Monday, July 14, 2008

Paul Krugman on the GSEs

He writes:

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.

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

In that case, however, how did they end up in trouble?

Part of the answer is the sheer scale of the housing bubble, and the size of the price declines taking place now that the bubble has burst. In Los Angeles, Miami and other places, anyone who borrowed to buy a house at the peak of the market probably has negative equity at this point, even if he or she originally put 20 percent down. The result is a rising rate of delinquency even on loans that meet Fannie-Freddie guidelines.

Also, Fannie and Freddie, while tightly regulated in terms of their lending, haven’t been required to put up enough capital — that is, money raised by selling stock rather than borrowing. This means that even a small decline in the value of their assets can leave them underwater, owing more than they own.

Ex post it would appear that Fannie-Freddie should have had higher capital requirements, if for no other reason than to bolster confidence during periods of stress. But ex ante, stress-testing models showed that Fannie was well capitalized and that Freddie was very well capitalized. Ironically, most of us who followed the companies worried a lot more about interest rate/prepayment risk than default risk.

This is not to say that past Fannie/Freddie senior management did not behave badly with respect to financial reporting, and I find it maddening that some of the worst actors wound up walking away with millions of dollars. While I made good friends at Freddie and learned a lot, the moral obtuseness of company leaders at the time (2002-03) made me very uncomfortable and I looked for a way out (I also discovered within about a week of being there that I really missed being a professor). Daniel Mudd's current silence also makes me wonder if there is a shoe to drop that has not yet appeared in the monthly volume summaries.

But for the reasons Krugman gave, moral hazard did not produce lax underwriting at Fannie-Freddie--regulation (and to be fair, I think corporate culture at Freddie) prevented that from happening. To the extent they are in trouble, it is because of market conditions outside the realm of historical experience. It is, after all, their job to be in the market at all times--no matter what. They is why they have their charters. A government backstop will not it their cases reward bad behavior; it will assure that they can do a job that purely private participants are unwilling to do at the moment.


Middle Man said...

One shouldn't be too confident interest rate risk might yet be realized. Dollar interest rates are being held down by emerging markets whose inflation is getting vexingly out of control, most especially for those highly sensitive to political risk (read: the Gulf, China). If they pull the plug, Freddie and Fannie's various hedging programs will likely turn a rout in the treasury market into the fourth horseman of the apocalypse.

In any case, I take significant issue with your accounting of this failure of the GSEs as if it were something beyond their control, when in fact they were directly responsible for instigating the mortgage finance bubble that led to the housing bubble, (albeit at the behest of the Greenspan Fed). Why does all that always have to disappear down the memory hole? Why do we have to be reminded that during the height of the LTCM crisis, when bonds of all stripes simply weren't trading and swap spreads went to astronomical levels, it was Freddie and Fannie that effectively ballooned their balance sheets (nearly doubling in circa two years) to reliquify the bond market. Why doesn't anyone acknowledge that their failure, this recession, the housing bust, negative savings rates, subprime, persistent current account deficits, the energy shock, exploding global dollar reserves, the sagging and imperiled exchange rate: all of it are symptoms of the same underlying unrelenting malignant credit bubble, in which Freddie and Fannie were instrumental? And who bailed out the credit market and economy again following the TMT bust? But of course. Here is Doug Noland of Prudent Bear on the subject:

"The Greenspan Fed cut rates aggressively in 2001, and Total Mortgage Debt (TMD) growth accelerated to a rate of 10.4%. With rates dropping to as low as 1.25% in 2002, TMD expanded 12.1%. With rates dropping to 1.0% in 2003, TMD increased another 11.9%. Despite TMD increasing by a stunning 38% in three years, Fed funds remained at 1% through the first half of 2004. TMD growth surged to 13.5% in 2004, followed by 13.4% in 2005, and 11.6% in 2006. The Greenspan Fed sat idly as mortgage Credit doubled in just six years."

So the entire stock of US mortgage debt doubles in six highly unexceptional economic years (probably better described as anemic) following on the heels of an historic expansion and stock market bubble and absent any intervening housing recession, all orchestrated by the Federal Reserve to 'risk manage' the economy off the shoals of non-existent deflation, and carried out, at least at first and before the accounting scandals started to bite in 2004, nearly exclusively by Fannie and Freddie. So after all of that kicks off the biggest residential housing bubble in human history, (the global housing bubble that Greenspan sees as exculpatory enigma actually and unsurprisingly is rooted in the same underlying causes by virtue of legion global dollar recycling/competitive devaluations (see Brad Setser for more)- and of course, housing wasn't the only asset class bubbling- you would find it more difficult to identify one that wasn't), Fannie and Freddie all of the sudden are victims of circumstances? Pardon me if I have a difficult time getting from here to there. Seriously. Any 'stress test' that showed these two entities with a $5tn book of business secured against a razor thin < $100bn slice of equity must have been based on the most laughably ridiculous assumptions, not least given the circumstances that Fannie and Freddie were prime movers in creating, (namely, one egregious bubble and attendant speculation). Now these are of course inanimate legal edifices, and I am not suggesting that there is something in their charter which preordained this outcome, but the actuality of their actions most certainly did! Krugman is wrong on this by a few hundred nautical light years, as is anyone who would advance the proposition that Fannie and Freddie are victims of a capricious housing bubble that beamed down from the clouds as directed by Angelo Mozzilo.

And whose fault was it? Well, naturally it was the fault of Greenspan, but that's just the tip of the culpability iceberg. It was equally the fault of regulators across the board and in all the major regulatory institutions, and of the politicians who put pressure on all of them (not least after irrational exuberance) and of a very powerful very moneyed Wall Street that put pressure on the politicians. Everyone had their hands in the cookie jar, everyone with any responsibility for these matters who didn't act regardless of consequences is responsible. And I can't think of anyone off the top of my head who didn't fall into line post-Volker. Wall Street was looking out for their myopic interests, the politicians were looking out for theirs, the regulators, and the execs running Fannie and Freddie were just another set of amoral cronies at the trough. Point being, none of the negative consequences we have experienced and the far worse to come will be rectified, none of the worst villains vilified, until we get the story straight. And that doesn't include letting anyone off the hook that didn't earn it.

BadTux said...

MM, by the peak of the sub-prime craze in 2005, Fannie/Freddie were securitizing or guaranteeing less than 38% of the mortgage loans made. You cannot blame them for the toxic mortgages that trashed the housing market. While they would have liked to have gotten into that market, they were prevented by their charters and federal regulations from doing so. It's just that they relied on having, well, stable housing prices, as part of their fundamental business model. The notion that housing prices could plummet by 60% in some zip codes (as has happened in some places here in California) simply has no precedent. They are exposed to only 80% of the risk of the loans on those homes if housing prices are stable and as holder of the first mortgage could traditionally make up their risk by foreclosing and selling the home. But if the housing prices have plummeted by 60% since the loan was originated...

Let's face it, there is no business model for any mortgage lender that can deal with that. None. No matter how well capitalized, well-regulated, or well managed (and I'll admit that "well managed" has not typified Fannie/Freddie management over the past decade, but law pretty much prohibited them from indulging in the worst of the sub-prime nonsense). A housing market decline on this scale simply has not happened within living memory of most people, there have been localized examples of housing busts such as the one in the Oil Patch during their oil bust from 1985-1990 or so, but a nationwide decline in housing prices by 20%? That just breaks the whole model that Fannie/Freddie were built around.

- Badtux the Economics Penguin

Middle Man said...

badtux, that accounting of the GSE's is akin to claiming that Soviet artillery played no roll in the encirclement of the German 5th Army at Stalingrad because the batteries themselves weren't the actual units doing the encircling. If you'll look at what I've wrote, it's clear that the GSE's were instrumental in instigating and maintaining the credit bubble that eventually manifested itself in a housing bubble amongst other things. It really doesn't do for the GSE's, the Fed or LTCM for that matter to hide behind the historical record without noting the rather different set of circumstances that gave rise to it. So what that the housing market had never seen the staggering losses that have happened and are well poised to continue? That hardly means they were remotely unpredictable (you will find Jeremy Grantham's quarterly commentary useful in this regard). Even aside from bog standard measures of affordability, I think you'll find rather rare instances in the historical record where the entire stock of mortgage debt in the country doubled in six years starting from smack in the middle of a recession which itself followed on from the largest peace time expansion in our nation's history, during which there were robust wage gains and the nation's largest stock market bubble by some metrics, (i.e. housing hadn't exactly been doing poorly for a while). I think you'll struggle to find remotely comparable circumstances, and I should think that any clear eyed person who looked at the egregious growth of the GSE's book of business over a 10 year period, and the rather curiously timed accelerations in balance sheet expansion tell a slightly more nuanced story than 'here you have some good banks that went bad by some unlucky rolling of the dice that resulted in a really bad housing market'. Sorry, but that won't wash, and the fact that people are advancing such things even now, even as it has become remarkably apparent how intimately close government and wall street have been at ballooning the dollar credit market, and how deleterious that has all become for the real economy- globally- and real economic maladjustments all over the globe, is hard for me to understand. In any final analysis, no matter your perception of the sensibility of the stress tests that evaluated these stunningly undercapitalized firms or lack thereof, (and, btw, there was little to stop borrowed money from being used against the 20% requirement), you can't simply exempt $5tn gargantuan enterprises and underwriters of marketplace liquidity for a speculative community whose growth was also explosive and destabablizing in that story.