Fannie and Freddie and the financial crisisFebruary 11, 2010Jon Brooks Comments Off
Two narratives seem to be forming to describe the underlying causes of the financial crisis. One, as outlined in a New York Times front-page story on Sunday, December 21, is that President Bush excessively promoted growth in home ownership without sufficiently regulating the banks and other mortgage lenders that made the bad loans. The result was a banking system suffused with junk mortgages, the continuing losses on which are dragging down the banks and the economy. The other narrative is that government policy over many years–particularly the use of the Community Reinvestment Act and Fannie Mae and Freddie Mac to distort the housing credit system– underlies the current crisis. The stakes in the competing narratives are high. The diagnosis determines the prescription. If the Times diagnosis prevails, the prescription is more regulation of the financial system; if instead government policy is to blame, the prescription is to terminate those government policies that distort mortgage lending.
Wallison argues for narrative #2: Fannie/Freddie causation.
There really isn’t any question of which approach is factually correct: right on the front page of the Times edition of December 21 is a chart that shows the growth of home ownership in the United States since 1990. In 1993 it was 63 percent; by the end of the Clinton administration it was 68 percent. The growth in the Bush administration was about 1 percent. The Times itself reported in 1999 that Fannie Mae and Freddie Mac were under pressure from the Clinton administration to increase lending to minorities and low-income home buyers–a policy that necessarily entailed higher risks. Can there really be a question, other than in the fevered imagination of the Times, where the push to reduce lending standards and boost home ownership came from?
The fact is that neither political party, and no administration, is blameless; the honest answer, as outlined below, is that government policy over many years caused this problem. The regulators, in both the Clinton and Bush administrations, were the enforcers of the reduced lending standards that were essential to the growth in home ownership and the housing bubble.
Last week, Barry Ritholtz, on his financial blog The Big Picture, debunked this notion, citing three main causes outside Fannie/Freddie: extremely low mortgage rates; unregulated subprime lenders, and ratings agency fraud.
He also wrote that blaming the Government-sponsored enterprise (or GSE) Fannie is a smokescreen:
The usual crowd of ne’er-do-wells are seeking to divert attention from their own roles in the crisis, and shift blame elsewhere. These people make up a big chunk of the Its All Fannie’s Fault! crew. By muddying the waters, they hope to avoid retribution for their own roles in what occurred. As the mid-term election approaches, we should expect to hear more from this crowd.
The reality of crisis causation is far more complex and nuanced. Looking at the many factors that independently contributed to the collapse, and prioritizing them by degree of causation is not easy. A sophisticated approach is required to separate the prime and secondary factors…
Whenever someone asserts as a cause an event or force relative to a particular outcome, you should always ask: “Is this a “BUT FOR cause of that outcome?” In terms of a specific result or outcome, “But for” this factor, how would the outcome have changed? Would the result have been the same or different?
My top 3 list of crisis “BUT FORs” are:
1) Ultra low rates;
2) Unregulated, non bank, subprime lenders;
3) Ratings agencies slapping AAA on junk paper.
-If it wasn’t for ultra low rates, the housing boom would likely have been much more modest; further, bond managers would not have been scrambling for yield, and searching for alternative products to low yielding Treasuries;
-If it wasn’t for the sub-prime lenders, the credit bubble would not have inflated; further, millions of unqualified borrowers would not have been able to purchase homes they could not afford;
-If it wasn’t for the ratings agency fraud, the enormous market for this high yielding junk paper — mislabeled as AAA — would not have existed; further, the primary purchasers were firms that were only permitted to buy investment grade bonds. No A+ or better rating, no sale.
Hence, these factors are huge causative elements — BUT FOR them, there is no boom and bust, no crisis and collapse. Bond managers could not have owned all of these securitized sub-prime mortgages; the credit default swap market would have been much smaller, perhaps 1/10 its size; Sovereign wealth funds around the world could not have purchased all this bad paper; Iceland does not collapse. That is these are the big 3 — why I label them the prime cause of the crisis…
…when I do the same BUT FOR analysis on Fannie/Freddie, I get different results.
-Were they an accounting fraud run by weasels? Yes.
-Did they securitze mortgages? Yes, for decades.
-What about securitizing sub-prime mortgages? Primarily after late 2005. By then, the die had been cast.
So are Fannie & Freddie a “BUT FOR” ?
I don’t see how. Wall Street had been securitizing most of the sub-prime mortgages for years without the GSEs — Fannie and Freddie jumped in very late because they were losing market share. Their timing was perfect they started doing nonconforming mortgages just as the market peaked.
And if Fannie & Freddie didn’t exist, mortgage securitization would have happened anyway, the way it did in areas where their were no GSEs — securitized credit card receivables, auto loans, small biz loans, etc. took place without GSEs. I assume there would likely have been a private sector version for conforming loans, the way there was a private sector securitizing response to the demand for non-conforming (sub-prime) loans.
That’s how I end up saying they were not a prime cause of the crisis.
Of course, they certainly made things worse — but so did a lot of other entities. But the key question for the blame Fannie/Freddie crowd is “Would the crisis has happened without them?” The answer is yes — FRE/FNM were not BUT FORs, because all of this was happening anyway, prior to their participation in subprimes late 2005.
Arguments over who’s to blame for the biggest financial catastrophe, thus far, in our lifetime, should continue for many years…