Fannie and Freddie: Supply Curves Slope Up, Demand Curves Slope Down

There is one huge argument against the claim that the crash in the mortgage market was in some sense the fault of excessively risky lending by the GSEs Fannie Mae (FNM) and Freddie Mac (FRE) which pulled the private sector along behind them: it is that Fannie Mae and Freddie Mac lost market share as all the loans that have now gone bad were made.

As Milton Friedman always used to say: supply curves slope up, and demand curves slope down. If something is due to a change in supply that causes movement along the demand curve, price will go down and quantity will go up. If something is due to a change in demand that causes movement along a supply curve, price will go down and quantity will go down.

Between 2001 and 2006 the "price" at which Fannie Mae and Freddie Mac sold mortgages--the terms they set--certainly went down. But did the quantity go up? No, Fannie Mae and Freddie Mac together had a much smaller share of mortgages in 2006 than in 2001: 37% as opposed to 48%. Price went down, and quantity went down.

This means that the dominant feature of the mortgage market in the 2000s was not an expansion of supply by Fannie Mae and Freddie Mac pushing their implicit government guarantee past the limits of prudence, but was a reduction in demand for Fannie Mae and Freddie Mac's products as private-sector mortgage lenders aggressively pursued and took away their markets.

At least, this is the dominant feature if you follow Milton Friedman and believe that typically supply curves slope up and demand curves slope down.

Comments

[Guero:]

As a mortgage originator in the middle of the decade, I couldn't get a Fannie or Freddie deal done unless the borrower had verifiable income & verifiable assets & a minimum credit score in the upper 600's. With a maximum debt ratio of 36% and 5% down. In other words, a solid loan risk.

On the other hand, if a borrower had no verifiable income or assets and a marginal credit score, there were "investors" all over the place that would take that action. New Century, Lehman Bros to name a couple. And with secondary financing and rolling in closing costs most times the borrower didn't need to pay a dime out of pocket. Countrywide would lend with basically just your signature, an appraisal and 5% down if your credit score was 720.

My point? Fannie & Freddie, despite their status as fave right-wing punching bags, were far from the worst of the lot. The Wall Street investment hotshots that were at the forefront of financial alchemy were by far the biggest perps in this meltdown.

Jan 28 12:39 PM

[User 265729:]

Don't complicate things for Bernanke with charts and graphs.

Jan 28 02:05 PM

[citizen Dad:]

Lehman and Bear's greed proved that you can cut your nose off despite your face. Their ideas on remodling mortgage banking were good if they had stayed disciplined to the fundamental principles of making good loans. Verify, Verify, Verify.
The challenge came the day they began to loosen their credit approval standards. It's a lesson that will be forgotten the next go around... It's only a matter of time. Effectively, their lack of experience in mortgage lending and lack of discipline singlehandedly slaughtered housing, the american economy, and the mortgage broker's ability to thrive. They also had the ability to prop up housing, the american economy, and the mortgage broker.
Fannie and Freddie are doing the right thing now - increase quality; show a track record of loans that do not default - bring back the mortgage security market by instilling confidence. The pendulum will swing too far to the right before it will swing left again. I don't think there is a way to ever stop the pendulum from moving; at least not in the land of the free.

Feb 02 03:46 PM