In a recent post, I discussed how the Federal Housing Administration’s subsidization of dubious mortgage loans is repeating one of the key errors that helped cause the financial crisis of 2008. In this Wall Street Journal op ed, Peter Wallison (who presciently warned of the danger posed by these policies back in 2005) summarizes the evidence showing that the federal government played a decisive role in promoting the vast majority of the dubious mortgages involved in the mortgage crisis, which in turn helped cause the broader financial collapse:
When Fannie and Freddie were finally taken over by the government in 2008, more than 10 million subprime and other weak loans were either on their books or were in mortgage-backed securities they had guaranteed. An additional 4.5 million were guaranteed by the FHA and sold through Ginnie Mae before 2008, and a further 2.5 million loans were made under the rubric of the Community Reinvestment Act (CRA), which required insured banks to provide mortgage credit to home buyers who were at or below 80% of median income. Thus, almost two-thirds of all the bad mortgages in our financial system, many of which are now defaulting at unprecedented rates, were bought by government agencies or required by government regulations.
Even some of the bad mortgages that were initiated by the private sector acting independently may have been influenced by Fannie and Freddie’s apparent willingness to purchase them at a later time should things go bad. Obviously, some private lenders and borrowers made mistakes of their own, and there were plenty of errors that cannot be blamed on the feds. However, absent the federal policy of promoting dubious mortgages and offering implicit government guarantees for them, the number of such mortgages would have been far smaller, and it is highly unlikely that a major crisis would have occurred.
I should note that the title of Wallison’s op ed “Barney Frank, Predatory Lender” is somewhat misleading. Frank did indeed play a key role in promoting policies under which government-backed firms issued and guaranteed dubious mortgages. But he was far from the only one. Members of Congress from both parties supported the same policy, as did the Bush Administration. It would be convenient if these policy errors could be blamed on a few individual villains, such as Frank or nefarious Wall Street executives. In reality, however, they arose from perverse systemic incentives of the kind I discussed in my last post on this subject.
Commenterlein says:
As much as a dislike the GSEs, fact is that their underwriting standards were consistently higher than those of their private sector counterparts. It was only towards the end of the bubble that the GSEs started to lower their standards, in fact exactly because they were being pushed out of the market by private lenders with much laxer underwriting policies. The GSEs declining market share then created pressure from Congress to lend more, and that’s what they ended up doing. But the notion that the crisis would not have occurred without the GSEs is just nonsense.
Shorter version: Assume that anything you read on the WSJ op-ed page is an ideologically motivated lie.
October 18, 2009, 2:22 amBruce Hayden says:
Oh, no. This can’t be true. We have been repeatedly told that the reason for the sub-prime meltdown was a lack of government oversight and regulation. :-)
October 18, 2009, 2:22 amMahan Atma says:
I call BS on his statistics.
First of all, subprime and “nonprime” loans hardly account for all bad loans. How about prime loans, interest-only loans, Pay Option ARMs, etc? The POAs are now become a huge, huge problem. Why focus solely on subprime in the analysis?
Second, what about the lack of documentation? Or the fact that mortgage brokers, assessors, and real estate agents were frequently engaged in fraud? These factors were hardly the result of govt regulation or the agencies.
October 18, 2009, 2:31 amMahan Atma says:
Here’s a contrary analysis of Fannie and Freddie’s role in subprime mortgages (although again, it’s nearsighted to focus solely on subprime):
.
October 18, 2009, 2:58 amRicardo says:
This piece relies on a giant non-sequitur. The only relevant statistic that goes to his claim is that 2/3 of all “bad” mortgages are linked to the government. He gets this number by setting the denominator equal to the 25 million “non-prime” (but not necessarily in-default) mortgages outstanding in the U.S. Then he counts 10 million “weak” loans held by Fannie and Freddie (not necessarily “nonprime”), plus 4.5 million Ginne Mae loans (here he doesn’t even offer a qualifier of “weak” or “nonprime”: what exactly this number represents he never says), plus 2.5 million CRA-eligible loans (which, again, were not necessarily nonprime). Plus, he doesn’t give us dollar figures so we don’t know the percentage in dollar terms of this already misleading calculation.
The article, much like the other articles Somin linked to in his earlier post, simply provides no data to support the argument that the government was behind a majority of bad loans. Pretty sloppy use of statistics.
Incidentally, the claim that Wallison was prescient back in 2005 is also dubious. In his piece, he cited two risk factors affecting the GSEs — credit risk and interest rate risk — but said interest rate risk was the greater risk of the two. This was wrong since holders of mortgage-related assets can and do short treasuries in order to manage interest rate risk. To hedge credit risk, you have to buy credit default swaps — issued by AIG.
October 18, 2009, 3:22 amsputnik says:
wow,
October 18, 2009, 7:32 amprof Somin.
Still can not let it go, hah?
After the excellent deconstruction in previous thread by Loki and many others…..
Have to fit my preconcieved ideology….. facts have to fit my pre-concieved idology….. isn’t that what you are trying to do here?
rather then admit that not always not all the time and functioning NOT IN THE TOTALITATIAN SOCIALIST ECONOMIES government can be not evil and in some cases better then unrestricted private greed of the immidiate satisfaction…
Duracomm says:
Government intervention in the market was one of the primary drivers of the housing disaster. The Feds low interest rates, the CRA, the GSEs, the mortgage interest deduction are just a few examples of government activities that helped inflate the housing bubble.
There may have been a housing bubble and bust without government interference in the housing market. There is no doubt that government interference in the housing market increased the size of the bubble, and the resulting damage when it collapsed.
Compare the economic damage done when the dot com bubble burst (little government involvement, relatively minor impact across the economy, fast recovery) to what happened when the housing bubble burst ( lots of government involvement, major damage across the economy, slow recovery).
There was plenty of stupid private behavior in the real estate meltdown but government actions helped accelerate and spread the idiocy.
For example, government regulation probably helped drive the development of many of the financial derivatives that blew up.
Mindles Dreck is the Dreck of my dreams
October 18, 2009, 9:12 amPersonFromPorlock says:
If you want a real villain in the housing bust, try the market’s delusion that price and value are the same thing. “The value of a thing is the price it will bring in the marketplace” they say.
Given that, rising property prices mean rising values and rising values establish a trend that justifies borrowing to buy at higher prices yet, and so on. This is a feast at which neither borrowers, lenders, real estate agents nor government (which profits from higher property tax revenues) have any incentive to back away from the table.
Then ‘value’ reasserts itself: in the case of housing, the utility of houses as somewhere to live is overwhelmed by their price and they fail to move on the market. Prices must fall, the illusion of endless profit fails and reality bites hard: the market does its Wile-E-Coyote-ten-feet-beyond-the-cliff’s-edge and here we are.
The government has some responsibility in this case: requiring subprime mortgages to be made surely helped start the upward trend of house prices and encouraged lax mortgage standards. But there was no shortage of willing hands in the private sector, and the root cause was the same self-serving confusion of price and value that underlies every bubble.
October 18, 2009, 9:22 amgeokstr says:
The feds were pressuring the banks to make substandard loans to people who should never gotten mortgages for a long time. I was in an S&L back in the 1980′s and we were getting heat for it back then. Then, between the regulators and the race-mongers like ACORN (represented ably in at least one case by our own Community Organizer in Chief) ramped up the pressure in the mid-1990′s, claiming that the banks were deliberately descriminating against minorities because of their skin color, not because they had abysmal credit ratings, no down payment, and non-existent employment histories. The thuggish tactics of ACORN are well documented.
Once the normal lending standards were demolished, and there seemed to be no increase in defaults (at least for the nonce), everyone started making poor loans to just about anybody. To claim that government (under both parties) had nothing, or even just a little, to do with the meltdown is totally dishonest.
October 18, 2009, 9:23 amDuracomm says:
The average person who puts his hand in a bear trap is going to conclude that hurts and avoid doing it again.
However, when it comes to the housing market, the government puts our hand in a bear trap and then concludes that the wise thing to do is put the other hand in another bear trap.
For example the FHA is busy continuing the disastrous policies of fannie and freddie, fannie and freddie still exist and have not been parted out, and congress created a large tax credit for new home buyers.
This idea that home ownership is a social good that needs to be promoted by government action has been deeply destructive to the economy at large and many private individuals, both home owners and renters.
Government promotion of home ownershipe needs to stop.
Obsessive Housing Disorder
Nearly a century of Washington’s efforts to promote homeownership has produced one calamity after another. Time to stop.
October 18, 2009, 9:48 amkarrde says:
For anyone interested in a close examination of the forces involved in the Housing boom and bust, I recommend a book by Thomas Sowell (appropriately titled The Housing Boom and Bust.
(Author’s website here.)
While the government agencies come in for some heat, and members of all political parties, Sowell does a very good job of tracing a variety of market forces and government policies that influence the housing boom. He also levels some heavy criticism on policy-makers who confused quality of housing with the personal habits that lead to both good housing and good communities.
October 18, 2009, 10:02 amtamerlane says:
As recently as four or five years ago the Boston Globe touted “research” by a couple of economists at the Fed claiming that private banks were discriminating against minorities by denying them risky mortgages. If I remember correctly, the article even included a poignant quote from Barney Frank. This was a standard liberal talking point then.
Just as the bubble was bursting, about a year-and-a-half ago the Globe ran another article bewailing the fate of some idiot minority woman who’d obtained a variable rate mortgage whose monthly payments exceeded her monthly take-home income. She’d planned to sell it when the value exceeded the purchase price, which she’d determined should happen sometime just before the principal repayments kicked in. This time, of course, it was once again the greedy lender who was at fault; not the relaxed federal regulations that allowed such behavior nor the amendments to the CRA that encouraged it. This had become the new liberal talking point.
October 18, 2009, 10:13 amMIke says:
Fannie Mae and Freddy Mac were not government agencies at the time.
I’m under the impression CRA loans were standard 30 yr fixed-rate mortgages. I’m also under the impression that CRA did not apply to any of the major banks.
The govt certainly enabled the crisis to occur — by for instance maintaining low interest rates and deregulating the financial industry. The question is, what is the solution? The above kinds of analyses do not support an argument that still weaker govt regulation is a solution.
October 18, 2009, 10:52 amDuracomm says:
Mike,
Spending levels make a very compelling argument that the financial industry was not and has not been deregulated in any sense.
There may have been stupid, ineffective, inappropriate, or damaging regulations but it does not look like there was significant deregulation.
Is This What Deregulation Looks Like?
It is hard to argue that deregulation of the financial services industry was rampant in Washington when the spending on finance and banking regulatory agencies kept growing so fast.
I don’t know what the exact solution is but two actions seem to be reasonable
1. Don’t do anything to reinflate the housing bubble
2. Prepare, carefully evaluate, and then implement simple, transparent regulations that increase public knowledge of the financial status of companies working in the banking and finance sectors.
Developing regulations of this type is not a trivial problem. Poorly thought out regulations could make the situation much worse or so the seeds for the next meltdown.
October 18, 2009, 11:35 amUgh says:
Kopel, Lindgren, now Somin. So sad.
October 18, 2009, 11:52 ampc says:
So I imagined it when Paulson (as CEO of Goldman) went up to Capitol Hill to lobby for the removal of the net capital rule? But I agree that we should deregulate more. That way hard working businessmen like Raj Rajaratnam won’t go to jail for creating wealth.
October 18, 2009, 12:01 pmDuracomm says:
pc,
According to the link Raj Rajaratnam was arrested for breaking financial regulations.
You are using that fact that he was arrested for breaking financial regulations to advance your position that deregulation caused the problem.
I’m not sure that fact set does a very good job of supporting your position.
October 18, 2009, 12:25 pmpc says:
No, I was pointing out that if we deregulated insider trading, Rajaratnam wouldn’t be going to jail. Certainly we are just criminalizing hard working businessmen by making insider trading illegal, right?
October 18, 2009, 12:43 pmDuracomm says:
pc,
Feel free to argue that a 26 percent increase in regulatory spending represents deregulation. Anyone who honestly pays attention to the facts is not going to find that argument to be either well thought out or persuasive.
The financial regulatory environment was and is complicated.
For example additional regulations for fannie and freddie were vehemently resisted and eventually killed in congress. However, congress passed the sarbanes oxley financial regulations which imposed massive regulatory costs on private companies.
Prudent folks will think about root causes of the meltdown and try and come up with reasonable policies to prevent another meltdown. They will try and ensure the new regulations don’t kill the economic recovery before it gets started.
They will also look at doing away with policies and regulations that helped drive financially counterproductive behavior and worsened the economic meltdown.
This is not a simple problem and I have seen no indication that any of the folks who are screaming deregulation caused the problem and demanding more regulation right now realize just how complicated the problem is.
Nor have I seen any indication that these same folks screaming for more regulation have any idea how much damage poorly thought out regulations could cause to the financial system and the overall US economy.
October 18, 2009, 1:18 pmDuracomm says:
PC,
Earlier you supplied a link describing the arrest of Raj Rajaratnam for breaking financial regulations.
One interesting fact about him is that he really liked to give donations to democrats.
Wall Streeter posts $100 million bond
That kind of flies in the face of the usual rhetoric about the evil deregulating republicans and their evil business supporters we have all come to know and love.
October 18, 2009, 1:35 pmMIke says:
The argument isn’t compelling at all. It could be that weaker regulations require greater staff and expertise to enforce. This is the natural deduction to make in the present case, since the fact is Congress weakened the limitations on bank holding companies.
And, indeed, one of the primary cases for widespread bailouts was to prop up the “too big to fail” bank holding companies, which were exposed to risks that they would not otherwise have been under previous law (at least this is my understanding of the effect of Gramm-Leach-Billey Act).
Posters above compare to the tech bubble, and blame govt regulation for the difference between how that panned out and how the bursting housing bubble panned out. Yet, it seems to me the difference between these scenarios (in part) is the reduction of regulation due to the above law. I gather this is only part of the difference, because the mortgage securities sector is gigantic next to the tech stock sector, and because a bailout of Fanny and Freddie seems to have been inevitable.
October 18, 2009, 3:00 pmpc says:
Duracomm, do you think there should be any regulation of the markets? If you are going to argue about corrupt Dems, don’t expect me to stop you. Government Sachs is a joke.
October 18, 2009, 3:26 pmDuracomm says:
PC said,
It would help the discussion if you read my comments before responding.
In one of my comments above I said,
If you had read my posts you would not have had to waste your time asking the question and I would not have had to spend time answering it.
October 18, 2009, 3:39 pmHarry Eagar says:
Well, say, Professor Somin, how is that implied guarantee working out for the lenders?
Countrywide’s doing just fine, I hear. No?
This desperate attempt to absolve the main actor, the unsupervised markets, reminds me of the remark made by the Belgian ambassador to the German foreign minister after the invasion in 1914. The ambassador went to reclaim his credentials, and the minister, rather embarrassed, said something on the order of, ‘Well, it is most unfortunate, but who can tell what history will say?’
And the ambassador replied: ‘Whatever history will say, it will not say that Belgium invaded Germany.’
If you want to persuade me, you’re going to have to explain how the government coerced investors in the secondary market to keep lusting after these mortgages.
October 18, 2009, 3:41 pmDuracomm says:
PC, getting close to the nature of the problem but still not getting it, snarked,
You have a very good point goldman sachs has an enormous influence on the regulatory process.
This is just another illustration of the fact that the existing entities in a market segment are often helped by regulations at the expense of their newer, smaller, more innovative competitors and consumers in general.
This process continues in the obama administration with treasury secretary geithner.
Yet another reason for proposed regulations to be simple, transparent and easy to follow. Otherwise sachs and the incumbent players will use the new regulations to protect their interests at the expense of their competitors and consumers in the US.
Geithner’s Old Boy Network Doesn’t Extend West of the Appalachians
Comment from the person who put up the linked article.
October 18, 2009, 3:58 pmEH says:
Duracomm:
That kind of flies in the face of the usual rhetoric about the evil deregulating republicans and their evil business supporters we have all come to know and love.
You’ve likely been either selectively or plain-not listening to the right rhetoriticians. It’s common knowledge that institutional criminals contribute generously to politicians of all stripes, particularly to those who are (or soon will be) in power. The political Serpico is rare.
October 18, 2009, 4:20 pmPQuincy says:
IS’s original post made some gestures at balance, which I appreciate.
The commentors, however — both those convinced that GSEs in particular and government regulation in general were not causative of the crisis, as well as those convinced (like Somin, despite his gestures) that the GSEs and the Fed caused the crisis — appear to exist in two different and incommensurate universes, or members of two different religions. Each has statistics to quote, authorities to mentions (since when did Sowell know anything about macroeonomics, though?), and orthodoxies to defend.
It’s a pity, because the role of the government in stabilizing markets is pretty much indisputable: truly ‘free’ markets without any regulation are well known to be wildly unstable and prone to bubbles and crashes, and the problem is only exacerbated when there are few rules on how non-market power is applied. Feudalism, after all, represented a use of military pressure to enforce rent-taking, and the experience of war-torn regions without government and urban societies where the government has abdicated any regulatory function (i.e., southern Italy) show that these regions are systematically poorer, more violent, and more economically unjust than areas with prudent regulation.
But as Duracomm notes, it’s not just the presence or absence, but the quality of regulation that matters. And while s/he and I might disagree on how to find that quality, that’s a sensible political debate.
Pretending that the GSEs, the CRA and Acorn were responsible for the real estate bubble is plain silly and not sensible, but neither is the position that the Fed, Congress and several administrations were completely uninvolved, or failed only by deregulating or failing to enforce regulations.
I wish we could get past the orthodoxies.
October 18, 2009, 6:11 pmJanon2 says:
If Wallison or Prof. Somin were to make these claims before a group of mortgage banking executives who were there when this was happening, the response would be embarrassed laughter. This is a purely post hoc argument–no one among Fannie’s private sector competitors was complaining then that Fannie and Freddie’s purchases were too risky. What they were complaining about was unfair competition in this lucrative market by these government-subsidized competitors!
October 18, 2009, 6:21 pmRicardo says:
Two quick points.
On the CRA:
Source
On regulation: Number of regulations or spending on regulations is a poor measure of how much regulations or lack thereof contributed to the crisis. The fact remains that the financial crisis is and was concentrated mostly in the investment banking sector. Commercial banks — which are much more heavily regulated than investment banks because they accept deposits from the public — got off relatively easy and the ones that didn’t are exactly those that started to delve into investment banking.
And focusing too much attention on federal regulators can be short-sighted. For instance, AIG approached New York’s insurance regulators sometime around 1999 or 2000 and asked if they wanted to regulate credit default swaps: the answer was “not really.” In retrospect, that was a mistake as the risk controls and capital requirements usually associated with vanilla insurance companies might have both lessened counterparty risk as well as kept firms from relying too much on credit default swaps as a way to hedge credit risk. This would have been good although I doubt it alone would have prevented the financial crisis — too many firms were willing to take unhedged credit risk on their books also.
October 18, 2009, 9:55 pmreadery says:
This is a really, really weak argument. As other comments have noted, the government agencies involved lowered their credit standards after the private sector already had. One could certainly argued they got caught up in the craze and shouldn’t have. But to argue that they started it?
To start something, ones actions have to proceed rather than follow it. Logic imposes limits on the permissable inferences one can draw from data, This is one of them.
October 18, 2009, 10:12 pmreadery says:
Sorry, I’m intending to include Fannie and Freddy, which weren’t government agencies at the time.
October 18, 2009, 10:14 pmscattergood says:
The argument that Freddie and Fannie, and thus the gov’t as a whole, are not responsible for the housing mess because Freddie and Fannie didn’t originate subprime loans is somewhere between naive and mendacious. Freddie and Fannie don’t originiate loans, they BUY loans and resell them with a gov’t guarantee attached.
Thus what they decide to buy not only directly affects the mortgage market place but also indirectly because they signal to the rest of the market place what the gov’t is willing to back up. The truth of the matter is that Freddie and Fannie were knee deep in this mess from the 1990′s:
So on the one hand you have the gov’t saying with the CRA, you have to loan to ‘hisorically discriminated groups’ or face consequences to your banking business, and on the other you have the gov’t saying through Freddie and Fannie that if you make those loans we’ll buy them from you and take them off your books.
By any stretch of the imagination that isn’t the free market at work. That other groups like investment banks came into the market after Freddie and Fannie created it and gave it legitimacy is no excuse for them, but to blame the private participants for their excesses when the gov’t started the ball rolling seems foolish.
October 19, 2009, 12:33 amHarryEagar says:
Scattergood, please explain why the largest bank in my state wrote 0 subprime mortgages, if what you wrote was accurate.
October 19, 2009, 1:15 amRicardo says:
80% of all subprime mortgages wound up being securitized. Of these subprime securities, almost all were underwritten by private investment banks which are not covered by various affordable housing regulations. I pointed out in a prior thread, if you look at all these subprime securities and where they wound up, fewer than 20% were purchased by the GSEs with the rest being sold into the private market.
These are very basic facts. Note that $18.6 billion is not “knee-deep” in anything. Do you realize that the subprime mortgage market was measured in the trillions of dollars?
October 19, 2009, 1:20 amscattergood says:
One datapoint unimportant as it can be explained with any number of reasons, such as target lending areas, type of institution, relationships with regulators, history of lending, etc.
It is like asking ‘hey if private firm X’ didn’t participate in the MBS / CDO / CDS mess, then how can you blame the private market for what happened?
October 19, 2009, 9:40 amscattergood says:
But eventually over 25% of the Freddie and Fannie yearly purchases were in “special affordable” mortages, as defined by HUD. If the gov’t were willing to back a portfolio with an increasing amount of such loans, could the private market really ignore it?
You do realize that the 18.6B number is for 2000? In that year there were 138B worth of subprim loans, and thus the gov’t was responsible for 13.5% of the subprime loans? You can say that having the gov’t create a market, be a very large participant in it, and have a large portion of their portfolio in it isn’t important, but I and many others would disagree.
Further with respect to CRA loans, which are not all supbrime, let’s compare Freddie and Fannie to a private institution:
You can see the sybiotic relatinship here. Private institutions issue the higher risk loans, only to have those loans bought by the GSE’s. Again, private institutions have plenty of blame to fall on their shoulders, but to sya that this is a problem of the ‘free market’ and we don’t have enough ‘regulation’ is poppycock.
October 19, 2009, 9:59 amAbdul Abulbul Amir says:
Huh!? The GSE’s lowered their standards during the Clinton administration in order to purchase and package no money down mortgages. This included no money down mortgages in states with anti-deficiency laws.
This is about as high risk as you can get.
October 19, 2009, 12:39 pmJanon2 says:
If you look at the previous thread on the same subject, you’ll see that the people who don’t accept the GSE/affordable housing explanation are a politically diverse group who happen to know something about the mortgage business and economics. On this particular blog, the ideologues are mostly conservative. If you went to a more liberal blog, the people who know something would be making the same arguments they are here, while the political types would be going on and on about predatory lending, greedy lenders, etc.
October 19, 2009, 10:55 pmBridge Finance says:
I just would like to thanks for the blog. Like it. Thanks
January 15, 2010, 7:42 pm