Under Development - My OEP On Fannie Mae And The Financial Collapse

So what is my Official Editorial Position on the role played by Fannie Mae in fueling the housing bubble and the resulting financial collapse?  Good question - I really ought to have one, and I am having a hard time swallowing the straight Republican line put out by the Republicans on the panel investigating this.

I am confident that the largest players in the US mortgage market played a role in distorting that market.  However, the numbers don't tell that story very convincingly - the conservator's report on Fannie and Freddie from 2010 showed them losing market share during the housing boom. Left unmentioned by even astute observers - Fannie Mae was hamstrung by an accounting scandal and was battling the Bush Administration.  However, per CNN the market had passed them by:

Another question that has been lost in the political wrangling is whether Fannie's business has changed permanently for the worse. Over the past 18 months the growth in Fannie Mae's portfolio has slowed sharply because of competition from banks and hedge funds, which are financing their mortgage purchases with cheap, short-term debt (a technique known as the carry trade). Back in 2002 the spread between the yield of Fannie's mortgage portfolio and its long-term liabilities was 63 basis points. In the second quarter of 2004 it had fallen to two basis points. To keep profits up, it looks like Fannie, which has disparaged the carry trade as too risky, may now be using the strategy itself, which would make it more vulnerable to rising interest rates. 

Gary Gorton of Yale has the must-read on how that repo trade worked out [another version here].

And the Republican arguments can become hazy here.  For examples, buyers may have proceeded with confidence in 2005, firm in the belief that Fannie would be back to bail them out in 2006. Even more importantly, not every bubble ends in a financial panic - for example, the tech collapse of 2000/2001 did not threaten to take down the banking system.  So even if Fannie helped inflate the housing bubble, should they be blamed for the panic?

Well.  This is a weekend for Christmas shopping.  Joe Nocera of the Times tackles the Republican report and vexes me with this:

The Republican document issued earlier this week did little more than regurgitate this theory of the case. “Subsidizing mortgages through the G.S.E.’s was a particularly expedient way to increase the homeownership rate,” they write at one point. At the same time, they tread lightly over the culpability of other nongovernmental culprits like the credit ratings agencies and Wall Street itself.

The only problem with Mr. Wallison’s theory is that it’s not, as they say, reality-based. Anyone who has looked at the role of Fannie and Freddie will discover they spent most of the housing bubble avoiding subprime loans, because those loans didn’t meet their underwriting standards. (Indeed, for most of their existence, Fannie and Freddie didn’t so much meet their affordable housing goals as gamed them.)

Well, Fannie and Freddie couldn't underwrite subprime loans, so they bught them for their own investment accounts from others, and scored that as providing affordable housing.  The WaPo has a chart from HUD (I think...) showing Fannie and Freddie buying 49% of the securities backed by subprime mortgages in 2003, 44% in 2004, 33% in 200, and 20% in 2006.  (In 2006 the dollar amount was $90 billion).  Even with declining market share, they were huge players.

On the other hand, the conservator reports don't show them with huge losses from their investment activity, despite holding a $700 billion portfolio of mortgages (all qualities, presumably).  I presume I am missing something.

LOVE THESE TYPOS: An earlier version (and possibly this one, too) had discussion of the baking system and the hosing bubble.  And I got no help from Spellchek, that uncertain ally.

IN BRIEF:  My current leaning is that Fannie and Freddie contributed to the general moral hazard promoted by the Fed - a never heard of 'em hedge fund (Long Term Capital) was too big to fail back in 1998, Bear Stearns was too big to fail in early 2008, and surely the housing market was too big to fail and would be propped up by Fannie, Freddie and the Fed.  Also important were the Basel capital requirements which gave banks around the world a special break on mortgage backed securities.

Easy money leaving investors scratching for yield, a regulatory structure encouraging banks to hold housing securities, huge government sponsored entities promising to buy anything in sight to keep the housing market humming - what could go wrong?

Comments

[Pagar]

"The Obama administration has been pushing for banks and investors to cut mortgage balances for homeowners who owe more than their home is worth. But the regulator for the biggest investors of them all — the government-controlled Fannie Mae and Freddie Mac — won’t let the two do it."
Fannie and Freddie opposes reducing mortgages for struggling homeowners.

Total confusion in government policy!

[Cecil Turner]

Okay, I have to retract that SWAG on FM/FM securitization levels above. The assumption was that the originations and MBS issuance were somewhat congruent by type, which appears unwarranted. In fact, I'm seeing claims that 75% of sub-primes were securitized, as opposed to what looks like less than 10% of total originations, so they are totally unrelated, and it looks like the Enterprises can only be responsible for a small fraction of the total.

A question for the experts out there. Does anyone know what percentage of the total subprime market was securitized by Fannie Mae and Freddie Mac? Or even if it's possible to estimate it?

[Cecil Turner]

Never mind, I found a good estimate:

Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication.

Contrary to the thrust of the article, that still leaves the Enterprises as the biggest single players, but they're clearly not holding anything like a majority of the toxic assets.

[RichatUF]

Cecil-

With Fannie and Freddie securitizing sub-prime loans, they were giving them a US government guarantee and private lable players could then bootstrap off of the AAA Fannie and Freddie paper.

Add in the mathematical tailsmans and computer totems and BOOM!

[Cecil Turner]

I think it's obvious they started a trend and others jumped in. The question appears to be what portion of the blame properly lies with Fannie and Freddie, and what part goes to those who leaped later. I can't see any way to give F/F less than half of it, but neither do they appear to be (effectively) wholly responsible as I once thought.

[boris]

"they started a trend"

ISTM they also established a false value floor with expected guv backing that was all too real.

[anduril]

The question appears to be what portion of the blame properly lies with Fannie and Freddie,

Cecil, I think that's Ritholtz's point:

The Gang-o-four [GOPers] absolves Wall Street and the banks, blames the government — for everything — and ignores the data that conclusively demonstrate otherwise.

It's a shortish blog, he's trying to make a point of the lack of balance in the report, and he has a book that goes into it in more detail. I haven't read the book, but his claim is that in it

I blamed Republicans, I blamed Democrats, I blamed the Federal Reserve, Congress, the ratings agencies, mortgage originators and lending banks, the biggest Wall Street firms, the SEC. I blamed US borrowers and home buyers, the RE agents, the mortgage brokers, and appraiser. I blamed the other end of the sausage factory, the collateralized debt obligation (CDO) underwriters, managers and the funds that bought them. I blamed Greenspan & Gramm, Bush & Clinton, Paulson & Bernanke & Rubin & Summers. Even mutual funds, compensation consultants and crony corporate board members come in for criticism. (This is only a partial list).

I think that's a pretty fair list of players who have earned varying degrees of blame, and I think it's fair for Ritholtz to challenge the GOPer report for not being either more even handed or more comprehensive, however you wish to characterize it. I see that you appear to be in substantial agreement with TM's major point and I think Ritholtz feeds into that.

[anduril]

Mel, I'll keep that in mind. I leafed through parts of the book at a B&N on our morning walk. They touch on some of the same or similar points that were mentioned in that longish economics paste job I did yesterday.

The point re China--I wish I could remember where I saw this but I know I read that the linkage with China that's been talked about so much was part of a conscious decision that it would be a good thing for the US economy to hold wages down. Contrary to the way that sounds, as I recall my source was neither lefty nor neo-mercantalist: it was a matter of fact description. The policy makers--GOPers and Dems alike--had what they thought were legit concerns and thought this would be a good way to address those concerns. Keep wages from increasing much, but compensate with cheap imported consumer goods, was the idea, if I recall correctly.

[anduril]

This isn't where I read it, but it's a good read from a piece by Niall Ferguson: What’s to Become of "Chimerica"?

Here's a longish excerpt that summarizes the nature of the beast. It also leads me to pose the question again re the "independence" of the Fed--what role did the Fed play in this? Anyway:

For a time, it was a symbiotic relationship that seemed like a marriage made in heaven. Put simply, one half did the saving, the other half the spending. Comparing net national savings as a proportion of gross national income, American savings declined from above 5 percent in the mid 1990s to virtually zero by 2005, while Chinese savings surged from below 30 percent to nearly 45 percent. This divergence in saving patterns allowed a tremendous explosion of debt in the United States, for one effect of the Asian "savings glut" was to make it much cheaper for households to borrow money than would otherwise have been the case. Meanwhile, low-cost Chinese labor helped hold down inflation.

The crucial mechanism that bound the two halves of Chimerica together was currency intervention. To keep the renminbi (and hence Chinese exports) competitive, authorities in Beijing consistently intervened to halt the appreciation of their own currency against the dollar. The result was a vast accumulation of dollar-denominated securities in the reserves of the People’s Bank of China, which became one of the world’s biggest holders of U.S. Treasuries as well as bonds issued by the government-sponsored (now government- owned) agencies Fannie Mae and Freddie Mac. Had it not been for the Chinese willingness to fund America’s borrowing habit this way, interest rates in the United States would have been substantially higher. It was Chimerica that kept the Age of Leverage going in its final phase, as total public and private debt as a percentage of GDP surged from 250 to 350 percent.

It was not, of course, just the United States that was borrowing, and not just China that was lending. All over the English-speaking world, as well as in countries such as Spain, household indebtedness increased and conventional forms of saving gave way to leveraged plays on real estate markets. Meanwhile, other Asian economies joined China in adopting currency pegs and accumulating international reserves, thereby financing Western current account deficits. Middle Eastern and other energy exporters also found themselves running surpluses and recycling petrodollars to the Anglosphere and its satellites. But Chimerica above all others was the real engine of the world economy.

It seems to me this was a deliberate policy. The Fed couldn't have been unaware of it, and wouldn't they have had to facilitate it in some way? Anyway, he has a lot of other interesting observations.

Comments? Criticisms? Anybody want to call me a name?

[anduril]

reading ferguson, i can see how other countries might come to view the u.s. as a predatory empire.

[Cecil Turner]

Hey, if we just read Ritholtz's conclusions and reason backwards it makes so much more sense. [/eyeroll]

But even that's more sensible than blaming the PRC's currency manipulations on the US.

[NK]

AODs and RichardUF have thr real estate finance part of this right. fannie for over 40 years had been the dominant source of liquidity and market making in the mortgage business. The 1997 Clinton/Repub deal on cap gains gave unprecedented preferential treatment to home ownership. Marginal income tax rates stayed high, cap gains to first home sales dropped to zero, and long-term interest rates were low, and Greenspan wasn't raising them despite the stock bubble. Basically, the gov't had set up the shift from the technology stock buble to the real estate bubble. Yes community reinvestment contributted, but in absolute terms, wasn't driving the bubble. The fuel had been established in 1997 and Greenspan/bernanke kept adding more during 2002-2004 by driving interest rates lower out of a concern of deflation (9/11, jobless recovery etc). But no one --not even TM-- can deny the explosive fuel Fannie/freddie added in 2004 by buying up securitized home mortgage tranches. That opened the flood gates. Community bankers/ Wall Streeters fell into line and issued stoopid debt, because it had no apparent risk to them Fannie was buying most of --ALL mortgages, not just sub-prime. Fannie skewed risk immeasurably-- I can't quantify the effect, but to me it drove the gigantic losses. Bankers just follow spreads. fannie mae widened the spreads and in bankers eyes reduced risk to nil. We are now all going to pay for it.

[cathyf]

I think that the "price support" paradigm is useful. The government sets a floor for the price of milk, and buys up and destroys the milk if the price goes below that level. They don't have to buy all the milk -- and the whole point of it is to have the rest of us buy the milk, at the higher price. In the same way, Fan/Fred set a AAA "price support" for "stinky" mortgage-backed securities -- securities that never should have been rated AAA because they contained all those pieces of subprimes in them.

[NK]

Cathyf-- not only the price floor, but Fannie ostensibly took the risk out of issuing, rating and underwriting stoopit mortgages-- subprime, "prime", Jumbo, all of them, by putting the taxpayers on the hook by buying these tranches of ugly mortgages at purported AAA prices. That was the oxygen for the firestorm of losses.

[anduril]

"Market investors [in the run-up to the Second Great Contraction], in turn, relied on the central banks to bail them out in the event of any trouble. The famous 'Greenspan put' was based on the (empirically well-founded) belief that the US central bank would resist raising interest rates in response to a sharp upward spike in asset prices (and therefore not undo them) but would react vigorously to any sharp fall in asset prices by cutting interest rates to prop them up. Thus, markets believed, the Federal Reserve provided investors with a one-way bet. That the Federal Reserve would resort to extraordinary measures once a collapse started has now been proven to be a fact. In hindsight, it is now clear that a single-minded focus on inflation can be justified only in an environment in which other regulators are able to ensure that leverage (borrowing) does not become excessive." Reihnart/Rogoff p. 291

Nice for the investing class, but who ultimately foots the bill?

Elsewhere, R/R note that housing bubbles in e.g. the UK and other Euro countries were fueled by massive inflows of funds, without specifying the source.

"Bernanke, while still a Federal Reserve governor in 2004, sensibly argued that it is the job of regulatory policy, non monetary policy, to deal with housing price bubbles fuelded by inappropriately weak lending standards. Of course, that argument begs the question of what should be done if, for political reasons or otherwise, regulatory policy does not adequately respond to an asset price bubble. Indeed, one can argue that it was precisely the huge capital inflow from abroad that fueled the asset price inflation [as Ferguson also states] and low interest rate spreads that ultimately masked risks from both regulators and rating agencies." R/R p. 213

[Cecil Turner]

That was the oxygen for the firestorm of losses.

Exactly. The Enterprises still had a plurality (borderline majority) of all loans either directly or securitized, and were the biggest players of the subprime MBS market as well (despite losing market share at the end). They also bear some responsibility for inspiring the johnny-come-latelies who essentially copied their business practices, and much of the blame for the general market overheating. By comparison, the other players only account for one aspect, and are less dominant than FM/FM even in the aspect they represent.

Moreover, Fannie and Freddie represent almost the entire cost to the taxpayer. The current CBO TARP program estimate is $25Bil, which represents a $7Bil profit from the financial institutions, $19Bil to the automotive industry, and $12Bil in mortgage payment grants (from the HAMP program split 50/25 between TARP and Fannie/Freddie). Compare that to the $291Bil already sunk on FM/FM (and the prospect of another $79Bil over the coming decade), and it's clear where the taxpayers' money went.

[NK]

Cecil-- I hope TM is reading these comments, I think we make a very persuasive case of why Fannie/Freddie were so instrumental in the financial collapse. I'm the first to concede that bamkers, regulators, mortgage brokers, the Fed (Big Time) and greed of the borrowers (zero down no doc 100% loans they couldn't afford) all played their part. But make no mistake Fannie/Freddie leveraged it (pun intended) into today's disaster. I'll quibble with only one thing you said-- the "automotive industry" didn't get the $19Billion, the UAW did. Every Voter needs to be educated that the banks paid back the TARP with interest, even AIG may break even for the taxpayers, fortunately the Treasury Dept. Inspector General forced BarryO to pull the deadbeat borrower HAMP program before it got too out of control, the 1/2 TRILLION the taxpayers will lose is for Fannie/Freddie, frikkin' GOVERNMENT SPONSORED ENTITIES. Why are Jim Johnson, Frank Raines and Jamie Gorelick not in Federal prison?