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Fannie and Freddie and the crisis

The SEC suit against former execs of Fannie and Freddie appears to vindicate the Pinto/Wallison view that government housing policy pushed Fannie and Freddie into unsafe loans and caused the financial crisis.

I think Pinto and Wallison are half right. Fannie and Freddie did help cause the financial crisis. But not in the way Pinto and Wallison claim and not without a lot of help from the investment banks. Fannie and Freddie helped push up the demand for housing between 1995 and 2003. During that time, they expanded their activities, particularly among low-income borrowers. They started making loans with low down payments. This was not a secret by the way. Fannie Mae’s CEO, Franklin Raines bragged about it in 2000. Josh Rosner wrote about it in 2001. All of that activity drove up housing prices. That in turn, made it imaginable to lend to people who normally would not qualify for a mortgage and to lend them money without very much or any down payment. That in turn made the financial alchemy of AAA-rated mortgage-backed securities (MBS) possible. So yes, Fannie and Freddie had something to do with the crisis.

The left is also only half-right. They blame the crisis on unregulated investment banks that ran amok. The left likes to point out that the subprime market took off in 2004-2006, a time when Fannie and Freddie’s activities in the housing market were surpassed by the involvement of investment banks in originating subprime loans and bundling them together to create subprime MBS. According to this narrative, the unregulated behavior of the investment banks and the derivatives they sold is what caused the crisis.

The left’s narrative does not explain why housing prices took off like a rocket between 1995 and 2003. Without that rise in housing prices, the whole subprime market would have stayed quiet. It was that rise that made it imaginable to lend money to people with little or no money down. It was that rise that encouraged people to buy a second and third house. It was that rise that allowed people to lend money to people with mediocre to poor credit because they would be able to flip the house quickly.

What explains that rise? There were a number of government policies in 1995-2003 that we would expect to push up the demand for housing–the requirements on Fannie and Freddie to ever more loans from low income borrowers, the toughening of the Community Reinvestment Act in 1995 and various state-level encouragement of home ownership. Bush I, Clinton, and Bush II all were eager to increase the home ownership rate. They were successful. Is it surprising that this push caused housing prices to rise especially in areas where supply was restricted by various legislation and zoning laws?

The reason Pinto and Wallison are only half-right is that they ignore the role of the investment banks. They also ignore the timing of Fannie and Freddie’s activity. In their latest defense, they point out how much garbage was on the books of Fannie and Freddie in the summer of 2008 before things fell apart. Yes, there was a lot of garbage on their books, lousy loans, loans with low down payments, loans with inadequate documentation. But look at the SEC suit. A lot of the garbage that was on Fannie and Freddie’s books were acquired in 2007 when the subprime market was drying up. It was drying up because even the investment banks saw the writing on the wall. But Fannie and Freddie did not. They kept acquiring garbage. Yes, this was partly to meet their housing requirements. But it was also because they probably weren’t very smart and had little incentive to be smart.

Here is a measure of how much subprime was originated and when:

So just because Fannie and Freddie acquired a lot of lousy mortgages in 2007 (and some in 2006) doesn’t mean you can blame them for the subprime meltdown. Those seeds were planted in 2004 and 2005 when over a trillion dollars of subprime mortgage were originated. A lot (most? almost all?) of that was originated by investment banks. Yes, Fannie and Freddie bought subprime MBS from those investment banks. They did that because they were trying to meet their affordable housing requirements. But would that subprime MBS have been bought by someone else anyway? Did Fannie and Freddie acquire so many lousy mortgages in 2006 and 2007 to meet those requirements or were they just trying to make money and they didn’t care about the risk?

One more point–the SEC suit doesn’t really fit the “government made Fannie and Freddie buy up lousy loans” story.  The whole point of the suit is that these were secret behaviors by Fannie and Freddie. They were buying a lot of loans that were a lot like subprime–loans with high default risk. But were these to satisfy ever more demanding affordable housing requirements imposed by the government? Who knows? I suspect they were just trying to make money like the other players. They just stayed in too long.

(And the suit also makes it clear that Fannie and Freddie knew these were lousy loans. This goes against another view of the crisis that it was just hubris and overconfidence in the risk models.)

Fannie and Freddie’s holding of lousy mortgages explain why they’re costing us, the taxpayers, $150 billion and counting. But I don’t think they caused the crisis all by themselves.

To really explain the housing boom and bust followed by the financial crisis, you need an explanation of why Fannie and Freddie AND the investment banks were so reckless. The Pinto/Wallison explanation is that Fannie and Freddie were reckless because the government made them do it. The left’s explanation is that the investment banks were reckless because the govnernment let them do it. Both left and right ignore the role of the other part of the market. But more importantly, both the left and the right leave unexplained how the reckless risktakers–the GSE’s and the investment banks–were able to do it–how they all were able to borrow money at relatively low rates despite ridiculous levels of leverage. How were they able to borrow all that money at so low rates when leverage meant high risk for the lenders?

My answer is that they were all GSE’s, all government sponsored enterprises–Fannie and Freddie and Bear and Citi and Goldman and Lehman and on and on. They all had an implicit guarantee from the government that allowed them to borrow at low rates (often from each other), rates that were well below market because of the implicit guarantee. And they were able to borrow at low rates even though they were highly leveraged which made them vulnerable to defaulting on their debt. Despite that vulnerability, they were still able to borrow at low rates. When things fell apart, almost all the creditors, lenders, and bondholders got all their money back, 100 cents on the dollar. The only exception was Lehman. The rest were all taken care of despite funding really bad bets.

My full story is here. In that essay I point out that Fannie and Freddie’s forays into low down payment loans were not a secret. The public didn’t know the full extent. But the public (including China) that was buying bonds of Fannie and Freddie seemed oblivious to the ever worsening state of Fannie and Freddie’s portfolio. This persisted into 2008 even after Fannie and Freddie went nuts with low down payment loans in 2007. Unlike the claims of the SEC suit, this was public information. Those who financed Fannie and Freddie’s bad bets, by buying their bonds, seemed not to care. It would be tempting to call those bond purchasers reckless, myopic and overconfident. But of course they turned out to be smart. They were buying assets that ended up being as risk-free as Treasuries but that paid a higher rate of interest.


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