Did Fannie and Freddie Cause the Mortgage Crisis?
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:
Here's the background: Fannie Mae (FNM) -- the Federal National Mortgage Association -- was created in the 1930s to facilitate homeownership by buying mortgages from banks, freeing up cash that could be used to make new loans. Fannie and Freddie Mac (FRE), which does pretty much the same thing, now finance most of the home loans being made in America.
The case against Fannie and Freddie begins with their peculiar status: although they're private companies with stockholders and profits, they're "government-sponsored enterprises" established by federal law, which means that they receive special privileges.
The most important of these privileges is implicit: it's the belief of investors that if Fannie and Freddie are threatened with failure, the federal government will come to their rescue.
This implicit guarantee means that profits are privatized but losses are socialized. If Fannie and Freddie do well, their stockholders reap the benefits, but if things go badly, Washington picks up the tab. Heads they win, tails we lose.
Such one-way bets can encourage the taking of bad risks, because the downside is someone else's problem.
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%.
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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:
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.
These developments appear clearly in the graph above after 2003, which is marked with a vertical line. And certainly much of the dramatic appreciation in house prices came in the two years after the GSEs began to contract.
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Even more striking is the explosion of home mortgages held in the form of privately-issued asset-backed securities that did not go through either Fannie or Freddie. By 2006, these represented 20% of all outstanding home mortgages.
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On the other hand, Tanta contributes this:
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 (hat tip: Economist's View) adds:
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.
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.
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This article has 14 comments:
r
>>> 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. <<<
That is not my position, but I've got an opinion on everything.
>>> 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? <<<
I guess you're asking why the GSE's increased their market share during this period. I guess the obvious answer was because they could -- they're for-profit enterprises, and increased market share can lead to increased profits if that business is properly written (i.e. proper risk-adjusted returns). Perhaps I'm misunderstanding the question.
To me, FNM and FRE generally guarantee the most conservative and basic mortgage products that exist in the country, and seeing their market share increase is a source of comfort, rather than alarm, because it means that a greater portion of the country's mortgages are conservatively financed and underwritten properly.
In fact, I believe it was the decline in the GSE market share starting in 2003 that foretold the mess that we're in now, because other, more reckless and less stable companies took market share from the GSE's, leading to a higher proportion of risky mortgages in the system.
Another data point to consider is that the default experience on mortgages written from about 2000 to 2005 has been far less than those written in 2006 and 2007 (for a snapshot of these numbers, look at FRE's recent investor presentation which shows cumulative defaults by year). It's the 2006 and 2007 loans that are the major problem. The loans that were written when FNM and FRE were at their recent market share peak are performing well. I think this indicates that FNM and FRE are part of the solution, not part of the problem.
>>> 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. <<<
Once again, it's a free market, and these companies thought they could make a lot of money playing the GSE's game. But they had a permanent disadvantage in funding costs that they had to make up elsewhere, and they tried to do this by inventing new mortgage products and laying off some of the risk to the bond market. This worked for a while, which is why GSE market share declined while the non-GSE profits boomed. But that chicken has come home to roost, and, as the Wells Fargo CEO recently said, things now look normal for the first time in a long while.
Uncle
Certainly in both cases these companies were mechanisms, albeit perhaps opportunistic ones at that, that facilitated the American dream - the housing and education boom. Indeed, the phenomenon itself took place in the larger context of the American Dream paradigm - housing and education are the best investments that you can make.
Just so happens that the American dream became a borrowed one - an education and owning a home would be one that most would have to be willing to go into debt for and spend the rest of life paying off and more and more people seemed resolved to do this and the mechanisms were there to facilitate it.
If oversight and regulations were in place to limit access to credit (to housing and education) we would not have experienced the economic boom that seemingly benefited everyone.
Perhaps regulation and limits might have kept both housing and education costs in check (vis-a-vis supply demand) and in effect we would have seen more moderate growth in both the cost of housing and education. But most would cry fowl and say let the markets do their thing. So the market has done its thing and the pendulum swings wildly....now back to the other side...and thus the current crises in the credit markets - limited access to credit
borenstein
Now ,who cares.
The FED and the Treasury had defined the issues well.
We have learned ,and the shorts are about to painfully learn that the the implicit guarantee behind the agencies is real.
No speculative entity will be allowed to destabilize the financial markets and create mega economic problems.
There is no need to blame the agencies for the irresponsible lending policies of the financial institutions and the over optimistic ratings given by the S&P ,Moody's and likes.
borenstein
solari.com/blog/?p=123...
Shorthairs
(with apologies to Tanta.. we're not in the same league)
Uncle Longhair, nice to see that there are other thoughtful uncles out there.
r
I've heard this hysterical statement uttered frequently in reference to FNM and FRE, which I think demonstrates the basic misunderstanding that many people have, both laypeople and professionals, about FNM and FRE.
First off, FNM/FRE's subprime exposure is not "untold". It's clearly reported in their investor presentations. Here's FRE's latest, from this month:
freddiemac.com/investo...
Page 42 shows their retained portfolio breakdown, and that about 13% of their retained portfolio, about $92B, is in sub-prime mortgages, and these have on average a 37% credit enhancement.
Second, many people hysterically scream "billions and billions" implying that the exposure is endless and fatal. Let's look at the numbers. A billion is a big number. A trillion is an even bigger number. FNM and FRE have guaranteed about $5.2 trillion of mortgages. One billion is 0.02% of that. FRE's $92 billion of retained subprime mortgages is 2% of that. The exposure is simply not enormous.
Subprime issuance has come almost to a complete halt, and subprime mortgages tend to prepay very rapidly, so within a year or two I expect FNM and FRE to have very little sub-prime mortgages in their portfolio.