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.
By James Kwak
My previous post on Fannie/Freddie had two major parts. In the first part, I questioned whether the thirty-year fixed-rate mortgage would really go away (or become much more expensive) without Fannie/Freddie, as some people have argued. In the second part, I said, who cares?
The first part has gotten a fair amount of good criticism, for example from Arnold Kling and John Hempton (by email), and also in comments. My position, simplified, was that a thirty-year fixed-rate mortgage includes three kinds of risk: credit risk, interest rate risk, and prepayment risk. Credit risk can be diversified, interest rate risk can be hedged, and Fannie/Freddie didn’t do anything about prepayment risk anyway. This is the kind of theoretical argument people make all the time, and the obvious question is whether the world actually works that way.
By James Kwak
(Yes, I know that isn’t saying much.)
Most people think that Fannie Mae and Freddie Mac had something to do with the financial crisis. Some people think that they were the major reason the crisis happened, which (to them) proves that activist government policy was the cause of the crisis. Other people, including me, think they were a modest contributing factor because they did buy a lot of securities that were backed by subprime loans, but they were well behind the curve when it came to mortgage “innovation” and the creation of toxic assets. But that’s not the question here.
The question now is what to do about them. Although they had been private, profit-seeking companies for forty years, they were taken over by government regulators in September 2008 when they had become clearly insolvent, and are still being operated in conservatorship. Because Fannie and Freddie were very, very long housing, they have suffered massive losses since the financial crisis began. But because the private mortgage securitization market has collapsed, they are the bulk of the secondary mortgage market at the moment, which means the housing market could collapse without them.
Arnold Kling of EconLog has done the hard work of setting out his theory of the financial crisis and what we should learn from it in a fifty-page but highly readable paper available here. I have some quibbles but think it is worth a read.
Here are the causes of the crisis in one table:
Via Yves Smith, John Hempton analyzes the quarterly results of Bank of America (so-so) and Fannie Mae (terrible). The underlying issue is that bank quarter-to-quarter results are largely driven by the amount of provisions they take against future loan losses. You can think of this as a very rough approximation to marking-to-market — instead of waiting for the loans to default, you estimate how many loans will default in the future (that estimate should change as the economic situation changes) and put that amount of money into reserves. Then when the defaults actually happen, you take the money out of reserves.
Hempton argues that Bank of America and Fannie Mae are estimating extremely different future loan losses, and those differences cannot be attributed to differences in their current performance (the rate at which loans are defaulting now). If I wanted to be provocative I would only show you this quote:
“If Bank of America were to provide at the same rate its quarterly losses would be 50-80 billion and it would be completely bereft of capital – it would be totally cactus. It would be – like Fannie Mae – a zombie government property.” [emphasis in original]
(“Totally cactus” — I like that.)