StanCollender'sCapitalGainsandGames Washington, Wall Street and Everything in Between

The Sarah Palinization of the financial crisis (cont'd)

06 Jun 2010
Posted by Edmund L. Andrews

 Since my last post, venting over those who blame the financial crisis on the government policies to help low-income people, Raghuram Rajan has fired back at Paul Krugman over how much blame should go to Fannie Mae and Freddie Mac.

Since I mentioned Krugman's criticism of Raghu, I want to clarify a couple of points.   For starters, I think Krugman was over-the-top toward him.   Rajan is most definitely not a member of the right-wing fantasy history campaign.  He may be at the University of Chicago, but he is not an ideologue and he is an outstanding scholar. 

As many people know, Rajan gave a courageous paper at the Fed's Jackson Hole conference in 2005, in which he argued that short-term incentives on Wall Street were corrupting the financial system and posing potential big risks to the world.   This was two years before the crisis got underway, and the main theme of that particular retreat was to celebrate the legacy of Alan Greenspan  (prematurely, it turned out).   I was there, and I can confirm that Raghu was greeted almost with scorn.   As Justin Lahart later remarked in the WS Journal, people reacted as if he were some kind of a Luddite.  But Raghu was right, and many of his criticisms are now conventional wisdom.

Second, Rajan's views are moderate and thoughtful compared to those of the true wingnuts.  In his recent FT commentary, Rajan glancingly referred to the vast sums of money that Congress steered toward low-income homeowners as part of how government policy "distorted" the market.  

Irrational exuberance played a part, but perhaps more important were the political forces distorting the markets.  The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans.

Compared to the truly awful World Bank paper I described last week, not to mention the right-wing talk-show hosts, this was pretty tame.  Rajan didn't even mention the Community Reinvestment Act in his FT commentary, which the talk-show types claim "forced'' the banks to make dangerous loans to irresponsible poor people.   In his response to Krugman, Rajan  completely disavows that whole argument.  Thank God.

On  Fannie and Freddie, he argues that  two institutions contributed to the mess by buying a lot of subprime-backed  paper -- as much as $434 billion worth during the housing bubble.   That's probably less a quarter of all the subprime and Alt-A securities that were sold in that period, but it's not nothing.  Rajan says that has to have played a role in the madness:

The key question the “Fannie and Freddie did not contribute to the crisis” battalion leaves unanswered is why the “greedy” bankers turned to lending to the poor....the housing boom and the bust were most pronounced amongst the lower end of the housing market, unlike previous housing booms .... I argue that the government and its support to low-income housing made this segment of the market attractive. The government and politicians may have gone in with noble intent (as is usually the case), but with devastating and unintended consequences.

I strongly disagree several of Raghu's points here.  For one thing, the government didn't need to prod the mortgage lenders into seeking out lower-income borrowers.  By 2004, and certainly by 2006, the higher end of the mortgage market was so picked-over and saturated that lenders were desperate for new territory.  They had no place to go but down. 

Second, the big question isn't whether Fannie and Freddie made thigs worse.  I agree; they did. But  the really  key question for future policy purposes is this: who was driving whom?  For that, you should look at who was firstest with the mostest in the subprime/no-doc/option-arm arena.   The answer on both counts, by a wide margin: private label securitizers. Yes, Fannie and Freddie contributed to the bubble and the bad lending.  But it wasn't because they were trying to help the poor, and they certainly weren't the driving force.  They were just trying to keep up with their private-sector rivals.  

That's a big distinction. The big lesson here was not about government distortions to the market (except perhaps the Fed's low interest rates).  The big lesson here was that unrestrained, unregulated lending practices by the private sector can be dangerous for consumers and for the financial system as a whole.   To the extent that "government policy'' contributed to the crisis, the first failure was in not stopping the reckless private-sector lending and the second failure was in not stopping Fannie and Freddie from following suit. 






Amen, Brother Andrews! Right

Amen, Brother Andrews! Right on all accounts.

I expect that the main role of the GSEs buying some of the subprime the banks were manufacturing was to intermediate some of the foreign sovereign demand for quasi-US-government paper. There was a whole lot of liquidity out there sloshing around.

As for political pressures. If my memory serves me, the GOP's pattern re the GSEs tended to track the banks' attitudes.

When the plain vanilla market started to really take off, the bankers wanted the action for themselves. So they wanted the GSEs held to strict limits on growth, types and sizes of mortgages they could handle etc. Hence the rapid decline in the GSEs market share.

The ensuing manufacture of vast quantities of dodgy assets was mainly a private sector orgy. During the time the private sector led the way, there were lots of industry and GOP complaints heard on the Hill about the GSEs -- how the GSEs were taking unfair advantage of their implicit government subsidy or running dangerous credit risks, etc. etc.

As the steam starting leaking from the housing bubble, the GSE managers all wanted to claw back market share. And the bankers were happy to let them back into the game as an easy place to stuff the garbage they were manufacturing. So you heard a lot fewer squeals from the GOP on the Hill, and the GSE managers were effectively let off their leashes by both Democrats and Republicans.

Then when the crash came the GOP went back to their old favorite anti-GSE spiel as if they'd been preaching it continuously rather than opportunistically. McCain was especially outrageous on that score. A safe operating assumption is that you can never be too cynical when you hear a GOP Congresscritter claim to have been a voice for tougher regulation.

Credit insurance

Fannie and Freddie's primary contribution toward the crisis wasn't their buying of $434B in subprime paper. It was the guarantees they made when packaging mortgages into MBS. It also had nothing to do with their quasi-governmental pseudo-status either. It was the same problem created by AIG with their CDS and by the monolines. The concept of credit insurance is faulty and has serious systemic consequences, so all forms of it should be outlawed. All it did was encourage the underpricing of risk and the taking on of excess leverage. It did not eliminate credit risk, it merely transformed it into counterparty risk, and in a manner where it was impossible for the insurers to ever pay out on claims.

Same argument at any percentage

"On Fannie and Freddie, he argues that two institutions contributed to the mess by buying a lot of subprime-backed paper -- as much as $434 billion worth during the housing bubble. That's probably less a quarter of all the subprime and Alt-A securities that were sold in that period, but it's not nothing."

The question is: would Rajan be making the same (initial) argument had the
percentage being, say, 10% ?

I think he would be making the same argument even if that percentage was _zero_.

And I like how "subprime" got morphed into "subprime and Alt-A" (to save the

Great comments

Great comments, and I appreciate all of them.  Just one quibble with In Hell's Kitchen's point about "subprime'' becoming "subprime plus Alt-A."  It's not unreasonable to merge the two.   Alt-A's (no- and low-doc loans, but to borrowers with good credit scores) defaulted at rates not that much lower than the true subprimes (low credit scores, high rates, prepay penalties).




Please keep the timeline intact

With all due respect (and, btw, everything I read in capitalgainsandgames
deserves it) I think this merging is uncalled for since Alt-A's started
showing signs of blow-up _late_ into 2008, well after the subprimes had
the house of cards coming tumbling down.

Has anyone read this:
From Barry Ritholtz.
To quote a little bit:

Over the past 2 years, I have repeatedly asked the people who push this narrative to provide some evidence for their positions. I have offered a $100,000 if they could prove their case.

Specifically, I have requested some data or evidence that DISPROVED the following facts:

-The origination of subprime loans came primarily from non bank lenders not covered by the CRA;

-The majority of the underwriting, at least for the first few years of the boom, were by these same non-bank lenders

-When the big banks began chasing subprime, it was due to the profit motive, not any mandate from the President (a Republican) or the the Congress (Republican controlled) or the GSEs they oversaw.

-Prior to 2005, nearly all of these sub-prime loans were bought by Wall Street — NOT Fannie & Freddie

-In fact, prior to 2005, the GSEs were not permitted to purchase non-conforming mortgages.

-After 2005, Fannie & Freddie changed their own rules to start buying these non-conforming mortgages — in order to maintain market share and compete with Wall Street for profits.

-The change in FNM/FRE conforming mortgage purchases in 2005 was not due to any legislation or marching orders from the President (a Republican) or the the Congress (Republican controlled). It was the profit motive that led them to this action.

These are data supported facts I pounded on in BN.

The comments here support this view and oppose the waffling by Raghuram Rajan
to blame poor people for the crisis.

Does RR have any evidence that would win him $100,000?

Hackdom is, as hackdom does

In the earlier post Mr. Andrews tells us that David G. Tarr is a 'hack'. From Tarr's bio:

Dr. David G. Tarr is a consultant and former Lead Economist with the World Bank and Adjunct Professor of International Economics at the New Economic School, Moscow. He has authored more than 60 refereed journal articles, written or edited 11 books or monographs and over 100 other professional papers. Dr. Tarr has worked in more than twenty countries providing trade policy advice . His solely authored journal articles include articles in Econometrica, Review of Economic Studies, Quarterly Journal of Economics, Economic Inquiry, the Southern Economics Journal, the Journal of International Economics and the Journal of Comparative Economics.

By contrast, Mr. Andrews is a journalist, whose credentials are:

'As I write in February 2009, I am four months past due on my mortgage and bracing for foreclosure proceedings to begin.' Thus begins this cautionary and critical examination of the housing crisis, a story that turned personal when New York Times economics reporter Andrews got caught up in the housing bubble after falling in love with a woman and a house. Bringing in $120,000 a year in salary—most of which went to child support and alimony to his ex-wife, Andrews says he was able to get a don't ask, don't tell mortgage with the assumption that his new wife, Patty, would be able to get a job to keep them afloat, an expectation that didn't work out as planned.

Not even worthy of a Pot, Kettle, Black Award.

Wall Street needed someone

Wall Street needed someone with a pulse to sign a mortgage to provide a basis for their CDO's. They couldn't create straw buyers. They drew poor credit risks into buying houses so they could have a basis for creating the huge leverage that garnered the large profits from selling CDO's far in excess of the value of the underlying mortgages.

waxing nostalgic for Michael Palinization & rational discourse

I certainly do not want to be perceived as “defending” the GSEs. I spent some significant effort in the late 1990s and early 2000s advocating to HUD/OFHEO that they be prohibited from buying subprime MBS, efforts that were obviously unsuccessful. The GSE model, especially its ability to resist stronger regulation and the allowance for the clear dominance of short-term profits over public mission, was deeply flawed. They did buy high-risk product, and especially high-risk MBS, the latter of which may have supported subprime growth. (Although given the appetite for yield among the general capital markets, I have yet to see convincing evidence there would have been a shortage of buyers for subprime MBS, or a significant effect on yields if they had not bought as much, and their share of the subprime MBS market dropped sharply after 2004.) Notwithstanding the real problems with their structure, to see serious folks echo claims by folks who rely on sketchy, questionable and often highly opaque data, such as Peter Wallison of AEI and Edward Pinto, is a bit disconcerting.

Much of the evidence offered by Mr. Pinto and others tends to be quite opaque and often misleading - and almost always ignoring ample, more rigorous evidence out there that contradicts his findings. Here is an example: He persists on the CRA allegations even though the substantive research showing that CRA lending had little to no role in the subprime crisis it is quite compelling.

One of the problem plaguing work by folks like Pinto (and Rajan) is confusing or conflating the purchasing and investment roles/activities of the GSEs (their purchasing of subprime RMBS was more substantial than their purchasing of subprime loans, which was modest, especially before 2007). Another is greatly expanding or distorting the use of the term "subprime loans" to include any loan with a characteristic that increases loan risk.

Using all loans to borrowers with credit scores below 660 as being sufficient for including a loan as a subprime loan is one example. Traditionally subprime loans have been defined as loans with higher rates and (often) fees that are marketed to people with (generally) weaker credit. It is generally the loan - and not the borrower - that is classified as subprime in this context. (See, for example scores of Fed studies, the Mortgage Bankers Association National Delinquency Survey, the Lender Processing Services database, etc.) More specifically, lenders typically had LTV by credit score matrices that determined whether a loan was subprime, so that a borrower with a 640 credit score, but had a 20% downpayment might be given a prime loan, while one with a 3% downpayment would get a subprime loan (if things worked properly). There are lots of folks in the 620 - 660 range, so Pinto's use of 660 is important.

An S&P study ( shows only 4% of GSE loans outstanding in late 09 were to borrowers with credit scores below 620, and I believe this includes whole loans in portfolio and the much larger set of GSE securitized loans. That study finds that about 20% of Fannie loans were interest only, option ARMs, and Alt-A and below 620 FICO scores. Another 10% or so were LTVs over 90%, but many of these would not be considered high-risk by most observers. 95% LTV loans to folks with 680 or above credit scores would have normally considered standard prime fare, and would include private mortgage insurance. So, 20% is a big number, but much of this would not be considered subprime by traditional definitions or by sources such as the MBA National Delinquency Survey. The table also shows that even the lowest credit score loans (under 620), the default rate is 13-16% in late 09, deep into the mortgage crisis. This rate, while high historically, is far lower than the rates for true private label securitized subprime loans.

A Chicago Fed study ( shows a subprime default rate EVEN in 2006 and 2007 (before they got even worse) was already 25-33%. They are now closer to 40-60%. The study also shows that, after controlling for credit score and many other variables, GSE loans defaulted at lower rates than non GSE loans. Of course, even 13-16% default rates are high, but given the state of everything, this is not what I would consider terribly high, relatively at least.

More specifically, the Chicago Fed study shows that from 2004-2006, Lender Processing Servicing data (the preeminent source for rigorous lending research recently) indicates that less than 5% of subprime loans were PURCHASED by the GSEs. A higher percentage in 2007 is due to the shutdown of the subprime market; so the small numbers of GSE purchases became a third of all subprime loans purchased, but the total subprime number had dropped dramatically.

Finally, former FHFA chief Lockhart reported that in 2008 Freddie Mac recorded realized and unrealized losses of $53 billion in its investments in private-label securities, which was three times bigger than its $16 billion in credit losses across its entire single-family book of business. From

Missing the point

All this discussion of subprime mortgages distracts from the point that it was inadequate collateral plus interest rate fluctuation that was the primary cause of the bubble and its burst. Not only subprime mortgages defaulted - I'm not sure they even make up a majority of the mortgages in default.

"missing the point" is the one missing it...


Subprimes certainly don't make up a majority of the defaults or foreclosures NOW. That is partly because they defaulted so early (most in the first 2-3 years) and essentially none have been made for almost 3 years. So the raw number of outstanding subprime loans has been severely depleted. So they couldnt constitute a large share of new foreclosures.

But through middle to late 2008 anyway, subprime loans DID constitute the majority of defaults and foreclosures despite accounting for about 15-20% of the mortgage market. And until property values had fallen a lot and unemployment had jumped, mostly by middle 2009 in most markets, prime foreclosure rates had stayed quite low. It was the subprime crisis, and the economic crisis it spurred, that pushed the prime delinquency and foreclosure rates into high territories, and they remain way below anything like the 40-60% default rates of the subprime sector.

More to the point, the discussion was precisely of the relative weight given to causes of the SUBPRIME crisis which culminated in the broader financial crisis beginning in the fall of 08.

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