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Two mysteries

I really like Barry Ritholtz. I learned a lot from Bailout Nation and from interviewing him. His blog, The Big Picture, is consistently interesting.

But there is a mystery about his recent writing on the crisis:

When writing Bailout Nation, I tried to steer clear of partisan finger pointing. I kept the focus on what actually occurred, what could be proven mathematically. I blamed Democrats and Republicans — not equally, but in proportion to their what they did. Unsupported theories, tenuous connection, loose affiliations were not part of the analysis. Every legislative change, each regulatory failure, all corporate actions, to be blameworthy, had to manifest themselves in actual mathematical proof.

This led me to ascertain the following 30 year sequence:

-Free market absolutism becomes the dominant intellectual thought.
-Deregulation of markets, investment houses, and banks becomes a broad goal.
-Legislative actions reduce or eliminate much of the regulatory oversight; SEC funding is weakened.
-Rates come down to absurd levels.
-Bond managers madly scramble for yield.
-Derivatives, non-bank lending, leverage, bank size, compensation levels all run away from prior levels.
-Wall Street securitizes whatever it can to satisfy the demand for higher yields.
-”Lend to securitize” Nonbank lenders sell enormous amounts of subprime loans to Wall Street for this purpose.
-To meet this demand, non bank lenders collapse lending standards, leading to a credit bubble.
-The Fed approves of this innovation.
-Housing booms, then busts
-Credit freeze, market collapse recession

Bailout Nation, as the title suggests, is about the relentless policy of Republicans and Democrats to bail out losers from the costs of their actions, particularly in financial markets. That is not consistent with the first three bullet points he lists above. In fact, bailouts don’t make his list of what happened over the last 30 years. That is mystery number one.

In the same post, he then quotes Kevin Hassett:

The worst financial crisis in generations was set off by a massive government effort, led by the two mortgage giants, to make loans to homebuyers no matter whether they could make the payments. Lenders were willing to lend money to just about all comers, no matter how low their income. Why? Because the lenders knew Fannie and Freddie would purchase the loans from them for a high price before bundling them into securities to sell to investors.

Ritholtz then explains how ridiculous this is:

Over the past 2 years, I have repeatedly asked the people who push this narrative to provide some evidence for their positions. I have offered a $100,000 if they could prove their case.

Specifically, I have requested some data or evidence that DISPROVED the following facts:

-The origination of subprime loans came primarily from non bank lenders not covered by the CRA;

-The majority of the underwriting, at least for the first few years of the boom, were by these same non-bank lenders

-When the big banks began chasing subprime, it was due to the profit motive, not any mandate from the President (a Republican) or the the Congress (Republican controlled) or the GSEs they oversaw.

-Prior to 2005, nearly all of these sub-prime loans were bought by Wall Street — NOT Fannie & Freddie

-In fact, prior to 2005, the GSEs were not permitted to purchase non-conforming mortgages.

-After 2005, Fannie & Freddie changed their own rules to start buying these non-conforming mortgages — in order to maintain market share and compete with Wall Street for profits.

-The change in FNM/FRE conforming mortgage purchases in 2005 was not due to any legislation or marching orders from the President (a Republican) or the the Congress (Republican controlled). It was the profit motive that led them to this action.

I agree with Ritholtz that Hassett grossly exaggerates the role of Fannie and Freddie. But Ritholtz understates it. His first three points are absolutely right:

-The origination of subprime loans came primarily from non bank lenders not covered by the CRA;

-The majority of the underwriting, at least for the first few years of the boom, were by these same non-bank lenders

-When the big banks began chasing subprime, it was due to the profit motive, not any mandate from the President (a Republican) or the the Congress (Republican controlled) or the GSEs they oversaw.

But Ritholtz ignores why subprime was so profitable. And part of the answer is that Fannie and Freddie had been buying up a lot of mortgages made to low-income buyers pushing up the demand for low-income housing. That in turn pushed up the price of houses in low-income areas.

The following chart is not in my paper but it should have been. It shows the growth rate in housing prices in the cities in the Case-Shiller index, divided into thirds. So the low-tier is the bottom third of the housing market in that city–the houses with the lowest prices. The middle tier is the middle third and the high tier are the highest priced houses–in the top third.

Housing Price Growth from 1998 to 2003, percent
Low Tier    Middle Tier    High Tier
San Diego                            133.4           104.0              82.3
San Francisco                     117.4              84.8              64.3
Boston                                  116.5              88.3             68.4
Los Angeles                        100.4               91.8              71.1
New York Commuter         93.4               83.4             67.4
Minneapolis                         91.7                66.1             57.6
Miami                                    79.9               66.5             62.1
Washington D.C.                 71.8                72.0            66.5
Denver                                  65.5                52.2             43.0
Tampa                                   63.3               55.3             46.4
Chicago                                 48.1               46.0             40.8
Atlanta                                  42.0               28.5             27.2
Phoenix                                 41.9                31.3             36.7
Seattle                                    41.7               37.3             32.7
Las Vegas                              37.8              37.2             36.8
Cleveland                              33.7              23.4             18.9

In four American cities, the prices in the bottom tier doubled or more than doubled in five years. The average increase across these cities in the bottom tier was 71%. For the top tier it was 50%. In the previous five year period, 1993-1998, the growth rate among the bottom tier was 27%. In the top tier, 20%. Something happened between 1998 and 2003.

I  think Fannie and Freddie had something to do with what changed around 1998. Under the housing mandates imposed on them by HUD and cheered on by both Clinton and Bush II, Fannie and Freddie became increasingly aggressive in purchasing loans made to low-income borrowers, especially between 1998 and 2003:

(This chart and the next one are from my paper on the crisis, Gambling with Other People’s Money)

Ritholtz is wrong when he says Fannie and Freddie bought only conforming mortgages before 2005, if by conforming loans, he means loans with at least 20% down:

UPDATE: As some commenters have noted, conforming usually refers to the size of the mortgage not the amount down. But others define it as “meeting Fannie and Freddie guidelines.” Most people think that Fannie and Freddie required 20% down and that was true until 1997. Below I mention that Fannie and Freddie did require PMI on low down payment mortgages. But I also point out below, I’m not interested in winning the $100,000. I’m interested in whether Fannie and Freddie contributed to the bubble. I think they did. They helped inflate the housing bubble that in turn helped create the demand for subprime. But either way, the really important underlying cause was the prospect for creditors to be rescued.

A loan-to-value ration above 95% means that the borrower put 5% down or less. By 2003, 714,000 loans—28 percent of Fannie and Freddie’s total volume of home purchase loans—were loans with less than 10 percent down.

Fannie and Freddie were aggressively involved in mortgage with less than 20% down. So the second mystery is whether I win the $100,000 Ritholtz has offered.

I will give him two outs. The first is that I don’t  want his money. I’d be happy if he’d concede that Fannie and Freddie had something to do with inflating the housing bubble even if they didn’t generate all the funding for subprime. The second out is that maybe by “conforming” he didn’t mean 20% down, exactly. As I note in my paper:

When the down payment was less than 20 percent, Fannie and Freddie required private mortgage insurance (PMI). On a zero down payment loan, for example, the borrower would take out insurance to cover 20 percent of the value of the loan, protecting Fannie and Freddie from the risk of the borrower defaulting. But starting in the 1990s, an alternative to PMI emerged—the piggyback loan, a second loan that finances part or all of the down payment. The use of piggyback loans grew quickly beginning in the 1990s through 2003 and even more dramatically in the 2004–2006 period.70 For example, in a study of the Massachusetts mortgage market, the Warren Group found that in 1995, piggyback loans were 5 percent of prime mortgages. The number grew to 15 percent by 2003. By 2006, over 30 percent of prime mortgages in Massachusetts were financed with piggyback loans. For subprime loans in Massachusetts, almost 30 percent were financed with piggybacks in 2003 and more than 60 percent by 2006.71

There are no public data yet available on how many of Fannie’s loans with 20 percent down were really piggyback loans with zero down—loans where the borrower had no equity in the house. Suffice it to say that Fannie and Freddie contributed to the zero or low down payment frenzy with their support of 3 percent down and eventually no money down loans. The full extent of Fannie and Freddie involvement in low down payment loans is unclear because of the piggyback phenomenon. Maybe we’ll find out down the road.


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