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%.

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:

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:

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.

Comments

[paine]

once again its shown
jim hamilton
is an easy third round knock out

i'm glad he's fightin' for ...the other side

oh if only milty and mank
had such easily reached glass jaws

[paine]

i like the twin menace approach

default risk to one side

dollar drop risk to the other

--------
on a bigger point

the implication
not drawn here btw

the trade deficit is a function of the fiscal deficit

forgets the variable not played fully enough for
the last 11 years or so
-- at least since the asian crisis of 97 --
the dollar forex rate

in particular
the "never a dirty peg shall be popped " policy
from rubin till today
all along maintained
regardless of trade imbalances
and thus payments imbalances
and thus' hot credit 'inflows

says...

The smoking gun(s), the enabling force, was ridiculously low interest rates (or demolishing the savings function). It was orders of magnitude easier to sell speculative mortgages with a 3 pct teasers than say, 6 pct.

IMO, no matter how you slice and dice it, the finger keeps pointing to Greenspan and Bernanke at the Fed and the republican deficit spending. Free money and a tidal wave of cash from the tax break deficits.

[bort]

$700 Billion Dollar Bailout Good For Economy

WASHINGTON (AP) -- It's the largest government bailout in U.S. history and two days after it was introduced to the Americans paying for it, the proposal is still largely a mystery.

Among the unanswered questions: How will the government mop up the bad mortgage debt on banks' books, who will run the process and how much will it cost?

ADVERTISEMENT
Key elements of the plan remain in flux as behind closed doors Democrats demand modifications that would provide more help for ordinary Americans in return for bailing out the country's financial giants.

[Lexington]

One thing I've seen no mention of is the dot.com crash, and specifically, the attempts by the Fed to engineer a 'soft landing'.

Well, they did. Only it wasn't really a landing...

[RW]

The "GSE's did it" argument is suffienciently absurd on its face that the most logical conclusion would seem to be that this is actually a recrudescent Southern Strategy deploying a modified code set; e.g., the myth that the (Democrat supported) GSE's were somehow a central, causal factor in the so-called subprime crisis is connected to the myth that the (Democrat supported) Community Reinvestment Act (CRA) and GSE's in collusion somehow forced banks to lend to poor minorities who were manifestly unable to repay the loans.

Never mind that only a lobotomized zombie could believe such nonsense, the Republicans rather clearly want to tie race to the condition of the economy.

Anyone surprised?

[Jim]

Too much money. Where to put it? Must lend, regardless of risk. Voila. Disaster.

[Kathleen M.]

One significant difference between Fannie/Freddie when compared to the banks or savings in loans that they may well have replaced is this; the banks had to hold more capital against a similar portfolio of mortgages. A major motivation (at least on the part of the industry) for the introduction of the new Basel II capital rules was that they would be able to lower their capital levels for the “safe” end of the portfolio, namely mortgages. Fannie and Freddie had a substantial competitive advantage in cost, because they could hold less capital than their competitors and not be punished by the bond market because of the implicit (now explicit) guarantee.

So by having this implicit guarantee we allowed them to put the risk to us. If these loans had been held by banks, the banks would have had to hold more capital against them.

Kathleen

[Lafayette]

Lest we forget

Article: 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.

Given the pervasive greed, this is perhaps a minor but nonetheless important point: Of this money collected by selling forward debt, some years ago (the Economist reported) the top five F&F managers apportioned amongst themselves more than 100 megabucks in compensation.

The gaming was simple. These GSE's, purportedly with government support, were thus able to borrow money at lower costs than Investment Banks, in order to purchase the toxic waste and resell it forward to investors. They were therefore exploiting a privilege or advantage. Should the management thus have profited personally from this privilege?

Of course not.

[hari]

Yesterday I was listening to a debate among financial experts on German radio which essentially argued that even if US Treasury tried to enforce Basel II, the balance sheets on Wall Street, in particular, didn't like the transparency demanded by Basel II. So, they argued, US made other CBs to administer the new accounting system without enforcing it at home.

I am not capable of adjudicating on or if Basel II implementation would have exposed some of the egregious money market institutions and their fraudulent book keeping practices.

[Lafayette]

From the Economist (Economics focus: “Beyond crisis management”; Sep 18th 2008): Not a moment too soon, suggest the results of a new study by Luc Laeven and Fabian Valencia, two IMF economists.* They examined all systemically important banking crises between 1970 and 2007, creating a database on how much financial crises cost and how they are resolved. The evidence is clear. Tactical crisis containment is expensive and frequently inadequate. In most financial meltdowns a comprehensive solution was required, and the sooner it was provided the better.

The study looks at 42 crises in all, spanning 37 countries. Like America today, most governments began with ad hoc crisis management. In 74% of cases, for instance, governments pumped emergency loans into failing banks or guaranteed their liabilities. An equally common tactic has been regulatory forbearance. Governments allowed banks to hold less capital than was normally required or softened their rules in other ways. These tactical responses, however, often did not work and ended up increasing the overall bill from a crisis. “All too often”, the economists conclude, “central banks privilege stability over cost in the heat of the containment phase.”

[bakho]

Fight the truthiness!

says...

It's instructive to go back and look at the original spreadsheets. Krugman and Hamilton both miss the point. The problem is not relative percentage of socialized risk (i.e., where the risk was hidden). The problem is that the socialized risk grew from a small value in 1980 to a large value (relative to GDP) in 2006. We had an debt bubble that was funded by leverage of many different kinds. The mortgage pool grew to $13 trillion in 2006. To put this in real terms (as opposed to money terms), it's roughly 25% of world GDP. That's a lot of debt.

Our choices now are to socialize the risk; or to follow Morgan's advice from 1929 and quickly liquidate (and deflate). The situation may be compared to stopping a car that's moving at 60 miles an hour. You can stop gently, by putting on the brakes; you can stop abruptly, by running into a tree. The car stops in either case; but the passengers have different experiences.

The important macro-economic policy decisions should not be concerned with retrospective decisions, nor should we be worrying about "setting wrong examples" by missing chances to punish the people who did wrong. The decisions should be made to protect the passengers.

There are roughly 6 billion people in the world who did not do anything to develop the asset bubble, and who were not involved in the policy decisions that led up to this point. But they all will be affected by the policy decisions made now. We should focus our attention on protecting them, and on minimizing prospective pain.

[Fred to Kathleen]

Kathleen is right on target. This comparison between Fannie Freddie and the S&Ls is wrong on several fronts, namely: (1) The short answer is in FNM's leverage ratio which went unchecked and was allowed to extend way out there, way way beyond a healthy leverage ratio to capital, (2) In the case of FNM and Freddie the govt implicitly guaranteed the credit of the issuer, not the deposits, (3) the govt guarantee of the deposits for the S&Ls did not regulate the S&L's lending acitivities (the bank regulators in theory did that), (4) The govt (Congress owns this one) failed repeatedly to regulate Fannie and Freddie despite numerous attempts to pass meaningful legislation, and (5) Fannie and Freddie were in fact extensions of the US Congress, in both form and function and as such were a de facto social instrument. The idea that overleveraged, government-guaranteed mortgage backed securities were not the basis of the entire securitization model for CDOs, CDSs and Swaps is flat out stupid. One question: had the Feds pulled the plug on Fannie back in 2005, what would have happened? The same unwind we are experiencing now, with the main difference being the loss severity that would have been immensely reduced had Congress (repeat after me: Congress) taken the right action and treated the entities like the banks they were supposed to be. If anyone tells you that home value appreciation and Fannie Freddie's activities were not inextricably linked, treat them with a high degree of skepticism and kindly suggest a change in careers.

[Irreverent Comment]

To Jim:

Too much money to invest regardless of risk? Yes... Question. Would infrastructure projects help to create other investment vehicles taking the pressure of hosing and CMO's? (Hint: according to the US GAO the total infrastructure investment has been declining since 1985. Since 2001 the funds were primarily allocated to security rather than to maintenance.)