Made-Up Definitions

By James Kwak

Many commentators who want to blame Fannie and Freddie for the financial crisis base their arguments on analysis done by Edward Pinto. (Peter Wallison bases some of his dissent from the FCIC report on Pinto; even Raghuram Rajan cites Pinto on this point.) According to Pinto’s numbers, about half of all mortgages in the U.S. were “subprime” or “high risk,” and about two-thirds of those were owned by Fannie or Freddie. Last year I pointed out that Pinto’s definition of “subprime” was one he made up himself and that most of the “subprime” loans held by Fannie/Freddie were really prime loans to borrowers with low FICO scores. Unfortunately, I made that point in an update to a post on the somewhat obscure 13 Bankers blog that was mainly explaining what went wrong with a footnote in that book.

Fortunately, there’s a much more comprehensive treatment of the issue by David Min. One issue I was agnostic about was whether prime loans to people with low (<660) FICO scores should have been called “subprime,” following Pinto, or not, following the common definition. Min shows (p. 8) that prime loans to <660 borrowers had a delinquency rate of 10 percent, compared to 7 percent for conforming loans and 28 percent for subprime loans, implying that calling them the moral equivalent of subprime is a bit of a stretch. Min also shows that most of the Fannie/Freddie loans that Pinto classifies as subprime or high-risk didn’t meet the Fannie/Freddie affordable housing goals anyway — so to the extent that Fannie/Freddie were investing in riskier mortgages, it was because of the profit motive, not because of the affordable housing mandate imposed by the government.

Min also analyzes Pinto’s claim that the Community Reinvestment Act led to 2.2 million risky mortgages and points out that, as with “subprime” loans, this number includes loans made by institutions that were not subject to the CRA in the first place. Of course, the CRA claim is ridiculous on its face (compared to the Fannie/Freddie claim, which I would say is not ridiculous on its face) for a number of reasons, including the facts that only banks are subject to the CRA (not nonbank mortgages originators) and most risky loans were made in middle-income areas where the CRA is essentially irrelevant.

Mainly, though, I’m just glad that someone has dug into this in more detail than I did.

22 thoughts on “Made-Up Definitions

  1. Read the entire historical series of pamphlets, newsletters, newspapers starting oh!!! around 1760 up to the present day, and you will encounter very persuasive arguments about the culpability of Black/Poor sometimes both, people in the mishaps that befall this great country. Arguments sustained by forces of tribal identity and social ordering, that will handily resist any reality visited upon them by the likes of Mr. Min. Nice try though!

  2. half of all mortgages in the U.S. were “subprime” or “high risk,” and about two-thirds

    ~~James Kwak~

    Although it is always tempting to say, “You drew the line here when it should have been drawn as a thin line there.”, eventually America the beautiful will come to realize that the debt cycle has gone on for too many iterations thus any loan is a risk thus sub-prime. When median man takes the mortgage burden in the strength and health of his middle life he seldom pays off the debt in time to will his home to his only child. Why seldom? Obviously — if most people had passed homes not debts to the subsequent generation, there would no longer be a need for home mortgage for most of our generation.

    Government should subsidize only smaller homes that are mere stop-gap for those ready to use austerity to climb out of the hereditary debt cycle. But, as usual the governments of the world are run by those of us who seek profit-taking not charity. The mortgage profiteers are unlikely to give up their tax-deductible-rackets.

  3. Regardless, wasn’t it the existence of trillions of dollars worth of credit default swaps on sub-prime mortgage securitizations that really pushed the banks/AIG over the edge? The derivatives losses had nothing to do with the actual mortgage borrowers. Anyway, the idea that the nation’s poor would on their own be capable of borrowing enough money to explode Wall Street is laughable.

  4. What percentage of total notes did they hold at the peak? What percentage now? Whatever it is/was it was a large percentage, subprime or not, and an integral part of the scam, making originate-to-distribute even easier and more desirable.

    And remind me again why we had both Fannie and Freddie when they were generally identical?

    And what business did they have flooding their favorite charities with dollars? Wasn’t Lincoln Center one of their favorites? The place where stagehands were making something like $200k-$300k a year? Here a mob, there a mob, everywhere a mob slob.

  5. Where is the link to the David Min article?

    The links seems to both go to the original Pinto article. is too slow to respond for me to see what they would actually serve up for issues/2011/02/pdf/pinto.pdf

  6. Given that the tea potters (and not just them) are so inclined to fixate on the bankster tale of the CRA, I think what the public should be compelled to understand is that the role of CRA was merely to give the the banksters an excuse–a cover story, if you will–to crank up the loan origination machinery to full blast. This is evident in the declining loan quality as the bubble aged.

    They *knew* they could blame it on the government. This should serve as a cautionary tale in future policy making.

    Policy makers should also not defend Fanny/Freddy in toto. They should rightly question the role that its public/private nature played in generating moral hazard within the institution. The implicit government guarantee combined with the profit motive served as model for the industry as a whole.

    This *is* the structure that the Paulson/Geithner/Summers Administration has institutionalized across the banking industry and got Congress to legitimize through the legislative process.

    So, anything the tea potters want to say about Fanny/Freddy then, now applies to the entire industry.

  7. Good article, but the problem is that the CRA issue isn’t fact-based for the people who are bringing it up – it’s just a convenient dog-whistle, since they can’t go on TV with their heartfelt beliefs that the n-words and Messicans blew up the economy.

  8. The CRA argument just doesn’t ring true for me.

    My default assumption is that the financial industry owns Washington instead of the other way around. How hard did the financial industry lobby to get rid of the CRA? When did they scream that they were being forced to take on too much risk because of the CRA? Why didn’t they just move to the sidelines because of the risk?

    Perhaps I am wrong, but Texas seems to have avoided the crisis with tighter lending laws. If CRA was such a big deal, the tighter lending laws of Texas should have made no difference and Texas should have had a bubble just as big as anywhere else.

  9. “Credit Rating Agency’s (CRA)”

    Largest…S&P {total# two[2]} only for banks and finance, and Moody’s trailing far behind!
    Fitch {by its lonely self [1]} is for Insurance Rating (AIG?) only.

    McGraw-Hill Companies owns “S&P Credit Rating Agency (BOD’s is laughable)”. Who is the largest shareholder: David de Rothschild…Surprised?
    Rothschild & Cie Banque (just to name one of many Rothschild Family’s influence upon)/ McGraw-Hill Companies

    McGraw-Hill Holdings, Europe Ltd.

    McGraw Hill Companies…all news releases:

    Go figure???

  10. Fannie and Freddie didn’t cause the crisis, but they contributed and, ultimately fell victim to it. Not because of CRA or any mandate to support housing for low-income buyers, although the mandate did provide some cover for management greed and recklessness. Rather,they both sought profits and market share. Mortgage originators theatened those goals when they threated to withhold product unless the GSEs started buying more subprime and other toxic loans. So the problems of Fannie and Freddie weren’t caused by efforts to assist the poor. They were caused by the profit motive that resulted from public ownership and greed-driven mismanagement. (Public ownership was caused by Lyndon Johnson’s effort to conceal the true cost of the Viet Nam war from the American people, but that is another story.)

    The real issue is what to do with Freddie and Fannie. Congress and the administration, at the behest of Big Banks and Big Finance, appear determined to shut them down and turn the entire mortgage market over to – guess who – Big Banks and Big Finance. Nearly everyone decries the losses suffered by the two, giant GSEs, already approximately $150 billion and estimated to reach $350 billion to $400 billion (the higher number is more likely if they are forced to sell off the loan portfolios now that the prices of the mortgages and MBS are beginning to regain value – another boon for Big Finance). $350,000 to $400,000 billion is a lot of money to lose. But it is a drop in the bucket compared to the harm caused by Big Finance and Big Banks when they blew up the mortgage and housing markets.

    What did it cost? All we have are estimates and the costs keep mounting, but let’s take a look. Between ’06 and the middle of ’08 alone, retirement assets dropped 22% from $10.3 trillion to $8 trillion, i.e. $2.3 trillion. Savings and investment assets lost $1.2 trillion and pension assets (including public pensions) lost $1.3 trillion in value. During that same period, home equity declined by $4.2 trillion. Overall, assets lost $8.3 trillion in value. As of last Fall, 23% of homeowners were still underwater on their mortgages and there is no end in sight for forclosures. No one lost a cent on Fannie’s or Freddie’s MBS or their guaranteed mortgages (or at least they shouldn’t have if they relied on the dreaded implicit government guaranty that their critics decry.)

    Sure, taxpayers may be on the hook for $350 to $400 billion to bail out Freddie and Fannie, but that is small potatoes compared to the damage done by Big Bannks and Big Finance. And don’t believe for a minute that the dismantling of Fannie and Freddie will put an end to implicit government guarantees. Those TBTF securitizers; MBS, CDO, CDS peddlers; off-balance-sheet investors; etc. all operate today with an implicit government guarantee that they will be bailed out the next time they blow up the economy. And their efforts to dismantle Dodd-Frank, or at least weaken the already pathetic provisions aimed at preventing a recurrence of the mess, demonstrate that they WILL blow it up again.

    So what to do? I suggest we restructure Fannie and Freddie, possibly combining them, as nonpublic enterprises. Require them to set high underwriting standards and price risk accurately. This approach represents the best insurance against a repeat of the recent mortgage disaster while at the same time ensuring that fairly priced mortgages will be available to all who can truly afford to purchase a home. And that at least some portion of future losses will be contained

    In the interest of full disclosure, I worked at Freddie for approximately two months in 1986, before regaining my sanity and returning to the Enforcement Division of the SEC. Be assured, nothing that occurred in those two month biased me in favor of Freddie or Fannie.

  11. This posting leaves us without really contradicting Pinto’s major claim: Freddie and Fannie really held a lot of risky paper and were critical to the existence of a market for that paper.

    It matters less what you call the paper. It was bad stuff and Freddie and Fannie owned it.

  12. @al

    It matters. The point is that Pinto claims that a lot of paper is 3 times more risky than it actually is.

  13. “a lot of paper is 3 times more risky than it actually is.”

    “Actually is” changed radically between 2007 and now. As the economy goes to zero, risk rises to infinity.

  14. As the economy goes to zero, risk rises to infinity.

    That is a very well made point and I agree, but one thing you overlooked was infinity actually has a limit, and then its beyond infinity. We crossed that point some 4 years ago forceing down the rate. Now the elite want to start over as if it were a game of monopoloy, which of course it isn’t, its now the game of life, with different rules than games of yonder years. Or did you already know that?

  15. This is like blaming the fever for making someone sick. You can’t treat an infection with tylenol.

    The underlying problem here was that for 28 years, 1980-2008, there was rapidly growing income inequality in the US, with the middle class falling more and more behind. The top 10% of the population took 96% of ALL income gains for nearly 30 years. Middle-class incomes stagnated, but the whole trend was so well concealed (by politicians of all stripes and useless media) that middle-class people thought they might stay even by expanding debt. Household debt skyrocketed, and mortgages were only one aspect. Everyone became over-leveraged, including the banks that were scrambling to expand credit to meet this demand.

    Eventually, it all came crashing down. The solution is not simply to nibble at banking and mortgages (aspirin for the fever), but to address the causal inequality of incomes and wealth.

  16. @jakepgh

    Well said.

    I’ve made the inequality point to some conservative friends. They blabber about the evils of redistribution of wealth, messing with free markets and attacking the rich. Ideology trumps everything.

  17. Min’s definition is just as made-up. The bank regulators have been using a 660 FICO cut-off in their mortgage guidance for years. Fannie/Freddie had lots of problems, maybe the worst was allowing their guarantee business to be levered 200-to-1. Their loan quality only made the bailout bigger.

  18. I did a lot of reading online about the mortgage collapse a few years ago and only one article I read pointed at that we did not have a sub-prime mortgage collapse because most were not subprime, most were used by the wealth as investments.

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