Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Short answer: No.
Longer answer: Look at the chart, which comes from the Financial Crisis Inquiry Commission report, page 124.
In the years that the credit bubble was distending, Fannie and Freddie together never represented a majority of the demand for securities made up of "subprime" mortgages.
Nor did either of these two "GSEs" (government-sponsored enterprises) ever comprise a majority of the demand for "Alt-A" mortgage securities -- often, investments backed by mortgages for people with good credit who still couldn't afford the house they were buying. (If I'm making $75,000 a year and have great credit, I can afford a house; I can't afford an $800,000 house. Hence, an Alt-A mortgage, complete with "teaser rate," etc. (If you are confused about these mortgages, go to your local library and ask for a lifestyle section from any newspaper circa 2005, with the obligatory feature about how you, too, can afford to live like millionaire, through the magic of no-down-payment, low-interest mortgages.)
Fannie and Freddie, in fact, struggled to keep up and compete with the other buyers who wanted to buy these supposedly risk-free, AAA-rated, mortgage-backed securities circa 2005 or so. All through the mid-2000s, European investors, in particular, couldn't get enough of these things. (I know this definitely; when I worked for Thomson (now ThomsonReuters), I talked to enough of 'em to get a feel for "market sentiment.")
It's important to make a distinction: Fannie and Freddie, like many others, acted negligently in not understanding what the heck they were buying, and they thus blew themselves up during the course of the crisis.
Furthermore, the twin mortgage giants' willful ignorance about what they were buying and disinterest in delving into the details of "safe" securities helped contributed to the bubble.
Moreover, Washington's lax attitude toward Fannie and Freddie's safety and soundness -- the firms held barely any actual cash back during the good years to absorb potential losses -- accelerated their downfall.
This laxity, though, was a symptom of the broader problem, not the problem itself. Washington and the financial industry thought that they could perfectly predict which kind of investments were safe and which weren't. They thought, too, that if they were wrong about these calibrations, together, armed with black cars and Blackberries, they could control any problems before they got out of hand.
A big firm (or two) can contribute to a bubble and bust, and magnify effects of a crash on the economy, without having caused it. Similarly, a big firm can fail (absent government support) in a crisis without having caused the crisis.
The now three-year-old fight over whether Fannie and Freddie were cause or effect, or somewhere in the middle, gets annoying, but it is important. If Fannie and Freddie caused the crisis, then you just get rid of them (this may still be a good idea, but that is irrelevant to this discussion).
If they didn't cause it, then you have to think about how to fix other things, including:
- a derivatives market that allowed financial-market participants to incur hundreds of billions of dollars in potential liabilities with no cash cushion for potential losses;
- synthetic securities that magnified the results of any one investment, including a mortgage-related-investment, going wrong, thus amplifying bubble mania and bust panic;
- a "repo" securities market that invites "runs" on the global financial system and attendant bailouts;
- dependence on ratings agencies' determinations of risk that encourages everyone to make the same mistake all at once;
- and other stuff, all detailed in the FCIC book, complete with case studies to illustrate the problems.
Fannie and Freddie are a problem, but not the problem.
Nicole Gelinas is contributing editor to the Manhattan Institute's City Journal and author of After The Fall.
- Comment (40)
- · Quote
- · UnfollowFollow (1)
- Pages:
- 1
- 2
- Pages:
- 1
- 2
Comments :
Jul '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Nicole, I was in the mortgage business at the peak of the bubble. Though Fannie Mae didn't buy all of our subprime and Alt-A mortgages (they competed with other buyers at weekly auction) all of our online mortgage approvals were processed through Fannie Mae's system. In other words, Fannie Mae set the criteria for mortgage approval.
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
I don't have any expertise here, Nicole, but Kenneth gets at something that--based on the little I know--feels right: Namely, the notion that Fannie and Freddie played a disproportionate roll in creating and sustaining the subprime market.
I'm not even sure how to state the question in a rigorous way, but let me take a stab at it: On the bar chart you reproduce, it looks as though Fannie and Freddie bought between a quarter and a third of the subprime mortgages during the boom years of 2003 through 2006. Might it be possible to argue that, because of their influence over the entire market through the approval process, because they were much, much bigger than any other purchasing entities, and because they seemed, however vaguely, to operate under government sanction--in view of all this, might it be possible to argue that, absent Fannie and Freddie, the market wouldn't have been, say, one third smaller, but only half as big?
I'm just groping here, but you see what I'm getting at. (I hope.)
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Your presence in the mortgage market represents the second piece of explaining you have to do, Kenneth. The first is to explain your new avatar.
Jul '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Peter Robinson
Your presence in the mortgage market represents the second piece of explaining you have to do, Kenneth. The first is to explain your new avatar. · Jan 29 at 6:41pm
The new avatar is my bull terrier, Fluffy, exchanging kisses with a little girl named Amanda. If Rob Long can put up a post about the dangers of sleeping with household pets as a lame excuse to show us a picture of his dog on the beach, why not me?
As for the mortgage biz, I was doing HR consulting for a few of the many burgeoning mortgage companies. When I saw how much money a mortgage broker could make, I said, "Hey, to heck with consulting, lemme in on this gravy train."
Jul '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Peter, the way it worked was that our mortgage brokers took all the applicants' information, keyed it into a software program and then transmitted it via internet to Fannie Mae. Within seconds, we had an approval - or not.
If the application met Fannie Mae's criteria, the mortgage could be sold to Fannie or any other willing buyer.
Of course, there were distinctions, based upon gradations of risk. My understanding at the time was that Fannie Mae was the buyer of last resort: if more risk-adverse buyers wouldn't buy a mortgage, Fannie Mae would be there to pick it up.
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Hi Kenneth -- Thanks.
But setting the criteria for a mortgage isn't the same as creating demand for a mortgage-backed security.
One of the biggest problems was that we had risky mortgages packed into supposedly risk-free AAA-rated securities. Then, on top, we had "collateralized debt obligations" (CDOs) -- that is, more supposedly riskless derivatives securities -- built out of those original mortgage-backed securities.
Many of the original mortgages could have faltered, and the economy could have withstood it (albeit with ripples). But the economy couldn't withstand the collapse of securities built on securities built on securities built on the mortgage themselves, all thanks to borrowed money. Plus, without the demand coming from those securities and their leverage, many of the original mortgages wouldn't have existed in the first place.
Continued below ...
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Yup, a big plurality buyer could set the tone for the market.
But ... the plot thickens. Managers of CDOs, who earned fees based on the dollar amount of the assets in the CDOs, themselves used borrowed money to push up demand for the underlying mortgage securities.
As James Grant wrote in 2006 (and as referenced by the FCIC report, p133), "Mortgage traders speak lovingly of 'the CDO bid'" -- that is, CDO managers who were bidding up the price of mortgage securities. "Without it, fewer asset-backed structures could be built."
Demand came from leverage throughout the system.
If everyone -- from the Florida homeowner to Fannie and Freddie to the managers of CDOs made up of more CDOs -- had had to put a significant, consistent percentage of cash down against losses, the thing would not have had the impact that it did.
That is one solution: consistent capital requirements, rather than leaving them up to regulatory discretion.
Jul '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Nicole Gelinas: Hi Kenneth -- Thanks.
But setting the criteria for a mortgage isn't the same as creating demand for a mortgage-backed security.
Nicole, I once asked one of the principals in our firm how it worked. He explained to me that our mortgages were auctioned off in bulk and then packaged into a security. Secondary buyers then bid on "tranches" of that security, based upon their appetite for risk. He likened it to a layer cake: the safest layers offered the lowest returns, the riskiest the highest returns.
The problem, to my limited understanding, is that many of those securities weren't actually sliced into tranches; buyers bought the whole cake and made mathematical assumptions that, though a certain small portion of the whole thing would go bad, they would profit on those which didn't.
However, when the crisis hit, the thing wasn't as much a layer cake as it was a raisin pudding. Since it was impossible to tell which raisins were toxic, the whole pudding had to be valued down to the most toxic raisin - in other words, zero.
Jan '11
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
I have a question, rather than an argument: There were reports of these packages working on 300-1 margins. No one "designed" a deal that works on a 300-1 margin. Are we ultimately discussing a human breakdown, or a design breakdown?
Jul '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
...
...
An excellent short assessment, at least to my non-expert eye. But to pull a piece off the middle, when these ratings agencies manage to slap an AAA rating on these bundled junk loans and everyone continues on pretending that these agencies know what they are doing for a living, a lot of private and public policies geared to apply ratings as if they were prudent assessments by sapient experts are waiting in queue to all fall down.
The problem is not just that we had this big, expensive wad of nothing that sank a bunch of investments. The problem is that a lot of the big, expensive wads of nothing may still be partying as if it were 2006. Has this ratings market been scrutinized and reformed. I am not a finance geek, so they could have slipped it in while I was enjoying a "Long View," but where are the House panels chewing these guys like burned oatmeal for their breakfast?
Inquiring minds want to know.
Edited on Jan 29, 2011 at 7:39pmMay '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Ah, might I suggest that the Fed done did it?
I think the credit crisis began as an excess supply of credit, which is something that only the Fed can perpetrate. A housing bubble doesn't require Fannie or Freddie, but it does require an expander of the supply of loanable funds. I believe the Fed is the elephant in the room and derivatives are the scapegoat.
Edited on Jan 29, 2011 at 7:44pmNov '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Hope DH doesn't mind that I've hijacked his post:
Elizabeth Dunn
Dan Holmes:
"Could free markets have sorted out the mess without extraordinary government action?" The housing crisis ... was caused by the financial institutions (Fanny & Freddie) socializing risk while privatizing profit. The bundling and selling of nearly worthless mortgages would not have happened with truly free markets, since there exists a huge risk of losing a lot of money in an authentic free market.
Excellent point. What are your thoughts about the Community Reinvestment Act, zealously enforced by the Clinton administration? · Jan 15 at 3:21am
The CRA represents a classic case of free-market distortion by the gov't, while proclaiming good intentions. It is the main cause of the housing crisis. It was begun under Carter, given milk teeth under Bush 41, and a full set of choppers under Clinton. It should be repealed.
It uses vague terms like "convenience and needs" and "meet the credit needs of the local community," and then explicitly delegates to the enforcement agencies the power to define these terms, all the while using the threat of denying applications to assure compliance with the agency-created definition.
Jul '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
By the way, it wasn't only subprime and Alt-A loans that went sour.
Many, many homeowners in the prime categories made stupid wagers, based upon their assumption that the value of their homes could only go one way - up.
We were offering 103% cash-out refinances. People could borrow more than the assessed value of their homes, with the re-financing fees rolled into the new loan, and take cash to spend on frivolities. I had customers who were on their 4th or 5th re-finance within two years.
At one point, I remember turning to another broker and asking, "When did every home become a million-dollar home? There simply aren't enough big earners to keep this game of musical chairs going."
From the ground level, it was obvious we were in a bubble. But the buyers of derivatives in, say, Germany or Hong Kong couldn't see what I saw.
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Yup -- I remember! :)
Some people who don't live in or near foreclosure-ville USA (AZ, CA, FL, NV) -- or have relatives who do -- tend to think that the crisis was rooted in government anti-poverty efforts, including affordable-housing goals.
But drive around empty or near-empty developments in FL, AZ, etc., and/or talk to the people left there, and it's easy enough to understand that they (and the economy) weren't the victims of some sort of left-wing social-justice experiment.
This ground floor of the bubble (forgive the mixed metaphor) was aspirational middle-class people, middle-class people, and upper-middle-class people. Gee, half of Westchester would be foreclosed if it weren't for the (continuing) bailouts and Bernanke's zero-percent rates.
General government affordable-housing policies may be a problem, too, but they were not, in the main, this problem.
Kenneth: By the way, it wasn't only subprime and Alt-A loans that went sour.
Many, many homeowners in the prime categories made stupid wagers, based upon their assumption that the value of their homes could only go one way - up.
We were offering 103% cash-out refinances.
Dec '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Doesn't matter if they created the market,
Sep '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Nicole,
To what extent do you think the new Basle financial regulations address this issue or do they at all?
ps I have to confess a certain purient interest as I do occasionally lurk on the Wilmott Finance site.
Dec '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Nicole Gelinas:
The derivatives were essentially insurance of debt. The major banks insured each other to share their debt risk. There is nothing wrong with this, unless you want to outlaw insurance of debt. Folks who are now buying insurance on their CC balances might not like that.
When the entire market went bust the banks forgave their mutual insurance liabilities. If I owe you $200 billion because I insured your debt and you owe me $200 billion for the same reason, we call it even.
AIG was an odd man out. They were an insurance company, not a bank. They couldn't offset a large portion of their insurance liabilities the same way the banks could.
Edited on Jan 29, 2011 at 8:32pmJul '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Nicole Gelinas:
General government affordable-housing policies may be a problem, too, but they were not, in the main, this problem.
Kenneth: By the way, it wasn't only subprime and Alt-A loans that went sour.
Many, many homeowners in the prime categories made stupid wagers, based upon their assumption that the value of their homes could only go one way - up.
We were offering 103% cash-out refinances.
Edited on Jan 29 at 08:18 pm
Jan 29 at 8:17pm
Well, Nicole, I have to respectfully disagree. It was Fannie and Freddie's discarding of the 20% down-payment requirement that precipitated the debacle. 95% of the people I dealt with could not have gotten a mortgage under the old standard. But with Fannie and Freddie standing by to purchase mortgages at 103% of assessed value, the party was on.
CDO's simply put the whole thing on steroids. And credit default swaps put it on super-steroids.
Edited on Jan 29, 2011 at 8:36pmDec '10
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Kenneth: Peter, the way it worked was that our mortgage brokers took all the applicants' information, keyed it into a software program and then transmitted it via internet to Fannie Mae. Within seconds, we had an approval - or not.
If the application met Fannie Mae's criteria, the mortgage could be sold to Fannie or any other willing buyer.
... My understanding at the time was that Fannie Mae was the buyer of last resort: if more risk-adverse buyers wouldn't buy a mortgage, Fannie Mae would be there to pick it up.
This is my understanding as well.
Most lenders would not have lent the money to people who likely could not pay it back if they could not pawn the bad debt off on someone else, like F&F.
I'm sure many of the original lenders knew they were making bad loans. But, hey, if F&F will take it off their hands, why not do it and make some money?
F&F created the market. The federal government encouraged it. The Fed provided the money to fund it. Everyone else behaved as Adam Smith would have predicted.
Jan '11
Re: Saturday Night Special: Did Fannie and Freddie cause the credit crisis?
Nickolas
The derivatives were essentially insurance of debt. The major banks insured each other to share their debt risk. There is nothing wrong with this, unless you want to outlaw insurance of debt. Folks who are now buying insurance on their CC balances might not like that.
...
AIG was an odd man out. They were an insurance company, not a bank. They couldn't offset a large portion of their insurance liabilities the same way the banks could. · Jan 29 at 8:30pm
Edited on Jan 29 at 08:32 pm
The interesting part about the credit default swaps was that multiple parties could take out CDS's on the same instrument. This added to the leveraging problem that was central to the whole mess. What happened to AIG was Goldman took out a bunch of CDS on AIG on a bunch of assets that were about to go broke, while simultaneously shorting AIG stock. The instruments defaulted, the CDS's kicked in, AIG couldn't pay up on all the accounts, and Goldman made out like a bandit.
The movie Inside Job tackled this part of the crisis well.