Streetwise Professor

The controversy over the culpability of US government real estate policy in the ’90s and ’00s, and Fannie and Freddie in particular, continue to rage.  To me, those who deny the central role of government policy and the GSEs have to answer a crucial question: if they were not absorbing a substantial amount of the credit risk in subprime mortgages, how did they lose so much money?

There are two new editorials that press the argument for a substantial F&F role.  The first is by Mark Brickell, formerly of J.P. Morgan and a past chairman of ISDA.  Writing in the FT, Brickell writes:

This suggests two important things. First, the housing finance crisis was not an unregulated market failure; no financial sector had more government involvement before the outbreak of the crisis than housing. It was failure driven by a public policy that was accepted by voters willing to spread the benefit of home ownership to fellow citizens. Yet, extra loans prompted by that housing policy nudged upward the indices that regulators and businessmen relied on to make their decisions.

Second, we need to remember that in any market, government subsidies have an important, indirect, cost when they affect the information that market participants – and regulators – use to make decisions. This time the distortion was pervasive, difficult to quantify, and hard to correct. That should guide regulators as they look for sources of widespread risk in the financial system.

It should inform Congress as it considers the fate of Fannie Mae and Freddie Mac. It should be of concern to participants in subsidised markets, such as education and healthcare, and to electorates that will be asked to approve “investments” in other sectors, such as green tech in the months ahead. The housing finance crisis has shown us how painfully high that cost can be.

The point in the last paragraph is particularly important for thinking about the future, as opposed to forensically examining the past.  All of the “investments” that Obama and the Dems are asserting are essential to “winning the future” (aka “WTF”) involve huge subsidies and government steering of capital to politically preferred sectors and firms.  Those tend to distort the allocation of resources, and the bigger the subsidy, the bigger the distortion.  Sooner or later, reality intrudes.  When that happens, the crash is brutal.  We’re still experiencing the dead cat bounces in the housing market, going on 4 years after that crash began.

AEI’s Peter Wallison also examines Fannie and Freddie, and particularly the ongoing failure to investigate thoroughly their role in the crisis:

For many years, Fannie Mae defined subprime mortgages as loans that it bought from subprime lenders, not by credit score. This had the effect of making its investment holdings seem less risky. In its 2007 10-K annual report, for example, the company estimated its subprime exposure at about 0.3 percent of its single-family mortgages. Tables deeper inside the report showed loans with FICO credit scores of less than 660 were 18 percent of the company’s single-family holdings.

The significance of this for the financial crisis is that Fannie and Freddie’s reports might have lulled analysts and risk managers into believing that if the housing bubble collapsed, the damage would be limited because the number of risky loans was small.

We now know the damage was severe. Had those 12 million Fannie Mae and Freddie Mac loans been prime instead of subprime, delinquencies and defaults probably would have been around 2 percent, not almost nine times higher.

No Inquiry

In writing my dissent from the commission’s majority report, I searched widely for examples of anyone — academic researcher, credit rating analyst or housing market expert — who knew before 2008 that half of all mortgages in the financial system were subprime or otherwise risky, or that Fannie and Freddie had contributed almost half of that total.

The commission had a chance to investigate the risks that Fannie and Freddie were taking and why the information available in the market was so deficient. But this would have required the commission to examine the losses caused by government housing policy. Angelides refused to do so. Instead, Fannie and Freddie’s contribution to the housing crisis was called “marginal” in the commission’s report.

As a result, the American people and Congress received a distorted picture of the causes of the financial crisis, not the thorough investigation they deserved.

Monocausal explanations of anything as complex as the housing collapse are unpersuasive.  But so are explanations that overlook the role of the GSEs.  There are hundreds of billions of reasons to suspect that they played a central role.  The Brickell and Wallison pieces help keep those reasons in mind.  That’s important not just so that we can understand the past better, but so that we have some chance of avoiding similar mistakes in the future.  Mistakes that we can no longer can afford.