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Wednesday, July 16, 2008

"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:


    Posted by on Wednesday, July 16, 2008 at 09:00 AM in Economics, Housing | Permalink  TrackBack (0)  Comments (32)


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