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September 22, 2010

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"The Story That Would Have Been Spun"

Posted: 22 Sep 2010 02:42 AM PDT

Arin Dube wonders how an alternative world might have played in the press:

Counterfactual: Or a Story that would have been Spun, by Arindrajit Dube: Six weeks before the midterm elections, the Democratic Party is facing major losses in both the House and the Senate, and is looking increasingly likely to lose control of the House altogether.
What is behind this rapid change in fortunes from only two years ago, when the Democrats swept into power? Based on extensive interviews with sources in both parties, including anonymous sources within the White House, it appears that an over-reach by the Obama administration pursuing a progressive and populist platform may have played an important role. Instead of an incrementalist, business-friendly strategy, the administration went to the hilt with policies focused on a greater role of government in providing jobs and healthcare, and perhaps pre-maturely ended American military involvement in both Iraq and Afghanistan.
Sources both inside and outside the administration agree that the pursuit of a health care policy with a strong role of the federal government (a "public option") played a large role in solidifying the image of the administration as one that did not spend enough time courting moderate Republicans such as Senator Chuck Grassley. Had the administration not insisted on a strategy that fundamentally ended the control of the health insurance market by a handful of key companies, these sources say that a bipartisan compromise on universal healthcare would most certainly have been reached.
The pursuit of a second stimulus in late 2009 measuring $700 billion dollars was likely the second reason behind the quick turnaround in public opinion. While economists largely credit the second stimulus for lowering the unemployment rate to below 7% through a focus on aid to states and direct hiring initiatives, the political reality remains that there is increasing concern about burgeoning government debt. Although interest rates on treasury bills have not risen – yet – experts we spoke with worry about a sudden increase in such rates at any time. A more measured approach which let the structural problems arising from the bubble sort themselves out though the private market may have not lowered the unemployment rate at the short term. However, politically, our sources say, such an approach would have demonstrated a hard-headed approach that eschews populism, and would have calmed both the markets and an increasingly nervous electorate worried about countercyclical deficit financing.
Finally, while the administration's economic advisors successfully pushed for a stringent and punishing regulatory policy with respect to the financial sector, some insiders grumble about the early decision by this administration to not recruit more palatable figures such as Timothy Geithner and Lawrence Summers. Lacking the "soft touch" approach championed by Clinoton-era protégé's of Robert Rubin, the brash economic team under Obama moved quickly to cap bank size, impose draconian capital reserve requirements, re-instate Glass-Steagall, and strong-arm Congress to impose stringent limits on financial sector pay. While possibly creating a less risky financial market, it no doubt led to a flight of talent from the financial sector. Today, the financial sector's share of employment is back closer to the late 1980s, which some believe is a cause for concern as financial innovations are unnecessarily stymied through regulatory pressure.
As a result of these and other factors, today's electorate is taking a hard look at the Democratic Party and its brand of economic policies. Looking back with the advantage of hindsight, perhaps the Democratic Party leaders will decide that pursuing a less populist and redistributive strategy would have secured it a lock on both the Congress and the Presidency for generations to come. And that it was the focus on reducing unemployment and providing affordable healthcare – at the cost of securing bipartisan agreements – that lay the foundations for a resurgent Republican party.

There's another possibility. If Obama had fought harder for some of these things, he probably wouldn't have made much more progress than he did -- perhaps a little, but not much. But the battle would have been worth having as a means of signaling to the base that the things they care about are worth standing up for, and for painting the other side as obstructionists standing in the way of moving forward. I think there are alternative histories where the administration is more combative and less devoted to bipartisanship that would have turned out much better than the reality we are seeing today. But the Obama I want isn't the Obama I have.

An Oversight on Oversight: The Federal Home Loan Bank

Posted: 22 Sep 2010 02:34 AM PDT

I am not as familiar with these banks as I should be. What else should I know about them?:

An oversight on oversight: The Federal Home Loan Bank, by Mark Cassell and Susan Hoffmann: Debate over financial regulatory reform has been far-reaching (see Brunnermeier et al. 2009 and Wyplosz 2009). Yet one set of institutions has gone largely unnoticed: the Federal Home Loan Bank (FHLBank) system, a government sponsored enterprise composed of 12 regional bankers' banks that has been at the centre of sustainable home ownership finance in the US since 1932 .
The lack of attention by lawmakers is not entirely a surprise. The Federal Reserve has long overshadowed the FHLBank system. Moreover, FHLBank leaders and supporters may well prefer flying under the Congressional radar to wait out the present financial storm. Regardless of the reason, we show in our recent book Mission Expansion in the Federal Home Loan Bank System (Cassell and Hoffmann 2010) that by neglecting the FHLBank system, lawmakers miss a chance to tap the most important source of housing finance expertise in the federal government. In addition, we lose an opportunity to reform the FHLBank system, which, while not at the centre of the current foreclosure and financial crisis, was certainly a player.
Tap the FHLBank system's housing finance expertise
Responding to the home mortgage foreclosure crisis of the Great Depression era, President Herbert Hoover spearheaded construction of a national system of Home Loan Banks. Modelled on the Federal Reserve, the FHLBank system's size and implied government guarantee enables Home Loan Banks to raise money collectively and cheaply in the capital markets and make wholesale loans – termed 'advances'– to member institutions, primarily for homeownership lending. Thus, for 78 years the FHLBank system has been the primary source of housing finance expertise in the US. Lawmakers should take advantage of such expertise in two ways.
First, Congress and the administration should recognise that the FHLBank system has demonstrated administrative capacity to understand and oversee the range of functions necessary for responsible, sustainable home ownership finance including regulating mortgage structure, supervising mortgage origination, and licensing mortgage bankers. Consumer protection in housing finance should be placed with the FHLBank system's regulator, the Federal Housing Finance Agency, and not with the Federal Reserve or the proposed Consumer Financial Protection Agency.
Second, federal policies to minimise the societal harm from foreclosures, including the Home Affordable Foreclosure Alternatives Program, should be placed in the FHLBank system, the agency whose primary mission for the past seven decades has been housing finance. At present foreclosure policies are housed mainly in the Department of Treasury, an agency with relatively little housing finance expertise.
The FHLBank system requires reforms
While it is an important resource that should be tapped, the FHLBank system also requires reform. IndyMac Bank and Countrywide Bank, two of our most notorious dealers of toxic loans, were both enabled by the cheap liquidity they received from the FHLBanks of San Francisco and Atlanta, respectively. A recent report by the Federal Housing Finance Agency found that in 2008, a fifth of the collateral used to secure advances from the FHLBanks were either non-traditional, subprime or Alt-A loans. The FHLBank system has taken important internal steps to tighten its lending and underwriting standards. Despite this, we suggest three major institutional reforms are also needed.
First, a cap should be placed on the size of depository institutions eligible for FHLBank system membership. There are approximately 8,000 members of the FHLBank system, most are small- and medium-sized commercial banks and savings and loan associations serving all regions of the country. Yet four institutions - Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo – control 31% of the stock in the Federal Home Loan Bank system. Enabling such large institutions to grow even larger through access to cheap liquidity is unnecessary and destabilising. These private institutions are large enough to raise capital on their own without the support of the federal government and taxpayers.
Second, lawmakers should refocus the FHLBank system's attention on its public purpose by making the system more like the Federal Reserve Banks and less like Fannie Mae and Freddie Mac. While FHLBanks' boards of directors would have discretion regarding the dividend they pay to member institutions, Federal Reserve Banks would pay members a dividend that is fixed in statute. Federal Reserve system earnings, after covering the system's costs of operation, would be turned over to the Treasury. Such a reform would not guarantee that Federal Home Loan Banks stays on mission, but it would relieve pressure on FHLBank managers to make policy decisions intended to maximise dividends potentially at the expense of taxpayers.
Edward DeMarco, acting director of the Federal Housing Finance Agency, recently criticised FHLBanks' risky investments and called on them to return to their core mission of providing advances for home mortgage lending. Capping dividends is one step to achieving that goal.
Finally, again in keeping with the Federal Reserve model, Congress should eliminate fixed assessments on FHLBanks. Currently, FHLBanks are obligated to make an annual payment to cover the Savings and Loan bailout of the 1980s and a 10% assessment to fund affordable housing programmes. As a practical matter, the S&L obligation is almost paid off and should be wound down as planned, but we recommend eliminating the obligation for affordable housing. Let FHLBanks make decisions based on the need for housing finance in the economy, the viability of member institutions, best practices in home mortgage structure, and the institutional stability of the FHLBanks – not on an imperative to make money. Let earnings after the cost of operations revert to the Treasury or be restricted for housing and community development needs. The latter option is likely to result in more, not fewer, funds for affordable housing and community development.
Comparisons between the present financial crisis and the Great Depression are often overstated. Yet, the public institutions that helped solve the financial crises of the 1930s offer a resource to lawmakers today, albeit with some needed adjustments. As reforms to America's financial regulatory structure are finalised, elected officials should finally take note of the FHLBank system, America's greatest resource in housing finance.

Figure 1. FHLBank System Assets, 1989-2007 (Dollar amounts in billions)

Cassell, Mark K and Susan M Hoffmann (2010), Mission Expansion in the Federal Home Loan Bank System, SUNY press.
Brunnermeier, Markus K, Andrew Crockett, Charles A Goodhart, Avinash Persaud, Hyun Song Shin (2009), The Fundamental Principles of Financial Regulation, CEPR Geneva Reports.
Snowden, Kenneth A (2010), "Is this your grandfather's mortgage crisis?",, 10 September.
Wyplosz, Charles (2009), "The ICMB-CEPR Geneva Report: "The Future of Financial Regulation",, 27 January.
1 A notable exception being this month's Vox column by Snowden (2010).

links for 2010-09-21

Posted: 21 Sep 2010 11:03 PM PDT

Summers Returning to Harvard at the End of the Year

Posted: 21 Sep 2010 05:13 PM PDT

As I'm sure you heard, Larry Summers, Director of the administration's National Economic Council, is returning to Harvard at the end of the year. From a political point of view, as far as I'm concerned, it's not a moment too soon. As I said in May of 2009:

One more note on Summers. I wasn't in favor of him when he was picked to be part of the administration because I thought he carried far too much political baggage. If he has value, it is not as a spokesperson for the administration. But again and again I heard that he was the only one smart enough to do this job. I don't believe that and never will, but if it's true, fine, put him in an office somewhere, let him be smart and helpful, but above all keep him out of the public eye. He does not help as a spokesman for the administration, he hurts the cause every time he opens his mouth.

The Fed Remains in “Wait and See” Mode

Posted: 21 Sep 2010 12:11 PM PDT

I have some comments on the Press Release from today's FOMC meeting at MoneyWatch:

The Fed Remains in "Wait and See" Mode

A New Marketing Campaign for Import Protection

Posted: 21 Sep 2010 11:07 AM PDT

A colleague, Bruce Blonigen, reacts to new measures "'focused on illegal import practices from non-market economies," and he explains why these new measures will harm US export competitiveness:

A New Marketing Campaign for Import Protection, by Bruce Blonigen: In a recent late August press announcement, U.S. Commerce Secretary Gary Locke announced "proposed measures – especially focused on illegal import practices from non-market economies - that will strengthen trade enforcement and help keep U.S companies competitive. These steps support President Obama's National Export Initiative (NEI), which aims to double exports in the next five years and support the creation of several million new jobs." (The link to the full announcement is here).
The press announcement ultimately details 14 proposed measures to "tighten" the U.S.'s enforcement of antidumping (AD) and countervailing duty (CVD) trade protection programs, which apply import duties on products where foreign firms are pricing their products "unfairly" low or foreign governments are subsidizing exports to the U.S.  Among other things, these measures will lead to investigation of more small foreign exporters, alter the methods by which Commerce calculates the size of the duties (presumably to apply larger AD and CVD duties), and "tightening the deadlines for submitting new factual information in AD/CVD cases."  God forbid that facts get in the way of these investigations!
As sad and petty as these new policies are, the scary part is how bold Commerce is to package these old-style import protection policies into the National Export Initiative to increase exports.  Let me briefly describe three ways in which these polices will unequivocally HARM U.S. export competitiveness. 
First, any general equilibrium trade model will show that limiting imports will also limit exports.  With the large trade imbalances we currently have, this point has less relevance for our current situation, but it is a warning about the long-run consequences of import protection and its connection to export competitiveness.
Second, and much more compelling for our current situation, is the real possibility of retaliation.  Work by myself and Chad Bown (see here), as well as other leading AD scholars (see here and here) have found significant patterns of retaliation in worldwide patterns of AD investigations.  So my advice to U.S. exporters is to get ready for much greater scrutiny and impediments in your foreign destinations in wake of these new Commerce AD/CVD policies. 
Third, most U.S. AD/CVD import investigations are on products that are essential inputs to a large segment of U.S. manufacturing industries, particularly steel and chemical products.  Greater import protection raises input prices for these downstream U.S. manufacturing industries, many of which are our engines of export growth.  Higher input prices lead to higher output prices and a loss of export competitiveness on the world stage for our U.S. manufacturing companies.
Of course, one hope is that these types of activities to "fine-tune" current AD/CVD policies will have minimal impact.  In prior work, however, I found that discretionary changes in methodology by Commerce were the major contributor of AD duties rising from an average of 15% in 1980 to an average of over 60% by 2000.  Hopes crushed!  It is clear that these new policies certainly have China in mind, with quite a few changes in methodology for non-market economies, a classification that often applies to Chinese firms subject to U.S. AD/CVD investigations.  However, many of these policies will clearly affect all import sources as well.
After the world recession took hold in 2009, many observers expected major back-sliding on trade liberalization, and they were relieved that the leading countries of the world did not resort to these tactics.  These recent policy changes by the U.S. should worry all of us that this may be changing.  No official statistics will reflect this, but with this announcement, the restrictiveness of U.S. trade policy just got measurably stricter.  Other countries will certainly take notice, and so the likelihood that other countries follow suit, especially in this period of economic uncertainty, is fairly high.  As a leader of the world economy, this is a dangerous precedent for the U.S. to set.

Fannie and Freddie Didn't Do It: One More Time with Gusto

Posted: 21 Sep 2010 10:25 AM PDT

Paul Krugman takes on the myth, yet again, that Fannie and Freddie caused the crisis:

Fannie Freddie Further, by Paul Krugman: OK, some readers want to know my answer to Rajan's defense on the FF issue. So, first of all, the first time I wrote about FF, I got something wrong — I was unaware of their late in the game rush into subprime.

But Rajan's other point, that securitization numbers — which show a much reduced role for FF at the height of the bubble — are misleading, is just wrong as a quantitative matter. Rajan makes much of the fact that the GSEs sometimes buy whole mortgages, rather than securitizing them. But as a quantitative matter, that's just not important.

Look at the flow of funds data on mortgage holdings (pdf). You'll see that securitization is the bulk of the story.

And let's do one more thing: let's look at changes in those mortgage holdings by the GSEs — securitized and not — and by asset-backed private pools. It looks like this:

Federal Reserve

During the peak of the housing bubble, Fannie and Freddie basically stopped providing net lending for home purchases, while private securitizers rushed in. Yes, very late in the game FF increased their share of subprime financing, as they tried to play catchup; but that's really off point.* The real question is, who was financing the bubble — and it wasn't GSEs.

Rajan asks why the government was boasting about how it was expanding low-income home ownership, if it really wasn't. Does that really require an answer? Governments always try to take credit for stuff, and remember than in 2004 subprime was considered a good thing.

Finally, why are we so hard on Rajan? Because the central theme of his book is that the financial crisis was caused by government efforts to help low-income families — which he treats as an established, undeniable fact. But it's by no means an established fact — on the contrary, most non-AEI analyses find government policy mainly innocent here. So his whole thesis is a structure built on foundations of sand.

*In fact, there's much too much emphasis on subprime. The problem was the housing bubble as a whole — including the bubbles in Europe.

I've written about this so many times that I just don't have the energy to write about it again, so I am going to repeat some past posts on this topic (there are more). The "I got something wrong" Krugman mentions is evident in the first post below as the graphs he uses stop at around 2005. The subsequent point about Fannie and Freddie playing catch up, i.e. that they were followers not leaders, is covered in the next post in my reply to Russ Roberts (I think I first heard this argument in an email conversation with Dean Baker, but I don't recall for sure). So the point that Fannie and Freddie followed the private market down the tubes in an attempt to preserve market share has been known since at least September 2008, i.e. for at least three years.

Here are the posts (there are even more posts noting that "It wasn't the CRA"):

July 16, 2008

"Did Fannie and Freddie Cause the Mortgage Crisis?": Jim Hamilton argues that Fannie and Freddie are partly to blame for "causing the underlying problem we face today":

Did Fannie and Freddie cause the mortgage crisis?, by Jim Hamilton: Some thoughts about the role played by the GSEs in the run-up in mortgage debt and house prices.

Paul Krugman ably lays out the case for why it's conceivable that Fannie and Freddie could have made a contribution...

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. The fraction of outstanding home mortgage debt that was either held or guaranteed by the GSEs (known as their "total book of business") rose from 6% in 1971 to 51% in 2003. Book of business relative to annual GDP went from 1.6% to 33%.


Sum of retained mortgage portfolio and mortgage backed securities outstanding for Fannie and Freddie (from OFHEO 2008 Report to Congress) divided by (1) total 1- to 4-family home mortgage debt outstanding (from Census for 1971-2003 and FRB for 2004-2007) and (2) annual nominal GDP.

The fact that the volume of mortgages held outright or guaranteed by Fannie or Freddie grew so much faster than either total mortgages or GDP over this period would seem to establish a prima facie case that the enterprises contributed to the phenomenal growth of mortgage debt over this period. Krugman nevertheless concludes that the GSEs aren't responsible for our current mess. ...

For my part, I have two questions for those who take the position that the GSEs played no significant role in causing our current mortgage problems. First, what economic justification is there for the dramatic increase in the share of loans guaranteed or held by the GSEs between 1980 and 2003 that is seen in the first graph presented above? What sense did it make to increase the ratio of such loans to GDP by a factor of 12 over this period?

Second, what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

Is that the answer to the second question? I'm not sure. But if anybody has a better answer, I'd still like to hear it.

In the mean time, I very much agree with Krugman that the most egregious problems were not caused by anything Fannie or Freddie themselves did. But I disagree that their actions played no role in causing the underlying problem we face today.

Justin Fox has a nice summary of some of the main events in the 1980s and 1990s in terms of mortgage share:

Fannie Mae started life in 1938 as a government agency, the Federal National Mortgage Association, and was privatized in 1968. Congress created Freddie — the Federal Home Loan Mortgage Corp. — in 1970 to give it some competition. For years the two companies operated on the fringes of the mortgage market, which was dominated by savings & loan companies. But after the S&L collapse of the 1980s, Fannie and Freddie swept in to take over. The widespread assumption that government would step in if they faltered allowed them to borrow money at only slightly higher rates than the U.S. Treasury, which meant they could outbid all competitors in the secondary mortgage market. Before long 60% of all mortgages made in the U.S. were passing through their hands, and their share would have been even higher if they weren't banned from buying loans above a certain size ($417,000 in 2007) and generally required to stay away from exotic loans and borrowers with poor credit. For a time in the mid-1990s, before the wave of bank megamergers that brought us the likes of Citigroup and J.P. Morgan Chase, Fannie Mae was the biggest financial institution, by assets, in the country.

Fannie and Freddie did get lots of flak, mostly from people on the political right, for taking risks for which taxpayers might eventually have to foot the bill (and, from other quarters, for its top executives' outsized pay packages). Both companies also got tangled in accounting scandals in 2003 and 2004. But more shocking was what followed from 2004 through 2006: The two mortgage giants got muscled aside by Wall Street firms willing to underwrite bigger, riskier mortgages than Fannie and Freddie were allowed to touch. Their joint market share fell to only about 25% in 2006.

In other words, Fannie and Freddie were mostly bystanders to the worst excesses of the housing bubble. Since it popped, they and the more explicitly government-backed team of the Federal Housing Administration and Ginnie Mae (which buys FHA-insured loans) have been crucial to keeping the mortgage and housing markets going. In January, Congress raised Fannie's and Freddie's loan limit temporarily to as much as $729,750 to aid struggling high-priced housing markets on the coasts.

With house prices falling in most of the country, though, even the relatively safe loans acquired by Fannie and Freddie are starting to turn sour at much higher-than-expected rates.

Update: Paul Krugman:

Why Fannie and Freddie got so big, by Paul Krugman:...Jim Hamilton asks why Fannie and Freddie grew so much in the years before the surge in subprime lending. Justin Fox had already suggested that Fannie/Freddie were taking the place of the savings and loans, after the crisis of the 1980s. Well, if I'm reading this data (xls) right, that's pretty much the whole story. This graph shows the share of savings institutions and "agency and government-sponsored enterprises-backed mortgage pools" in total mortgage holdings:

The big switch

Now here's the thing: S&Ls are private, profit-making institutions whose debt (in the form of deposits) is guaranteed by the federal government. Fannie and Freddie are private, profit-making institutions whose debt is implicitly guaranteed by the federal government. It's not clear to me that the switch shown here led to any net socialization of risk.

The S&L story, of course, ended in catastrophe, because deregulation led to an explosion of bad lending. That didn't happen with Fannie and Freddie, at least not to anything like the same extent.

What did happen was an explosion of risky lending by other parties, which crowded out the GSEs; you can see that at the end of the figure (which runs up to 2006). So I stand by my view that Fannie and Freddie aren't the big story in this crisis.

Here's another graph with a bit more detail from the post from last year Jim Hamilton references above. Note the spike in asset backed securities at the end that matches the decline in lending from GSEs:


Sept 25, 2008

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:


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.

[Update: Follow-up argument: Barry Ritholtz: Fannie Mae and the Financial Crisis, What Caused the Financial Crisis?. For a recent academic paper at odds with the claim, see: It Wasn't Fannie and Freddie.]

October 1, 2008

It Wasn't Fannie and Freddie

More evidence:

Coleman, Lacour-Little and Vandell argue that house prices made sense until 2004, by Richard Green: The abstract of their new paper:

The cause of the "housing bubble" associated with the sharp rise and then drop in home prices over the period 1998-2008 has been the focus of significant policy and research attention. The dramatic increase in subprime lending during this period has been broadly blamed for these market dynamics. In this paper we empirically investigate the validity of this hypothesis vs. several other alternative explanations. A model of house price dynamics over the period 1998-2006 is specified and estimated using a cross-sectional time-series data base across 20 metropolitan areas over the period 1998-2006. Results suggest that prior to early 2004, economic fundamentals provide the primary explanation for house price dynamics. Subprime credit activity does not seem to have had much impact on subsequent house price returns at any time during the observation period, although there is strong evidence of a price-boosting effect by investor loans. However, we do find strong evidence that a credit regime shift took place in late 2003, as the GSE's were displaced in the market by private issuers of new mortgage products. Market fundamentals became insignificant in affecting house price returns, and the price-momentum conditions characteristic of a "bubble" were created. Thus, rather than causing the run-up in house prices, the subprime market may well have been a joint product, along with house price increases, (i.e., the "tail") of the changing institutional, political, and regulatory environment characteristic of the period after late 2003 (the "dog").

This result is hardly consistent with the charge that the GSEs were the principal source of the problem. It also says something about having a purely private mortgage market.

This McClatchy article was one of the first media publications to put it all together:

October 11, 2008

Sometimes We Do have a Better Press Corps (Another McClatchy News Edition): It wasn't Fannie and Freddie, and it wasn't the CRA:

Private sector loans, not Fannie or Freddie, triggered crisis, by David Goldstein and Kevin G. Hall, McClatchy Newspapers: As the economy worsens and Election Day approaches, a conservative campaign that blames the global financial crisis on a government push to make housing more affordable to lower-class Americans has taken off on talk radio and e-mail.

Commentators say that's what triggered the stock market meltdown and the freeze on credit. They've specifically targeted the mortgage finance giants Fannie Mae and Freddie Mac, which the federal government seized on Sept. 6, contending that lending to poor and minority Americans caused Fannie's and Freddie's financial problems.

Federal housing data reveal that the charges aren't true, and that the private sector, not the government or government-backed companies, was behind the soaring subprime lending at the core of the crisis. [...continue reading...]

February 3, 2010

Did Fannie-Mae Cause the Financial Crisis?: When discussing regulatory reform of the financial sector, I have emphasized the need to separate the factors that caused the crisis from those that magnified the effects of the crisis once it began. For example, I think of regulatory failures as part of the causes of the crisis. But factors such as high leverage ratios, while not causative, had the effect of substantially magnifying the effects of the financial sector shock once it hit.

I am not sure we can ever plug all the holes in the system and ensure that another crisis never happens, there are many, many ways to cause a crisis, some of which have not been dreamed up yet by imaginative financial engineers. We should still try, of course, and prevent what we can. But we also need to make sure that the effects of the next financial crisis are as muted as can be, and that requires regulation on the magnifying factors such as leverage.

Barry Ritholtz uses a similar distinction to sort the causes of the crisis (the "but fors") from the magnifiers (exacerbators in his terms), and uses this to ask whether Fannie-Mae is a primary casual factor, or whether its role was limited to contributing to the severity of the crisis once it began:

Causation Analysis: What "But Fors" Caused the Crisis?, by Barry Ritholtz: They're back!

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.

Rather, than just repeat my list of factors what were the causal factors, today I want to try a different approach. Let's do a "Causation Analysis" of the biggest factors to see if we can determine not just the various elements that contributed to the credit collapse, but which factors actually caused it to occur and what merely exacerbated the collapse, making it worse.

Understand that this is a theoretical discussion based on counter-factuals — what is likely to have occurred if various elements leading up to the crisis were different. We are trying to discern the differences between primary and secondary factors, separating the causes from the exacerbators.

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.

Why are these "But Fors?" But for these things occurring, the crisis would not have happened..., there is no boom and bust, no crisis and collapse. ... That is these are the big 3 — why I label them the prime cause of the crisis.

There is a secondary list of things that might or might not be prime causal factors; at the very least, they made the crisis significantly worse:

1) The Commodity Futures Modernization Act of 2000
2) Net Cap Rule Change of 2004 (aka Bear Stearns exemption)
3) Repeal of Glass Steagall (1998)

...Here's the kicker — when I do the ... 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.

June 5, 2010

It Wasn't Fannie, Freddie, or the CRA: I've written the CRA and Fannie/Freddie rebuttals so many times over the last few years, e.g. see here and here, and it just came up here, that it seems repetitive to take it up yet again. But it doesn't seem to want to go away, so one more time, with gusto:

The Sarah Palinization of the financial crisis, by Edmund L. Andrews: Of all the canards that have been offered about the financial crisis, few are more repellant than the claim that the "real cause'' of the mortgage meltdown was blacks and Hispanics.
Oh, excuse me -- did I just accuse someone of racism? Sorry. Proponents of the above actually blame the crisis on "government policy'' to boost home-ownership among low-income families, who just happened to be disproportionately non-white and immigrant. Specifically, the Community Reinvestment Act "forced'' banks to make bad loans to irresponsible borrowers, while Fannie Mae and Freddie Mac provided the financial torque by purchasing billions worth of subprime paper.
The argument has been discredited time and again, shriveling up almost as soon as it's exposed to sunlight. But it keeps coming back, mainly because the anti-government narrative gives Republicans a way to deflect allegations that de-regulation allowed Wall Street to run wild. It's the financial version of Sarah Palin's new line that "extreme environmentalists" caused the BP oil spill. ...
But far more outrageous is this working paper, which Bruce Bartlett brought to my attention, published last month by no less an authority than the World Bank. What galls me ... is that the World Bank would cloak a piece of political drivel with fixings of a serious economic analysis. Written by David G. Tarr,... the paper says Wall Street and the banks were led by the government like lambs to the slaughter. ...
But none of the devil-made-me-do-it arguments is new, and none of them is true. The Federal Reserve analyzed the Community Reinvestment Act in 2008, and emphatically concluded that it had nothing to do with the explosion of hallucinogenic mortgage lending. ...
What makes this smear so repellent is that it blames poor people – mostly minorities – for bringing on the crisis. But what makes it so maddening is that it's so demonstrably false. We have reams of evidence that banks and mortgage lenders actively targeted blacks, Hispanics and other immigrant groups for reckless loans. The lenders weren't forced. They were making a fortune.
An almost equally unforgivable lie is that Fannie and Freddie caused the subprime meltdown. ... Fannie and Freddie weren't driving the market. They were scrambling to keep up with private mortgage securitizers.
As Krugman shows, Fannie and Freddie were largely sidelined during the heyday of the subprime market, partly because they were doing penance for their prior accounting scandals. Fannie and Freddie's market share in securitizations slumped from 2004 until 2007. By contrast, the market share of private issuers soared. ... Fannie and Freddie ... pushing their private sector rivals to roll the dice. They were late to the craps table and desperately trying to make up for lost time.

Aug 27, 2010

An Autopsy of Fannie Mae and Freddie Mac: The arguments below concerning Fannie and Freddie's role in the crisis have been made many times here over the last several years, see the second link at the end, but it's worth a reminder given the concerted attempt by anti-government types to make people think that Fannie and Freddie played a large role in causing the crisis. They didn't. That's not to say that Fannie and Freddie are defensible in their present form, see this discussion for example, or this from Dean Baker. But placing the blame for the crisis in the wrong places will lead to ineffective and potentially counterproductive attempts to prevent this from happening again:

An Autopsy of Fannie Mae and Freddie Mac, by Binyamin Applebaum, NY Times: Here's a last-minute option for summer reading material: An autopsy on Fannie Mae and Freddie Mac by their overseer, the Federal Housing Finance Agency.
The report aims to inform the continuing debate in Washington about the future of the government's role in housing finance. ... And it does a good job of making a few key points:
1. Fannie and Freddie did not cause the housing bubble. In fact, you can think of the bubble as all the money that poured into the housing market on top of their regular and continuing contributions. There's a good chart on Page 4 of the report illustrating this...
The market share of the two government-sponsored companies plunged after 2003, and did not recover until 2008. In 2006, at the peak of the mania, the companies subsidized only one-third of the mortgage market.
2. This was not for a lack of trying. The companies bought and guaranteed bad loans with reckless abandon. Their underwriting standards jumped off the same cliff as every other participant in the mortgage market.
3. Importantly, the companies' losses are mostly in their core business of guaranteeing loans, not in their investment portfolios. The guarantee business is the reason the companies were created. ...

More here. And here.

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