CRA and Fannie & Freddie: Betes Noires

There is so much chaff floating around about the roles of Fannie and Freddie and of the Community Reinvestment Act in the current crisis, despite the best efforts of economists like Jim Hamilton [0] [1], Mark Thoma and Janet Yellen, that it seems worthwhile to once again go through some of the arguments that have been forwarded.

From David Goldstein and Kevin G. Hall, "Private sector loans, not Fannie or Freddie, triggered crisis":

Federal Reserve Board data show that:

• More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.
• Private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year.
• Only one of the top 25 subprime lenders in 2006 was directly subject to the housing law that's being lambasted by conservative critics.

From David Goldstein and Kevin G. Hall, "Private sector loans, not Fannie or Freddie, triggered crisis," McClatchy Papers (October 12, 2008).

The article continues:

What's more, only commercial banks and thrifts must follow CRA rules. The investment banks don't, nor did the now-bankrupt non-bank lenders such as New Century Financial Corp. and Ameriquest that underwrote most of the subprime loans.

These private non-bank lenders enjoyed a regulatory gap, allowing them to be regulated by 50 different state banking supervisors instead of the federal government. And mortgage brokers, who also weren't subject to federal regulation or the CRA, originated most of the subprime loans.

In a speech last March, Janet Yellen, the president of the Federal Reserve Bank of San Francisco, debunked the notion that the push for affordable housing created today's problems.

"Most of the loans made by depository institutions examined under the CRA have not been higher-priced loans," she said. "The CRA has increased the volume of responsible lending to low- and moderate-income households."

In a book on the sub-prime lending collapse published in June 2007, the late Federal Reserve Governor Ed Gramlich wrote that only one-third of all CRA loans had interest rates high enough to be considered sub-prime and that to the pleasant surprise of commercial banks there were low default rates. Banks that participated in CRA lending had found, he wrote, "that this new lending is good business."

One point the article does not touch on is why the states did not regulate more rigorously the banks most involved in subprime lending. The answer is, in part, explained by this item (which I've cited in the past) from the NYT:

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

What about the charge that Fannie and Freddie "made" the market so that all these subprime loans could be securitized? There's a grain of truth in there, but I think keeping in mind which loans are going bad is useful, when reading this excerpt.

This much is true. In an effort to promote affordable home ownership for minorities and rural whites, the Department of Housing and Urban Development set targets for Fannie and Freddie in 1992 to purchase low-income loans for sale into the secondary market that eventually reached this number: 52 percent of loans given to low-to moderate-income families.

To be sure, encouraging lower-income Americans to become homeowners gave unsophisticated borrowers and unscrupulous lenders and mortgage brokers more chances to turn dreams of homeownership in nightmares.

But these loans, and those to low- and moderate-income families represent a small portion of overall lending. And at the height of the housing boom in 2005 and 2006, Republicans and their party's standard bearer, President Bush, didn't criticize any sort of lending, frequently boasting that they were presiding over the highest-ever rates of U.S. homeownership.

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. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.

During those same explosive three years, private investment banks -- not Fannie and Freddie -- dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data. [Emphasis added -- MDC.]

Now, again, consider which subprime loans, in the graph below, went bad...

Figure 1.8 from IMF, Global Financial Stability Report, Oct. 2008.

Notice that the delinquency rate is highest in the years after Fannie and Freddie are constrained in terms of their subprime holdings. So, more regulation of F&F was a good thing, I'll say, with the benefit of hindsight.

Now, there are more sophisticated, game-theoretic based arguments. In particular, Jim has observed that the mere existence of GSEs with substantial portfolios of MBSs meant that the government -- by insuring Fannie and Freddie -- would implicitly insure the private firms as they expanded their operations, supplanting F&F's market share:

What forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

This is by far the most intelligent and plausible interpretations of how F&F could have contributed in a significant way to the current housing crisis (as separate from the overall crisis, which would have been triggered by some other market given the mixture of securitization, credit default swaps and high leverage [2]). In fact, Mike Dooley and I have made similar arguments about the expansion of contingent liabilities, in the run-up to the East Asian crises [3].

The challenge here is how to test this hypothesis against others; we need to measure the implicit insurance that these private firms felt they had directly from the Fed's intent keep the monetary policy sufficiently expansionary to keep housing prices going up, separate from the insurance committed directly by the Treasury to prevent individual banks from going under. (By the way, this is a separate issue from whether F&F made sense economically in their circa 2006 form; see the analysis by Frame and White. I tend to think the answer is no.)

Interestingly, one of the corollaries of this argument is that it would be hard to disentangle the balance of blame of F&F and the "Greenspan put".

One question I do (or will) have is the following: if the credit card or auto loan securitized markets blow up [4], who are the equivalents to the GSEs?

I think all of this leads to a more nuanced view of the role of CRA and the two GSEs in the crisis. If I had to identify the central factors, I wouldn't point to F&F alone, or CRA alone (if at all). Rather, I'd look to (i) monetary policy (including whether it was lax, and the implications of the "Greenspan put"), (ii) what drove down the returns at the long end of the maturity spectrum ("the conundrum") thus inducing the desperate search for yield, (iii) securitization in the absence of countervailing regulation and (iv) the development of a completely non-transparent and unregulated over-the-counter credit default swap market.

Comments

[Moon Kil Woong:]

Your assessment is quite good. The Brokerages wanting to play CDS infinite leverage games were the ones that catapulted the whole thing off a cliff and we Know Goldman was principal in that when Paulson was around because most of AIG's CDS were made for Goldman Sacs. Although CRA is a bit anti-free market, the root cause for the whole collapse is banks lining up with brokerages and Insurance companies to increase their safe leverage under 10x to leverage of 30-40x and then their attampts to use CDS contracts with no down payment and liability for failed mortgages to only occur after 20-30 years in the future. They thought that gave them 0% current cash flow payout, allowed them unlimited leverage with no regulation, and freed them from collateralization of any sort. Also there is no one to enforce payout anyway. What a great deal for crooks. Gordon Gecko would be proud. Paulson and him both have a lot in common since Goldman figured out the worse mortgages they sold the more they made. So they bought more than 100% CDO coverage to make extra loot. Too bad AIG couldn't pay for it, or can they. Yep, the Fed's bailout of AIG goes straight to Goldman... Sweet for Paulson... No conflict of interest there.

2008 Oct 22 05:12 AM

[John Preston:]

First, F/F do not get a hall pass...the reckless growth of their underwriting model went beyond anything ever attempted by the "private lenders". 28/36 income debt ratios guidelines became 60/65 realities....at 100% LTV with 600 FICO scores....and no reserves....

Second, all of these "private lenders" fall under the umbrella of federally regulated loans/lenders....so there was the right and responsibility of regulatory agencies to watch what was going on...

Third...the leverage issue created on Wall Street and utilized by ALL lenders, public and private....played a big roll in the motivation to push the limits...

CRA, and other attempts to broaden the F/F footprint....all of this counts...and then there is the "F/F "I bought your vote with my money" list.....

2008 Oct 22 08:57 AM

[Stephen Met...:]

Citing the best efforts of economists known for liberal tendancies, especially Janet Yellen, does not give me a comfort feeling for a white wash of F&F, but otherwise an interesting article.

2008 Oct 22 11:19 AM

[Tom Lindmark:]

Pretty good article but I agree with the comments above that Fannie and Freddie don't get a pass on this one. One thought on your statement that the delinquencies in the later vintages occurred after F&F pulled back. A lot of the delinquencies that you see in the latest vintages of both subprime and Alt-A are refi's of older loans. The loans that were never going to work just got rolled from vintage to vintage until the game stopped. The original loan was made when F&F were fully involved.

2008 Oct 22 12:51 PM

[Tom Lindmark:]

You might find this link of interest. query.nytimes.com/gst/...

2008 Oct 22 01:09 PM