Fannie, Freddie, and Subprime

While (following Mr. Ransom's lead) on Nov. 15, 2007 the Financial Accounting Standards Board with Statement FASB 157 constrained accounts and provided the same accounts with incentive to under value Mortgage Backed Securities (MBS) on corporate financial statements. So it is apparent, at least to me, it was government and regulatory intervention in the market which created many of today's financial woes.

Here's a the other side. Their claim seems to basically be that the GSE's basically took over the S&L market share, and that explosion of asset backed securities coincided with the decline in the GSE market share. I think that I've also read that the GSE's had to have higher standards on which subprime loans they could purchase.

I don't doubt that the GSEs exacerbated the bubble, but I don't think they're the primary cause. Nor was the CRA (not that I would try to defend their existence…). There were large housing bubbles in Europe without GSEs or CRAs, and this leads me to believe that they are not the primary causes. They certainly weren't in Europe anyway where some bubbles were arguably larger.

I think if you want to understand the main causes of the bubble, you have to read this and this. The first one explains how the Fed's low rates helped facilitate low teaser rates on ARMs, and the second one explains how regulatory arbitrage encouraged banks to choose to hold these AAA rated securities instead of easier to assess whole mortgages. Interestingly, banks in Europe were subject to the same capital requirements (Basel), and their central banks' interest rates basically followed the Fed (at least directionally). Certainly there were other factors that helped blow the bubble, but I believe those two links have the most important points to understand.

Actually, Dave, that’s not the other side.

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.

FNM & FRE are government mandated to purchase your mortgages because Congress told them to. Which caused the problem in the first place.

They’re about to purchase a shitload more, because they’re A GOVERNMENT SPONSORED ENTERPRISE (GSE), at your expense.

Do you think this a good idea?

Dave,

a) what European housing bubble? Apparently, all the world's troubles are our fault.

b) explain this.

You let this fuck do what he wants to do, go for it.

I’m out.

Dave–

The key counter argument seems to rest on this (from your link):

"Once the reset occurred 24 months later, it was long off the books of the mortgage originators — by then, it was Wall Street’s problem."

The problem is that assumes Wall Street would be oblivious to the nature of the ARMs and the obvious effect on risk. This is just simply implausible on a large scale.

For Wall Street to purchase them, they must've assessed their value, with full knowledge of their underlying terms, as profitable.

So the real question is, why would such securities appear profitable? You might fall back on the nature of a speculative bubble where there is gross ignorance because nobody perceives that the ground below them is rising. In particular, if nobody was expected to hold a mortgage beyond the teaser term (because it was widely observed that people could easily flip their houses by then), then the existence of the ARM did not really portend a substantially higher default rate.

That then places the blame firmly on the CAUSES initiating the bubble's erroneous signals, not the EFFECTS (like teaser rates) of an existing bubble already underway.

Dave–

"poor regulatory incentives to hold highly rated securities of junk"

Along the lines of my previous post:

You can assume there was gross malpractice by the ratings agencies, but there really is not much precedent for such a belief. It would seem far more likely that conditions were such that the given ratings appeared to be correct. That is, even the most informed, conscientious, and properly motivated team of analysts, even you, would've rated them the same way with what was known.

To assume an unprecedented grand coincidence of grand mistakes or a grand conspiracy is to deny that bubbles exist. But bubbles do exist. And grand confusion is their very nature–otherwise they would not exist!

And is not just the market forces that were confused. You might think some kind of regulation could've prevented this, but then you look and see that every level of regulation from the Federal Reserve, to the Executive, to Congress was either oblivious, or actively striving to facilitate the bubble.

EVERYONE, including the regulators, are inspecting the same reality. Not until it pops does anyone realize it was just an illusion.

So again, the real question must be, "Why did the signals get so confused BEFORE the bubble started?" It is of no use to point to the confusion created by the bubble.

Guys, the risk-free rate is there for a reason: it’s the risk-fucking-free-rate, i.e. US Gov’t backed rate.

Which has never failed.

So far.

As the Chinese know.

Mesa,

Good to see you posting again, I missed the no nonsense bite your comments bring to discussions.

How many times can someone use the word "fuck" in one post?

1) Have the government “stimulate” your industry.

2) Contemporaneously recognize this as a problem.

3) Have the government subsequently vilify you, your industry, your family, and steal even more of your time, money and energy.

Think that would fucking piss you off, too?

Oh, and 4) Have muirgeo-intelligence-level bureaucrats hound you constantly, with no objective.

"Welcome to France, fuckwads. You voted for this shit."

I may be a fuckwad, but I surely did not vote for this shit.

Mesa, you sure we would have been that much better off with McCain? Republicans are "limited government" in name only.

avikingvista,

I disagree that teaser rates were strictly a result of the bubble, although I would acknowledge that there may have been some cross causality. But the bubble was caused by a degradation in lending standards, which let more buyers of worse credit into the market with more leverage. More buyers with more leverage = higher prices. This seems to have happened because home buyers were given low teaser rates, after putting little or no money down, so that they could afford that would later balloon into larger payments. It wasn’t until the very end of the bubble that people started defaulting even on their teaser rate payments.

Barry’s point is that the originators, who personally vetted the borrowers, had an incentive to make sure that the borrowers didn’t default for the first 90 days, after which they were no longer responsible for the mortgage, given that they could sell it initially. I think you’re missing the point when you react to his “by then, it was Wall Street’s problem" statement, because it is not the case that Wall Street banks simply bought the mortgages from the originators and held them. They are the ones that securitized, paid rating agencies for the AAA ratings, and resold them. They were making money off of this. And when the buyers of CDOs got them, it was no longer easy to “assess their value, with full knowledge of their underlying terms” because the mortgages had been sliced up into tranches and bundled together by the thousands.

Re: rating agencies. They had awful incentives, helped by poor regulations that relied on their ratings. If a rating agency refused to give their security a high enough rating, the bank could threaten to hire another one. So willingness to give high ratings directly resulted in more money for the rating agencies. The rating agencies used to make their money on the buy side, when they worked in the buyer’s best interest. It is a more recent development that they were paid by the sell side, which is where these dubious incentives came from. And here, I blame regulations for giving so much and protection to the rating agencies. They receive this treatment both from Basel and the SEC (who deems them as “Nationally Recognized Statistical Rating Organizations”), in an effort to increase market liquidity by having them rate everything. And by the way, I’m not arguing that more regulations could have prevented this. I’m arguing that the Fed and current regulations were the main causes.

And yes, I believe that a simple mania has something to do with the bubble, in terms of homebuyer/flipper psychology. But without the regulatory incentives and low rates from the Fed, I don’t believe that the mania would have been able to get off the ground in the way that it did.

"Your link to the Boston Fed’s pamphlet is not evidence that the GSEs caused the housing bubble"

It tells you what the regulators wanted. And this is just one example. What regulators want, regulators get. And boy did they get it.

Fuck you Dave.

Divide your face into 2 regions: stupid and moronic. If you don’t get the obvious good intention factor that spun wildly out of control there, well, you’re dumber than fucking muirfuck.

Everyone who thinks that ballooning the deficit to 11% GDP is a great idea raise your hand….

Oh, I know, let’s add to Fannie & Freddie’s obligations by requiring them to further subsidize low-income energy housing & healthcare. We can make it fun! What could possibly go wrong?

Some smartass had a great comment at WSJ 2 days ago. “Perhaps Obama could merge GM with Amtrack. That way, we could park the cars no one will buy next to the tracks no one rides….”

"But the bubble was caused by a degradation in lending standards, which let more buyers of worse credit into the market with more leverage."

You again are confusing cause and effect. No matter how short term the holding, you still must find a buyer. By presuming that suddenly the feedback mechanisms that maintained lending standards all disappeared, you must assume that vast numbers of self-motivated intelligent, and frankly conservative, financial professionals suddenly and all at once became self-destructive idiots. Your position is untenable.

The only reasonable explanation is that under the conditions that appeared to exist, those lowered lending standards did not impart a greater risk or lower value.

If you want to identify the cause of the current problem, you have to identify the cause of the bubble, not the effects (even the effects with positive feedback).

And to identify the cause of the bubble you have to find something that came before the bubble started, and is not explained as an effect of the bubble conditions. Here your identification of monetary and regulatory policy makes more sense, as it is easy to find examples that clearly predated and were initially independent of any changes in the housing market.

There are bad incentives with the ratings agencies, but that has been true for a long time, and the agencies rate thousands of securities, and you are not talking about a subtle drift in ratings standards, but absurdly misapplied ratings of AAA to junk. Frankly, I don't see how the bureaucracy of those companies would even have flexibility to effect such rapid change in ratings procedures. Companies that size have at least SOME momentum. It is plausible that their old ratings procedures did not apply to new market factors, but that is the same as saying that they, like everyone else, was fooled by the bubble.

Further, you don't hear many of the institutions who entered this market blaming ratings agencies, but those institutions do their own analyses and the ratings agencies are for the most part a regulatory formality.

And you often hear the claim that these securities were not understood. That is a claim that really can only be believed by someone without any analytical experience. We're talking about financial experts who deal regularly with high level statistical methods, calculus, and empirical analysis. There was nothing in CDO's beyond their ability to understand. If there were significant barriers to obtaining information, that uncertainty would have been identified, and reflected in the ratings.

Occam's razor. It just makes no sense to assume a vast conspiracy or coincidence among the many players across all the ratings agencies.

The simultaneous rapid development of many raters rating junk as AAA, many lenders dramatically lowering standards, many conservative investors overpaying for junk, many insurers grossly underestimating risk, many mid and low income individuals flipping houses, and many regulators happily and publicly cheering it along; followed by vast confusion about how it could all go so wrong. This IS a bubble, not its cause.

"Everyone who thinks that ballooning the deficit to 11% GDP is a great idea raise your hand"

I actually heard some political strategist on one of the 24hr blabfests defend Obama's budget by saying it's actually smaller next year than Bush's was last year. You gotta smoke alotta dope to get on TV and make such a stupid statement as that.

And never mind that the underlying statistics for this study were bogus.

Yeah, Dave, there’s no evidence that Fan & Fred were the cause.

Nah.

Do try to pay better attention, Dave.

Mesa Econoguy,

I can tell by your level of discourse that you are quite an intellectual. It would help your arguments if you were able to articulate the main points of the links that you give. Instead, you seem to hold their value as self-evident argument-enders. It leaves me to believe that you don't even understand what they are arguing, but that you merely see people who seem to support your ideological beliefs and count such endorsements as "evidence." However, you have presented no coherent story as to why the GSEs were the main cause of the bubble.

I do agree with some of the points made in the two links that you presented. I believe that the political atmosphere was conducive to the bubble. I'm sure politicians were patting themselves on the back when home ownership rates were rising. However, the CRA regulations didn't cover almost all of the largest mortgage lenders in the US. And, as I've mentioned before, I do believe that Fannie and Freddie added to and participated in the bubble to some degree. The favoritism given to the ratings agencies is also implicated, which I mentioned above.

The main problem with the arguments made in those links is that they simply align factors that help make their argument, while ignoring circumstances that don't support the thesis. This is a confirmation bias. I believe you suffer from this as well. Also, neither of those links even addresses the arguments that I've presented. The Independent one is reacting to "[t]he main answer that is being given, that unscrupulous lenders were taking advantage of poorly informed borrowers," which it correctly concludes "does not fit the evidence nor does it dig deep enough." This does nothing to address my points.

There is also no attempt to put the GSEs activities into perspective. No mention of market share over time for various types of loans. As a result, while we can conclude that they participated in the bubble, we have no way of gauging the magnitude of their impact.

By the way, you still have not answered how the GSEs and US regulations caused the housing bubbles in Europe. In fact, you didn't even seem to be aware of housing bubbles in Europe which makes me think that you haven't bothered to educate yourself on the matter.

The funny thing about this argument is that we're both arguing that it's the government's fault. However, I care about magnitudes and root causality. You seem to be interested in confirming your priors and name calling.

That the Boston Fed document is signed by Richard F Syron isn't a cause-and-effect indictment that Feddie and Frannie caused the housing bubble. Syron worked for the Boston Fed at the time, and the document even says that the suggested guidelines are not regulation (see my comment that quotes it above regarding that point).

Thanks for reminding me of why I seldom comment on this blog. Russ and Don are great, but there are definitely some commenters who need to learn how express their arguments intelligently.

And no, vikingvista, pointing out that the Boston Fed is privately owned does not make me a troll. I can't believe that you would read the comments between me and Mesa Econoguy and conclude that I'm the troll in this. I present facts, figures, and graphs. Mesa Econoguy types profanities. Anyway, you certainly have argued more coherently than Mesa Econoguy, even if I disagree with you. So congrats on that, for whatever it's worth…