Once Again, It Wasn't Fannie and Freddie

Russ Roberts:

Krugman gets the facts wrong, by Russell Roberts: Back in July, as Fannie and Freddie were starting to implode, Krugman concluded that Fannie and Freddie weren't part of the subprime crisis:

But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

His conclusion is quoted approvingly by Economist's View, a couple of days ago.

Alas, Krugman has his facts wrong. As the Washington Post has reported:

In 2004, as regulators warned that subprime lenders were saddling borrowers with mortgages they could not afford, the U.S. Department of Housing and Urban Development helped fuel more of that risky lending.

Eager to put more low-income and minority families into their own homes, the agency required that two government-chartered mortgage finance firms purchase far more "affordable" loans made to these borrowers. HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing.

Housing experts and some congressional leaders now view those decisions as mistakes that contributed to an escalation of subprime lending that is roiling the U.S. economy.

The agency neglected to examine whether borrowers could make the payments on the loans that Freddie and Fannie classified as affordable. From 2004 to 2006, the two purchased $434 billion in securities backed by subprime loans, creating a market for more such lending.

$434 billion isn't zero, and that's just from 2004 to 2006.

I'm a bit confused about the part pointing to this blog. I don't quote that passage. In fact, I don't quote that column. In fact, I don't even link that column myself - it's only linked within a post from Jim Hamilton that I echo, and that's a post disagreeing with Krugman. So, saying I "quoted approvingly" is not exactly accurate.

The title of the post was "It Wasn't Fannie and Freddie." The point from Krugman I was referring to is (and yes, I do approve of it, and I'll explain why):

...I stand by my view that Fannie and Freddie aren’t the big story in this crisis.

Fannie and Freddie did not cause the credit crisis and nothing in the article quoted by Cafe Hayek, or anything since the article came out last June changes that.

There are two questions that are being confused in the debate over the source of the financial crisis:

1. What caused Fannie and Freddie to fail?

2. What caused the financial crisis?

Answering the first question does not necessarily answer the second. Showing that some politician, some policy, some legislation, lack of effective regulation, whatever, caused Fannie and Freddie to fail is important, we need to know why they were vulnerable when the system got in trouble, but Fannie and Freddie did not cause the crisis, they were a consequence of it.

How do we know this?

Fannie and Freddie became fairly large players in the subprime market, and they got that way by following the rest of the market down in lowering lending standards, etc. But they did not lead it down. Their actions came in response to a significant loss of market share, and it is this loss of market share that motivated them to take on more subprime loans.

We need to understand why the overall market - the part outside of Fannie and Freddie's domain - was able to lower lending standards (and increase their risk exposure in other ways as well), and how regulation which had worked up to that point failed to keep Fannie and Freddie from dutifully responding to the market pressures on behalf of shareholders by duplicating the strategy themselves, but again, they were followers, not leaders.

Tanta (via econbrowser) describes the downward plunge of the GSEs:

Fannie and Freddie .... didn't like losing their market share, and they pushed the envelope on credit quality as far as they could inside the constraints of their charter: they got into "near prime" programs (Fannie's "Expanded Approval," Freddie's "A Minus") that, at the bottom tier, were hard to distinguish from regular old "subprime" except-- again-- that they were overwhelmingly fixed-rate "non-toxic" loan structures. They got into "documentation relief" in a big way through their automated underwriting systems, offering "low doc" loans that had a few key differences from the really wretched "stated" and "NINA" crap of the last several years, but occasionally the line between the two was rather thin. Again, though, whatever they bought in the low-doc world was overwhelmingly fixed rate (or at least longer-term hybrid amortizing ARMs), lower-LTV, and, of course, back in the day, of "conforming" loan balance, which kept the worst of the outright fraudulent loans out of the pile. Lots of people lied about their income (with or without collusion by their lender) in order to borrow $500,000 to buy an overpriced house in a bubble market. They weren't borrowing $500,000 from the GSEs.

Michael Carliner continues, explaining how Fannie and Freddie took on the extra subprime debt:

Fannie and Freddie are ... subject to regulation by HUD under mandates to serve low- and moderate income households and neighborhoods. As originators and investors with more energy than brains expanded their (subprime) lending to those borrowers and neighborhoods, it was difficult for Fannie and Freddie to increase their shares. They didn't want to buy or guarantee subprime loans, correctly perceiving them to be insanely risky. Instead they purchased securities created by subprime lenders, taking only the supposedly-safe tranches. Those portfolio purchases were counted toward their obligations to lend to lower-income home buyers, but are now part of the write-downs.

Until Republicans started trying to claim that Fannie and Freddie caused the financial meltdown as a means of tying Obama to the crisis - a strategy that backfired badly when all of the embarrassing connections to Fannie and Freddie within the McCain campaign were revealed - nobody was saying Fannie and Freddie caused the crisis. Republicans simply worked backwards - they found connections between Democrats and Fannie and Freddie (never thinking to ask about their own connections), then tried to blame the crisis on Fannie and Freddie so as to make people think it was the Democrat's fault.  And it's still going on despite the fact that the data doesn't support this story.

There is no excuse for the actions of the management of Fannie and Freddie, and I'm not trying to defend them or their choices, but the idea that Fannie and Freddie caused the general credit crisis is wrong.

Richard Green is dismissive of the whole notion:

Charles Calomiris and Peter Wallison blame Fannie Mae for the Subprime Mess:

Hmmmm. The loan performance on Fannie's book of business is substantially better than the overall mortgage market. And starting in 2002, Fannie Freddie (pink line) lost market share to ABS (light blue line). [The data underlying the graph is from the Federal Reserve, Table 1173. Mortgage Debt Outstanding by Type of Property and Holder.]

It wasn't Fannie and Freddie.

[Update: Follow-up argument: Barry Ritholtz: Fannie Mae and the Financial Crisis, What Caused the Financial Crisis?. For a recent academic paper at odds with the claim, see: It Wasn't Fannie and Freddie.]

Comments

[Richard Boltuck]

OK then -- if it was Andrew Cuomo, Barney Frank, and the CRA, then, what was it? What did cause the financial crisis? This question has not been convincingly answered (though innumerable elements of the story have been rehearsed over and over again.)

I have a humble hypothesis. A significant share of investors in the shadow banking sector, perhaps all of it, has benefited from broadly understood implicit Federal guarantees, which we now see being paid off. Shared asset risks made major portions of this sector too big to fail. Hence, moral hazard.

Moral hazard caused by "free" Federal insurance, sans regulation (and as a libertarian, I would argue in many instances, even with regulation), leads to excessive risk-taking -- a widely acknowledged consequence.

Here's the innovation I would like to add at this point in the story. "Fly-by-night" firms, in the IO literature, are those that rationally adopt a short-run profit strategy at the expense of long-run persistence in the market. The usual example is production of a sub-quality experience good that consumers buy and try, because until they do they cannot distinguish it from higher-quality established competing products. If the profits are sufficiently great from selling such a product, the inability to engage in repeat sales might be an acceptable cost for such a firm to pay.

I suspect that the insolvent investment banks adopted something very much like a "fly-by-night" strategy through mid-2007. High leverage achieved with low-cost short term debt (at a time when short rates were historically low) that lenders regarded as probably Federally guaranteed, combined with product innovations (securitized MBSs, CDOs, CDSs, and various derivatives) that spun off high revenues as long as real estate prices were rising. The progressive expansion of ever crappier mortgages, funded by the highly leveraged non-bank banks, fed the real estate bubble.

Consider this example. Thirty-to-one leverage (remember, no regulation). Any given year, a 10% chance of wiping out all equity (going insolvent), and an 90% chance of winning, say, profits equal to three times equity. The downside is limited to the ante on the table (the equity), capped by corporate limited liability -- and in the case of management, subject to agency problems that permit execs to distribute much of the profits in the form of bonuses with very little skin in the game. Let's say from 2002-2006, this strategy won each year, leading to profits equal to 15 times equity. Then in 2007/08, it lost, wiping out equity and bankrupting the firm.

This was a rational strategy, even assuming an informed understanding of risk. It beats investing the equity in perpetuity, at say, 10%/year. Over time, of course, super-normal returns would be eliminated by entry, but then again, the entire strategy may play out in period too short to permit much entry. Did I mention this was a rational strategy? These people weren't stupid or (privately) irresponsible (as they are being portrayed in some incomplete accounts of the crisis).

One reason it is important to examine why the crisis occurred is to design policies that prevent it in the future. Some would take from this story that the lesson is to regulate the shadow sector, and indeed, that appears certain to happen. But regulation is an imperfect solution. Countrywide was regulated when it was creating the worst sub-prime and alt-a crap. On the other hand, the hedge funds haven't, at least yet, contributed to any systemic trauma -- and they aren't regulated at all (but also, not implicitly Federally insured, or at least they have not been regarded as insured).

Another possibility: let's revisit deposit insurance and implicit Federal guarantees altogether. This should be one the questions raised by the current episode, but surprisingly, I haven't seen it discussed anywhere. Federal insurance is intended to stop bank runs -- but may actually make them more likely by encouraging the accumulation of riskier assets and even, in the extreme, "fly-by-night" investment strategies.

Thoughts?

[Patrick]

The Austrians may have a point on this one (I guess they're not all wrong): interest rates were too low for too long. Money was too cheap so money got on credit wasn't put to sufficiently productive use. Residential housing really is just about the least productive asset imaginable - and boy does the US have a ton of it now.

Bill Gross may get his wish! There's a good chance much of it will be demolished, but it won't be for rebuilding. It'll be for salvage.

[Anon]

That WaPo article is grossly misleading. I looked into the issue after reading it and this is what I found:

Agency purchases of subprime MBS increased dramatically in 2004 (but not when measured as a fraction of the market), leveled off in 2005 and dropped back to the 2003 level in 2006. Private issues of subprime MBS increased dramatically in 2004 and 2005 and held steady in 2006. It appears that the strict criteria the agencies applied to their purchases protected them to some degree from the worst excesses of the bubble. When one compares the pattern of agency purchases and of subprime MBS issues, there does not appear to be any reason to believe that demand from the agencies was a cause of the increase in sub-prime lending.

Tanta's posted some great mortgage data (http://calculatedrisk.blogspot.com/2007/10/mbs-market-data.html).

I for one would really appreciate it if the folks at Cafe Hayek would take the time to look at the data before making an argument.

[Anon]

I left out the now well established fact that the 2004 vintage of subprime is vastly superior to the 2005 and 2006 vintages.

[Anon]

Data for Fannie and Freddie is here: http://www.ofheo.gov/media/annualreports/OFHEOReporttoCongress07.pdf

[BJ Feng]

I believe the accounting scandal that led to the resignation of the CEO, Raines, was a major factor that made Fannie decrease their rate of growth in the subprime/Alt-A marketplace.

Like I said, Fannie and Freddie were not the sole reasons for the bubble. Private institutions would not have been able to package as many subprime loans if not for the demand from investors. Why were bond investors so hungry for yield? Partially because the FED kept the ex-post real federal funds rate at a historically low level. In fact, the rate was negative for a lengthy period of time.

It was impossible for investors to get a positive real return without taking risk, and because past performance was very strong (defaults less than 2% on even subprime) on Alt-A and subprime mortgages, people were blinded to the actual risk. Besides, historical data indicated that housing prices could fall only a certain amount before stabilizing, remember the often touted fact that median home prices had never fallen more than 10% from peak or some number like that? We've never seen this type of decline in the housing market, the quants were wrong, their models which used past historical records for a worst case scenario underestimated the potential loses. That explains the demand side of the equation.

Money searching for yield fueled by an extended easy money policy by the FED created the demand for these risky loans. Private institutions crowded out by Fannie and Freddie in the prime mortgage marketplace searched for a new space where they could compete. Put one and one together and you have our crisis.

[Easy Money]

Cafe Hayek is a partisan blog that does a disservice to Hayek.

However, it's time economists read Hayek and Mises again. They have clearly described the perils of easy money we now face. Time to rethink the benefits of The Great Moderation and all that it has wrought.

[Anon]

BJ: How do you square your view with the fact that Fannie and Freddie were withdrawing from subprime MBS in the years when it deteriorated?

[spencer]

Cafe Hayek is never confused by the facts.

[ken melvin]

Just when you thought they could go no lower, the right always go lower. All the spawn of Jim Crow Crackers.

[Eric]

Roberts's post doesn't conclude that Fannie and Freddie caused the subprime crisis. It demonstrates that Fannie and Freddie were involved in subprime lending -- and that the government encouraged that. (It's merely making the more limited point -- answering question 1 of your 2)

It's a response to Krugman saying this: "Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago", which is obviously false.

The idea isn't that the FMs were issuing subprime mortgages, but that they were buying them. To confuse the loans the FMs issued with the loans they bought (as I think the chart does) is to miss the point.

[robertdfeinman]

The Crisis Explained - Really

Analogies are never perfect, but here's one using horse racing. Don't expect a perfect correspondence to the banking situation, but I think it is close enough for government work.

Joe goes to the track and bets $2 on a horse.

Two guys standing nearby get into a discussion and Fred says to Sam, "I'll bet you $5 that Joe wins his bet."

Next to them are Bill and Bob. Bill says: "I'll bet you $10 that Fred welshes on his bet if he loses."

Next to them is Sally. Sally says: "For $3 I'll guarantee to Bill that if Bob fails to pay off, I'll make good on the bet."

Sally then goes to Mary and borrows the $7 needed in case she has to ever pay off and promises to pay back $8. She doesn't expect to every have to pay since she believes Bob will always make good. So she expects to net $2 no matter what happens to Joe.

A quick calculation indicates that there is now 2+5+10+3+7 = $27 riding on the outcome of the horse race.

Question how much has been "invested" in the horse race?

Answer:

$50,000 by the owner of the horse who is expecting to recoup his investment from the winnings of the horse and other future deals. Everyone else is gambling, not investing.

The issue with the home market is that the only "investor" was the person who bought the home. All those engaged in the meaningless derivatives spun off from this are gambling. You can see how quickly the face value of all these side bets can exceed the underlying investment. Who is holding these side bets - not the homeowner? It is the people at the failing investment banks, hedge funds and similar enterprises. Notice that the bailout is being directed at them not the homeowners.

The real world is, of course, even more complicated. Over the last 30 years people have been allowed to place bets on everything starting with the value of stock averages. They might as well bet on the temperature in Newark at 8:00 AM.

So when you hear everybody saying this is a crisis caused by the housing collapse, be skeptical. We are in the midst of a classic pyramid or Ponzi scheme and there is no way out except for people to lose a lot of money. All that is different this time is that it is the taxpayers who are being asked for the cash.

[Mark]

Richard Boltuck: "This was a rational strategy, even assuming an informed understanding of risk."

What does this approach say about the players on the buy side? What about players operating on both the buy and sell sides?

[OhNoNotAgain]

"Private institutions crowded out by Fannie and Freddie in the prime mortgage marketplace searched for a new space where they could compete. Put one and one together and you have our crisis."

The bottom line is that none of this would have been an issue if regulations were in place to prevent it. So, give us all a break and stop trying to deflect this on to FM&FM. The private firms knew damn well that this stuff was toxic as hell, but they all went along with it because the money spigot was flowing and they were dumb enough to believe their own bullshit about how "this time it's different" and that they had finally figured out a way to eliminate risk altogether by slicing and dicing all of the MBS's. The private ratings agencies should be prosecuted to the fullest extent of the law for rating all of this junk AAA-grade when it was obviously worth crap.

[?]

Their actions came in response to a significant loss of market share, and it is this loss of market share that motivated them to take on more subprime loans.

I'm not sure of your wording here Mark. The term market share is generally refered to in terms of creating or maintaining a brand with respect to the end user of a service known as the customer.

I hope you weren't refering to the term market share with respect to getting more stockholders or investors.

[No, I was using the term properly. But thanks for the concern trolling. MT]

says...

fraudulent earnings by the gse's did nothing to fan the flame? maybe not. hard for me to believe though. while their lending practices were much higher quality, when you start throwing earnings out like they did you are going to get plenty of people saying i'll give you a better yield for more risk.

did gse's "cause this"? probably not, but looking solely at wall street mortgage bond underwriters and/or regulators seems a bit of a stretch.

[Russ Roberts]

Mark,

I should have said that you approved of Krugman's conclusion rather than implying that you approved of his factual error. I'll correct that at Cafe Hayek soon.

Eric,

Thanks for making my logic clear.

Anon,

In 2004, according to the WaPo, Fannie and Freddie bought 44% of the subprime MBS that year. I call that a significant fraction.

Fannie and Freddie were heavily involved in low-income high-risk loans in a variety of ways. They were not "the" cause of they crisis but they contributed. Krugman's attempt to keep their influence out of the narrative is a factual error.

[don]

Krugman may be technically right, but it is curious that the national mortgage market's meltdown is biased to those bi-costal states that, if memory serves me right, are blue states, although admittedly Florida is a mixed case. So apparently most of the fraud and flipping and liar loans on the federal homeboy mortgage network happened in democratic states. So since republicans are voting a strict party line, if Obama looses because of neo Jim
Crow racism, it must be a democratic party problem. Perhaps the democrats should consider a party purge and show trials.

[Richard Boltuck]

Mark: The buy side? Investors bought debt and counterparties bought derivative side bets. Both groups regarded themselves, with considerable cause, to be Federally insured. That's one of the two reasons that the investment banks' cost of funds was so low (the other being the Fed's short term interest policies during the relevant period).

My suspicion is that Federal insurance, or the general understanding of implicit insurance, is the government intervention at the heart of the failures that have led to this crisis. Moral hazard is not principally the consequence of the actual bailouts, but of the ongoing understanding over the past five to 10 years that investing in investment banks was nearly free of risk.

[Rajesh Raut]

There is a lot of confounding of sub-prime lending and lending to lower income borrowers. A family with $40,000 income and no debt but little savings may not be serviced by many banks because they have not proven capacity to be "serviced" by the financial system. They are not eligible for loans because they have no credit history.

Another family with an income of $80,000 and $10,000 in credit cards might be targeted by banks because their credit history shows they pay a lot of interest and late fees: they are the classic sub-prime.

Many of the loans going bad are to middle class and upper-middle class families who believed the mortgage broker when they were told they could afford the house of their dreams.

But we hear the same complaints about affordable housing because when facts don't fit your prejudices, you just ignore them.

[andrew]

don:

The key bubble areas were San Diego, Florida, Las Vegas, and Phoenix.

[bena gyerek]

some cite fannie & freddie as cases of moral hazard. but cdos and mbs are a massive moral hazard problem. supposedly they are used to transfer risk from those that have less appetite to those that have more (aka "diversification"). now we know they were used to transfer risk from those that understood it (countrywide et al) to those that didn't (e.g. gormless european banks).

if countrywide gets ultra-cheap credit insurance from the mbs market, and they get compensated on volume, then tah-dah they increase volume at the expense of quality. fly-by-night indeed.

investors that have no relationship with the end investors take the underlying credit quality as a given, and focus on how "diversification" will help enhance their alpha. they don't stop to consider that their very action of investing in credit they don't understand inevitably leads to a worsening of the underlying credit quality.

and we all understand the ponzi dynamic - gormless investor inflows lead to inflating housing prices, leading to superficially improving credit quality, leading to more gormless investor inflows. same is true on the gormless borrower front.

here is a great standup piece explaining the subprime crisis from a year ago already. open and shut case in my mind:

http://uk.youtube.com/watch?v=mzJmTCYmo9g

and a more recent one:

http://uk.youtube.com/watch?v=lWDdcD-1xoo

[skeptonomist]

The Bush-appointed regulatory agency for Fannie/Freddie assisted as far as they could in reducing capital requirements, etc. to allow F&F to dig themselves deeper. Revamping the regulatory system after the accounting scandals could have been constructive in regard to avoiding excessive risk, but instead was another Bush screwup.

[Tosk]

Study by a couple of economists concludes that the GSEs (Fannie & Freddie) were not the major issue...

"... The most important and heretofore unrecognized impact of lending patterns on subsequent house price returns was found to originate with the regime-shift which occurred in early 2004, with the squeezing out of the GSE‘s from the market, both because of political, regulatory, and economic factors. The resulting reshuffling of supply of mortgage capital in the market, resulted in both a record increase in total lending volume after 2003 and a substantial substitution of alternative private instruments for conventional conforming GSE loans... The dominant policy conclusion that can be drawn from the findings of this paper is that the existence of subprime loan products alone may not merit primary blame for the problems currently being experienced in the housing and mortgage markets. Rather, political and regulatory actions and economic conditions -- which led to a disruption in traditional flows of credit into the market and permitted not only new instrument designs, but also weaker underwriting standards, to flow in great volumes into the void – may be deemed complicit, if not dominant in precipitating the subsequent series of adverse events."

Get the link to their study at http://www.ph2dot1.com/2008/10/wall-street-vs-maain-street-i.html