also something that can be assessed using real data — including the recent Flow of Funds data produced by the Fed.

I would argue that this data suggests a more complex story than is commonly told. The Agencies certainly played a role in turning US mortgages into an asset that credit risk adverse central bank were willing to hold: the availability of Agency bonds with an implicit government guarantee interacted with the acceleration of global reserve growth to help make too much credit available to American households.

At the same time, it wasn’t just a story of a market hopelessly distorted by the Agencies’ implicit guarantee. The Agencies implicit guarantee isn’t exactly a new development. Moreover, at the peak of the lending boom, regulatory restrictions kept the Agencies from growing their books rapidly. The big surge in risky, exotic mortgages was made possible by a surge in demand for so called “private” MBS — that is to say mortgage backed securities that did not have an Agency guarantee. ... Central bank demand for Agencies freed up private funds to invest in riskier assets rather than directly financing the most risky mortgages...

Agency lending has been absolutely essential to avoiding an outright recession over the past few quarters. A surge in Agency issuance has offset a total collapse in “private” MBS issuance. Without the Agencies, US households probably wouldn’t have had any access to credit over the past year. The US government actually started to intervene heavily in the market last fall, when it reduced limits on the growth of the Agencies to keep credit flowing. It isn’t an accident that the Agencies provided $1.1 trillion in new credit to the US last year, while ABS issuance fell from $900b a year to less than zero. ...

The overall result was that central banks took on dollar risk..., while private investors took on the credit risk associated with the housing boom. In hindsight, that looks to have been a bad trade on the part of private investors. Central banks have taken currency losses (though those are mitigated the more Asia sells off). But those losses are a lot smaller than the losses US banks (and European banks that borrowed in dollars to buy dollar-denominated MBS — i.e. institutions like UBS) took on their mortgage book. ...

Agencies remain modest relative to the total outstanding stock of Agencies. Central bank holdings of Agencies only surpassed US commercial bank holdings of Agencies in q2 2008... So why have I emphasized central bank demand for Agencies?

To start, central bank demand absorbed a significant share of the incremental growth in Agency bonds outstanding since 2000. If you believe flows matter — and I do — central banks have been big players...

But this effect - the concentration of risk in the US as the guaranteed assets issued by Fannie and Freddie went primarily to foreign central banks - is a consequence of our need to borrow from foreigners to finance our budget and trade deficits. Without those deficits, more of the safe assets stay home and the overall pool isn't as risky. So to the extent that this concentration of risk is a factor in causing the problems (and I don't know how important it was), it was caused by trade and budget deficits, not the actions of Fannie and Freddie.

So, overall, perhaps the implicit asset guarantee did distort markets, but those distortions did not start with Fannie and Freddie, and they did not substantially worsen when Fannie and Freddie took over where the S&Ls left off. And even if there was some distortion, it's hard to find any linkage between the onset of the financial crisis and changes in the net socialization of risk through Fannie and Freddie. There was, apparently, some concentration of risk due to central banks buying the safe assets and leaving the riskier ones behind, but even so, it's not clear to me that this was a primary factor in bringing about the crisis. And even if it is the cause, or part of it, the behavior of central banks was not driven by changes in the behavior of Fannie and Freddie.

    Posted by on Monday, September 22, 2008 at 04:32 PM in Economics, Financial System, Housing | Permalink  TrackBack (1)  Comments (15)

          

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