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 HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable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:

gse.gif 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.

Originally published at Economist’s View and reproduced here with the author’s permission.

2 Responses to "Once Again, It Wasn’t Fannie and Freddie"

  1. Paul Tioxon   October 4, 2008 at 1:00 pm

    I worked at Conti-Financial, the financial sub-prime lender that was a subsidary of Continental Grains. We made more money for them than their entire world wide agri-products operations did. Conti went down during the Russian currency crisis in 1999, putting over 1000 people out of work. I can point out some anecdotal facts that are by no means isolated to Conti. Conti started to buy up mortgage origination companies, like Resource One, in Oxford Valley, PA. When I joined, they barely had 12 offices in NJ and PA. That was 1996. I had found a successful niche re-financing high interest rate loans left over from RTC era of the 1980’s. I was the number one producer in my NJ office for a few months running when the regional VP told me I was losing money for the company by not placing these clients into sub-prime loans. I was forbidden to originate any conventional, Fannie and Freddie, loans. I posted out to the parent company to join Conti-direct, which was operated out of their new state of the art HQ in Hatboro, PA. The building was a recycled rustbelt factory, given millions of PA job training loans and grants for consolidating their operations. The grand opening was attended by then Gov. Tom Ridge, Mr. Homeland Security. Their mortgage backed paper could not survive that one credit crisis. A $12 billion loan portfolio and a selling machine with a nationwide footprint was not enough for us to be bought by GMAC’s subprime unit. The deal was killed at the closing table by the car guys in Detroit. Smart move, somebody saw through the smoke. This is just one of two major failures in the Philadelphia region of sub-prime outfits that foreshadowed the weaknesses of that kind of enterprise as a whole. I am sure there were others, and I am sure some analysts somewhere tried to report these early warning to no avail. It was known that this was an unstable and unsustainable business model, but it made too much money to be left alone.

    • Anonymous   January 10, 2009 at 9:48 am

      insightful indeed