Did Fannie and Freddie Cause the Mortgage Crisis?

 |  Includes: FMCC, FNMA
by: James Hamilton

Some thoughts about the role played by the GSEs in the run-up in mortgage debt and house prices.

Paul Krugman ably lays out the case for why it's conceivable that Fannie and Freddie could have made a contribution:

Here's the background: Fannie Mae (FNM) -- the Federal National Mortgage Association -- was created in the 1930s to facilitate homeownership by buying mortgages from banks, freeing up cash that could be used to make new loans. Fannie and Freddie Mac (FRE), which does pretty much the same thing, now finance most of the home loans being made in America.

The case against Fannie and Freddie begins with their peculiar status: although they're private companies with stockholders and profits, they're "government-sponsored enterprises" established by federal law, which means that they receive special privileges.

The most important of these privileges is implicit: it's the belief of investors that if Fannie and Freddie are threatened with failure, the federal government will come to their rescue.

This implicit guarantee means that profits are privatized but losses are socialized. If Fannie and Freddie do well, their stockholders reap the benefits, but if things go badly, Washington picks up the tab. Heads they win, tails we lose.

Such one-way bets can encourage the taking of bad risks, because the downside is someone else's problem.


Fannie and Freddie had purchased $4.9 trillion of the mortgages outstanding as of the end of 2007, 70% of which the GSEs had packaged and sold to investors with a guarantee of payment, and the remainder of which Fannie and Freddie kept for their own portfolios. The fraction of outstanding home mortgage debt that was either held or guaranteed by the GSEs (known as their "total book of business") rose from 6% in 1971 to 51% in 2003. Book of business relative to annual GDP went from 1.6% to 33%.

Sum of retained mortgage portfolio and mortgage backed securities outstanding for Fannie and Freddie (from OFHEO 2008 Report to Congress) divided by (1) total 1- to 4-family home mortgage debt outstanding (from Census for 1971-2003 and FRB for 2004-2007) and (2) annual nominal GDP.
gse_to_gdp_jul_08.gifClick to enlarge
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The fact that the volume of mortgages held outright or guaranteed by Fannie or Freddie grew so much faster than either total mortgages or GDP over this period would seem to establish a prima facie case that the enterprises contributed to the phenomenal growth of mortgage debt over this period. Krugman nevertheless concludes that the GSEs aren't responsible for our current mess:

But here's the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that's because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn't do any subprime lending, because they can't: the definition of a subprime loan is precisely a loan that doesn't meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.


These developments appear clearly in the graph above after 2003, which is marked with a vertical line. And certainly much of the dramatic appreciation in house prices came in the two years after the GSEs began to contract.

S&P/Case-Shiller Composite 10 home price index (data source).
case_shiller_jul_08.gifClick to enlarge
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Even more striking is the explosion of home mortgages held in the form of privately-issued asset-backed securities that did not go through either Fannie or Freddie. By 2006, these represented 20% of all outstanding home mortgages.

Dollar value of home mortgages held by private asset-backed securities (from Census for 1971-2003 and FRB for 2004-2007) divided by (1) total 1- to 4-family home mortgage debt outstanding and (2) annual nominal GDP.
abs_to_gdp_jul_08.gifClick to enlarge
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On the other hand, Tanta contributes this:

Fannie and Freddie .... didn't like losing their market share, and they pushed the envelope on credit quality as far as they could inside the constraints of their charter: they got into "near prime" programs (Fannie's "Expanded Approval," Freddie's "A Minus") that, at the bottom tier, were hard to distinguish from regular old "subprime" except-- again-- that they were overwhelmingly fixed-rate "non-toxic" loan structures. They got into "documentation relief" in a big way through their automated underwriting systems, offering "low doc" loans that had a few key differences from the really wretched "stated" and "NINA" crap of the last several years, but occasionally the line between the two was rather thin. Again, though, whatever they bought in the low-doc world was overwhelmingly fixed rate (or at least longer-term hybrid amortizing ARMs), lower-LTV, and, of course, back in the day, of "conforming" loan balance, which kept the worst of the outright fraudulent loans out of the pile. Lots of people lied about their income (with or without collusion by their lender) in order to borrow $500,000 to buy an overpriced house in a bubble market. They weren't borrowing $500,000 from the GSEs.


Michael Carliner (hat tip: Economist's View) adds:

Fannie and Freddie are ... subject to regulation by HUD under mandates to serve low- and moderate income households and neighborhoods. As originators and investors with more energy than brains expanded their (subprime) lending to those borrowers and neighborhoods, it was difficult for Fannie and Freddie to increase their shares. They didn't want to buy or guarantee subprime loans, correctly perceiving them to be insanely risky. Instead they purchased securities created by subprime lenders, taking only the supposedly-safe tranches. Those portfolio purchases were counted toward their obligations to lend to lower-income home buyers, but are now part of the write-downs.


For my part, I have two questions for those who take the position that the GSEs played no significant role in causing our current mortgage problems. First, what economic justification is there for the dramatic increase in the share of loans guaranteed or held by the GSEs between 1980 and 2003 that is seen in the first graph presented above? What sense did it make to increase the ratio of such loans to GDP by a factor of 12 over this period?

Second, 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.

Is that the answer to the second question? I'm not sure. But if anybody has a better answer, I'd still like to hear it.

In the mean time, I very much agree with Krugman that the most egregious problems were not caused by anything Fannie or Freddie themselves did. But I disagree that their actions played no role in causing the underlying problem we face today.