More Debunking of the “Freddie and Fannie Caused the Crisis” Meme

There are a lot of bad things you can say about Fannie and Freddie: that they were part of the oversubsidization of housing in America, that they’ve had an overlarge side business of funneling cash to friendly politicians, that some of their “innovative” practices, like requiring the use of the electronic mortgage registration system, MERS, have proven to be detrimental (by clouding title and facilitating foreclosure abuses). And it’s pretty easy not to like the use of Fannie and Freddie as pretty much the only game in town now in mortgage-land.

But a common charge, “Fannie and Freddie caused the subprime bubble” is plain barmy. As we’ve noted on this blog repeatedly, with the generous help of Tom Adams, and also detail in ECONNED, collateralized debt obligations were a bigger driver of the toxic phase of subprime issuance (third quarter 2005 through 2007) than is commonly realized. And CDOs were created strictly from “private label,” meaning non-Fannie/Freddie mortgage pools.

McClatchy (hat tip lambert strether) does a nice job of shredding this erroneous line of attack on the GSEs, with simple talking points to use with resistant true believers:

Subprime lending offered high-cost loans to the weakest borrowers during the housing boom that lasted from 2001 to 2007. Subprime lending was at its height from 2004 to 2006.

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.

Yves here. As we and others have pointed out, Fannie and Freddie’s share of lending to moderate and lower income borrowers FELL as the subprime market became reckless:

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….

But these loans, and those to low- and moderate-income families represent a small portion of overall lending….

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.

Fannie and Freddie are not only zombie financial firms, they seem to have more than the normal number of zombie news stories associated with them.

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  1. attempter

    Also, since it’s usually Republicans who tell this lie, let’s always recall the fact that it was none other than George Bush in 2005 who ordered the GSEs to go all in on subprime, though as the numbers show they were still never the decisive players.

  2. Average Joe

    You will never find direct evidence that Fannie and Freddie caused it if you look at the loans they actually made. But the reality is, as Paulson finally admitted, their debt was as “good” as Treasuries and everyone knew it (as Paulson also admitted).

    How are the private lenders supposed to compete with a lender who gets money cheaper than anyone else? They improvise. They get creative.

    How do those who provide the mortgage market with money to lend accurately assess risk and the price of that money?

    The truth is that money was too cheap. Risk was underpriced.

    This fundamental distortion of the market resulted in all the unintended consequences that you call the “direct” causes of the “crisis”.

    1. Average Joe

      If Walmart decided to sell gas (at a loss) for $1.00 a gallon, then every competitor better find a way to sell it for 99 cents. Their choice would be to not lose money, and go out of business, or to sell gas at a loss and go out of business slowly. Angelo Mozillo is a testimant to what method they chose and why.

      Walmart may sell the least amount of gas, but whose fault is it when all their competitors die a slow death, and Walmart is the last man standing and everyone is driving around in a gas guzzling SUV.

    2. Yves Smith Post author

      Average Joe,

      With all due respect, what evidence do you have here? None. Fannie and Freddie default rates on prime paper (different category than subprime, remember?) are a fraction of subprime. And they were losing share in subprime, prima facie evidence that other players were more aggressive than they were.

      And if Frannie and Freddie were underpricing risk, why pray tell did we have them lending to mid and lower income borrowers without major mishap from 1992 (why did we not have a disaster much sooner), and why with major Frannie and Freddie involvement, was the 1990s subprime market much smaller and resolved its excesses with no widespread damage?

      All you have are data free and irrelevant analogies.

      What changed was the creation in June 2005 of the ISDA protocol that allowed for the creation of standardized CDS on asset backed securities, particularly residential mortgage bonds. The toxic phase of subprime lending started almost immediately thereafter. The two are directly related. And Fannie and Freddie had NOTHING TO DO WITH IT.

      I have an extensive analysis in Chapter 9 of ECONNED. One hedge fund, Magnetar, drove the demand for 35% to 60% of subprime lending though its hybrid CDO program. I was able to prove out only 35% for certain by the time the book went to press; industry sources insisted 50% to as much as 75%. I’ve since come to understand another mechanism related to the Magnetar trade and am now confident they accounted for at least 50% of subprime demand. And their program was copied, so its total impact was even larger.

  3. Average Joe

    Thanks for the reply. As I said, I have no direct evidence.

    My analogy is not irrelevant however:
    “In 1996, the Congressional Budget Office wrote “there have been no federal appropriations for cash payments or guarantee subsidies. But in the place of federal funds the government provides considerable unpriced benefits to the enterprises… Government-sponsored enterprises are costly to the government and taxpayers… the benefit is currently worth $6.5 billion annually.”

    “The GSEs, Fannie Mae and Freddie Mac, are exempt from this capital/asset ratio requirement and can, and often do, maintain a capital/asset ratio less than 3%.”

    “FNMA is also exempt from state and local taxes.”

    “The perception of government guarantees has allowed Fannie Mae and Freddie Mac to save billions in borrowing costs. Estimates by the Congressional Budget Office and the Treasury Department put the figure at about $2 billion per year.[32]”

    “In testimony before the House and Senate Banking Committee in 2004, Alan Greenspan expressed the belief that Fannie Mae’s (weak) financial position was the result of markets believing that the U.S. Government would never allow Fannie Mae (or Freddie Mac) to fail.”

    I do have common sense. It’s hard to argue that Fannie and Freddie’s existance would provide no distortion whatsoever on the market.

    All those who claimed that Fannie and Freddie unleashed would distort the market in unforseen ways were either lucky or right.

    1. Anonymous Jones

      Where did she say they didn’t distort the market?

      Did you really say “All those who claimed that Fannie and Freddie unleashed would distort the market in unforseen ways were either lucky or right?”

      I can assure you that almost everything that will happen to you for the rest of your life will be distorted in “unforeseen ways.”

      The point Yves is making is that a supervening, or at least much more proximate, cause (massive regulatory arbitrage in hedge funds and derivatives creation that induced radical shifts in the way non-GSE subprime loans were originated) is a much more appropriate place to focus our attention.

      Enough with the analogies. I think the GSEs are, were, and have always been *terrible* ideas that making housing *less* affordable. At the same time, to credit them with being even a minor cause of the subprime debacle is to really, really not want to see the evidence all around you.

      Please think before typing. Seriously…

  4. average Joe

    Perhaps one more irrelevant analogy:

    I’ve been told that I should not violate the trust of the public as a police officer, since if I do “bad things” tend to happen.

    Now, would proving the officers who beat Rodney King were no where near Reginald Denny when he was assaulted by random rioters mean they had nothing to do with it? Technically I suppose. The point is that bad things were gonna happen to the mortgage market. People predicted it. It happened.

    Those who say Fannie and Freddie caused the mortgage meltdown are accepting the idea that they were the indirect cause. A predictable cause. One that we should not repeat.

  5. OtherJoe

    Those who say F & F caused the MM > Want to Promote Hatred Against Efforts to Assist Minorities! That is the effect they want.

    Average Joe, stop siding with them! Stop making excuses for them!

  6. FinancialObserver

    Joe, it’s curious that you don’t seem very interested in debating a very good fact set that Yves has presented you with. Easier to spin homey analogies? My guess is that you’ve spent a fair amount of time watching Fox, probably have at least a glancing familiarity with Peter Wallison, and know just about enough to be dangerous. Yes, you can probably rightly make the argument that Fannie and Freddie had some (small) indirect effect on what became this financial crisis. But since you like analogies: If you build a house out of cardboard, and the windows out of Saran Wrap, and a hurricane blows it over, is the main problem that the windows were made out of Saran Wrap or that the house was made out of cardboard? Take your time, Joe. Think about it. :)

  7. rjs

    Fannie & Freddie didnt cause a worldwide crisis:

    House Prices Declining from Peaks Around the World – Once and for all, let us nail the lie that the global credit crisis was basically a US sub-prime property bubble that went wrong, and that Europe was merely an innocent bystander hit by shrapnel.This is the property bubble chart on Page 12 of the IMF’s latest report (Article IV) on France. If you read the whole report – (click “Staff Report” here) – note the horrendous decline in French export share. But that is another story. As you can see, France had the most extreme price rises from 1997 to 2009, followed by Spain and Italy some way below. The Anglo-Saxons were more moderate. The US bubble was tame by comparison (measured by price: inventory overhang is another matter) and has largely corrected. This the American way, a short sharp purge. The Club Med bubbles have not corrected, by a long shot.

  8. sherparick

    This zombie idea (along with the even stupider zombie idea that the bubble was the result of the CRA) will not die because it serves an ideological and tactical political purpose. Large groups of people want to believe it. Neo-classical economists who believe in the perfection of markets want to believe it because they can blame “Gubmint” for the crash, a crash they failed to predict with their free market models and the existence of Fannie and Freddier were not a big secret the 2001-07 period want to believe it. Republicans, Fannie and Freddie are associated with certain high profile Financial Interest Democrats, and by blaming them, they hope to escape the responsibility for the huge distoring bubble that occurred on their watch and that they celebrated. (Just go back to the 2004 election campaign and how they were celebrating the rise of in house prices as the proof of “Bush prosperity.”) And for a fair number of my fellow white, middle class, boomer generation Americans, who have just seen the value of their principle asset shrink by between 5 to 50 percent, depending on where they live, it is a seductive song to blame those dark (Black and Brown) others for the crisis, for buying houses they could not afford due to the policies of liberal, DFH, types running the Gubmint and making all “socialist” and promoting all those preferential policies they have been hearing about all their lives rather then accept that the country is being run by confidence men and women.

    These bubbles were complex events, and probably multiple factors had to come into play at the same time to create such an extraordinary bubble in the U.S. housing market (as for the European and Australian bubbles, I don’t know enough about the preconditions in thouse countries (although I do know that land use is much more restrictive in Europe than in the U.S. and that new house contruction has been much more limited).

    The last two recessions in the U.S. were both induced by the crash of bubbles rather than Federal Interest rate increases constricting activity as was the case in the previouis recessions of 1990-91, 1981-82,1980, 1974-75, 1969-1970, etc.. Yes, the Fed was starting to raise interest rates, in 1999-2000, but the bubble crashes, first the short circuited its interest rate increase before it could chill the housing market, and the cuts it made in response to the weakening economic conditions in 2001 suddenly made houses seem like the best investment around as the stock market tanked.

  9. Richfam

    Isn’t the fact that the agencies are zombie banks make them part of the problem?

    Two things:

    If you look at their balance sheets leading up to the crisis you see that they were a large buyer of sub-prime CDO’s and loans that were never securitized. I’m too lazy to go back and pull out the analysis but basically to the tune of 2-3x equity I think I remember. So this was step one in their demise.

    They ran leverage much higher than other financial institutions and usually that can be okay. Meaning even in a dificult economic climate if the loan underwriting was good and the buyer put down 20+% they were in good shape. But their growth accelerated and their standards fell not unlike the rest of mortgage finance so they end up overlevered on subprime loans that they’re on the hook for. They took plenty of bad sub-prime loans like the rest.

    So they’re a huge part of the problem and absolutely one of the causes. Private label sub-prime and such an important cause for sure as well, probably more so.

    The line of reasoning that government directing the agencies and big banks to provide loans for low income housing seems indirect to me since bad loans in 2006 were not about that but there’s a little causation there as well, very little.

    The financing advantage holds no weight for me either. Financing was dirt cheap for everyone.

    I think its a severe simplification to place the blame for the whole thing on CDO’s and Magnetar. We’re ants, we built our hill higher and higher and then it blew away. Poor underwriting, a system created to reward transactions and fees top to bottom, no money down infomercials, housing as the investment that never fails, CDO’s, the agencies, flipping houses, on and on the ant hill grows. So casting blame on th evil CDO market? Sure but it was a frenzied bubble and a ponzi scheme. The same bad loan in 2003-4 was not as bad as the one in 2006 because the asset value was higher. And wall street had not yet figured out a new way to sell the loans through and expand the markets… on and on. So nobody’s fault and everybody’s fault. Both lender and borrower.

  10. Jim the Skeptic

    Fannie Mae and Freddie Mac were created to provide an additional funding mechanism for housing purchases. These GSEs bought conforming loans which required lower down payments to credit worthy applicants. They existed alongside the conventional home mortgage system for DECADES without the problems seen after 2000.

    If you want to blame Fannie Mae and Freddie Mac for the housing bubble then you will need to explain what changed after about 2000.

    It was a workable system until investment bankers decided to game the system. They bought any mortgage paper they could find, packaged them into securities, and sold them. Credit worthiness of the home purchaser was not a concern to the mortgage company because they could sell just about ANY mortgage paper to investment bankers. Credit worthiness was not a concern to the bankers or investors since credit default swaps were used to hedge against losses. That is real market distortion!

    That explains the housing bubble better than any theoretical argument that GSEs distorted the market.

    If I open a discount clothing store across the street from WalMart then I cannot claim unfair competition sometime later. And my banker should be held in utter contempt for funding such an enterprise.

  11. Costard

    Yves, no credible person to my knowledge is arguing that Freddie and Fannie were the only players in the subprime market. But they were necessary ingredients in the bust, for several reasons.

    First, they were major buyers of subprime, period. Whether they bought 48 percent or 24 percent on the secondary market, those are enormous numbers. The 48 percent figure is more important because it was earlier; the later stages of manias are self-feeding, as higher prices become a reality and everyone jumps in.

    Every bubble is predicated on a belief that prices will rise. Government intervention in the mortgage market, not just through FRE and FNM but the through the Fed’s money policy and through various regulatory frameworks, instilled a belief that the powers that be wanted Americans to own homes, and to get rich owning them.

    It is impossible to quantify the effect of Freddie’s and Fannie’s role as end-of-the-line buyers. Every development in the mortgage industry and the manufacture of cdo’s was made with the understanding that the government was buying this stuff, and would continue to do so. Markets can be profoundly changed by relatively small inputs, if those are especially watched or accorded some kind of leadership. There can be no doubt that the government took the leading role in the idea of mass homeownership – it was always a policy directive – particularly (but not just) amongst those who couldn’t traditionally get loans.

    If you sincerely wish to test this “meme”, then you should do several things. 1) Examine the market from 2001-2004 — this is the important period. Climaxes are always a matter of momentum, and looking at 2006 tells us almost nothing. 2) Be willing to consider things that cannot be quantified. Statistics can never establish cause, and yes this means that economic “proofs” are largely hyperbole. Because A lent the mortgages, does not mean B isn’t responsible. 3) Examine the effects of government purchases in other areas, such as corporate bonds. If you recall, the entire premise was that these purchases would instill confidence and get the private debt market churning again. Why should the effect of “god’s hand” be any different with mortgages?

    1. Anonymous Jones

      “But they were necessary ingredients in the bust, for several reasons.”

      This may be true, but mostly irrelevant to your argument.

      As much as I dislike having the GSEs at all, they were certainly not *sufficient* ingredients.

      Thus, you’re going to need a lot more ammo (which obviously, I believe exists) to argue for their eradication.

  12. Progressive Ed

    Interesting article. Glad to know that without the CDO’s F&F wouldn’t need a trillion dollar gov backstopping. And going forward F & F should be just fine. I’m sleeping better already.

  13. Stelios Theoharidis

    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. Now about 70 percent of all U.S. mortgages are in this secondary mortgage market, but I don’t know what percentage of subprime was in the secondary market in relation to prime.

    Between 2004-2006 the share of subprime mortgages relative to total originations ranged from 18%-21%. Which means as the market was growing Fannie and Freddie were pairing back on their secondary purchases of subprime loans.

    The way I think about that is that in a given year you are going to get some toxic and some good loans. Fannie and Freddie can’t take the most toxic garbage out there but they were taking the less toxic stuff. But, as this system progressed and as more people were in home loans, less and less vanilla deals were going to be originated and more and more nuclear waste / fraudulent deals were coming through. Everything would have slowed down and we would have had a smaller bubble on our hands, but, that is where Magnetar stepped in making the market by buying the nuclear waste so that other purchasers could get the other less volatile (but AAA rated) CDO tranches. This put prices higher and more toxic waste out there making the downturn worse when it actually burst.

    Fannie and Freddie had a role, but as a sucker, they were hosed along with a lot of other sophisticated and not so sophisticated parties, but as these suckers run through all of this paper and discover all of the improprieties things will come back on many of the other parties involved.

    Now Fannie and Freddie are coming back at a lot of lenders who sold them these mortgages due to deceptive and fraudulent practices through forced mortgage buyback. “Freddie Mac had $4.8 billion of repurchase requests pending as of March 31” (up one billion from the previous quarter). Fannie has not disclosed how much mortgage buyback they are engaging in. We will see how this progresses, but 1 billion increase in a quarter, and just for Freddie, how much paper do you think there was that was fraudulent at that rate.

    And they are not the only ones with the FED “Through our ongoing management of the Maiden Lane portfolios we are involved in multiple efforts related to exercising our rights as investors in non-agency RMBS or CDO securities including those that require originators to repurchase ineligible loans,” Jack Gutt, a New York Fed spokesman, said in an e-mail.

    In addition the private firms are getting into this game as well, “after Reuters last month reported that investors representing $500 billion in bonds —or a third of the private mortgage bond market — said they have taken the biggest steps yet in their effort to force banks to repurchase loans sold in error.”

    Don’t deceive someone and then try to blame them for letting you deceive them.

  14. CJS

    How does this theory co-exist with the last of today’s links, which talks about how the very existence of the government guarantee is the problem with banks?

  15. Progressive Ed

    CJS: They don’t co-exist but are contradictory. The push to exonerate F&F in the Millennial Meltdown is part of a larger effort to reassure people as the present Progressive administration in Washington massively increases the power of the executive branch (primarily but not exclusively through regulatory administrative control expansion). What’s interesting to think about is with the extraordinary amount of mortgages that F&F now “own”, what percentage of residential property is now government owned!?

  16. Tom

    Prog. Ed-
    I just don’t buy that there is a “push to exonerate” the GSEs for the meltdown. It seems far clearer to me that various politicians have advanced the theory that Fannie, Freddie and the Community Reinvestment Act were responsible for the Crisis (listen to WABC, as I did today, or Fox News, etc.) without bothering to provide any evidence, analysis or economic rationale.

    Any sensible person who was participating in or near the market at the time of the buildup to the crisis, who wasn’t actually on the payroll of such politicians or in thrall with politics for sport, would react – as I do – as if their head might explode when they hear these arguments. This is not out of a love for Fannie or Freddie (for I have none) but rather out of an extreme dislike for nonsense masquerading as thought or analysis.

    Fannie and Freddie bought conforming mortgages as their primary business and then issued mortgage backed securities with their guaranties. While performance for these loans has deteriorated with the real estate downturn and weak economy, the the credit underwriting standards under which the companies created for “prime, conforming” loans held up remarkably well, especially compared to the “non-conforming” market. Had all lenders maintained the credit underwriting standards of Fannie and Freddie across their different loan programs, far fewer loans would have been made and the bubble would have been much less severe.
    The wild, standard-less, lending that dominated sub-prime, Alt A, option arm, second lien markets post-2003 took place almost entirely outside of Fannie and Freddie’s underwriting guidelines.
    The conforming loans did not cause the meltdown at Freddie and Fannie, nor was the performance of these loans the trigger for Fannie and Freddie’s bailout by the government.
    Unfortunately, Fannie and Freddie also had large investment portfolios. Somehow, Fannie, Freddie and their regulators convinced themselves that it made sense to invest in MBS backed by loans which they had effectively rejected, previously, for credit reasons.

    In addition, they were held to different accounting standards for their investments than for their lending and, when the subprime market collapsed in 2008, Fannie and Freddie were forced to Mark-to-Market billions they had invested in AAA rated non-conforming, non-prime MBS. In 2007 the subprime MBS market (including the CDO’s on which they relied) froze, which triggered a rolling freeze of the rest of the securitization market. It took many months for financial institutions to realize and admit that their investments in subprime MBS and CDOs had not just declined in value but were now effectively worthless – the entire market was a “no bid”. Marking subprime MBS and CDOs to market was virtually impossible for months and the best case scenarios even for AAA bonds was 40-60% of par. Fannie and Freddie did not have the capital cushion to absorb discounts to their subprime investment portfolios of the magnitude. Neither did many other financial institutions (banks, bond insurers, AIG, etc.). The Subprime MBS investment portfolios mark to market write downs in the summer of 2008 (which had been building for over 12 months already), caused the initial bailout.

    As “lenders” Fannie and Freddie maintained a decent level of discipline in the market. As investors, they were foolish, too reliant on the rating agencies and not diligent enough about the bigger forces driving mortgage lending. I don’t know why they felt the need to buy so many subprime bonds, but they were far from the sole buyer of AAA subprime MBS (and they only bought the AAA bonds). Other, non-governmental investors had comparable appetite at the same credit spreads as Fannie and Freddie. The continuing low interest rate environment, which drove tremendous levels or mortgage refinancings, was creating reinvestment issues for all MBS investors – they had to keep buying faster and faster to keep up with the run-off in their existing portfolio.

    Most Fannie and Freddie critics have no idea about any of these issues, but are nonetheless, firmly convinced that CRA, Fannie and Freddie were the root of the problem. Of course, anyone who listens to a politician, or radio talk show host, to understand financial and economic issues is not really interested in the finding the truth. As Matt Taibbi mentioned in his most recent article, it should be obvious to everyone by now after the FinReg fiasco, that no one in Washington has any idea what happened and, ultimately, they don’t really care that they don’t know.

  17. Tomato Cain

    I’ve been trying to figure out how it came to be that Fannie Mae and Freddie Mac were bundling and securitizing prime and sub-prime loans on the open market. And why such a bubble seemed to follow the expansion and aggressive actions of the CRA and ACORN? Just asking… And everytime any kind of financial reform, such as the one just passed by Congress and the President in 2010, that F&F are excluded from regulation?

    Anyone have an answer other than “because you’re a hater”, or “you listen to talk radio too much”?

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