Insider's Game

Apparently, Larry White and his three co-writers, all professors at NYU, could not decide upon which metaphor to use.  So they used them all. In Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance, the GSEs were described as  “the largest hedge fund on the planet,” a “ticking time bomb,” a “monster” created by “Dr. Frankenstein,” “the  Devil’s Cigarette Lighter,” as well as “King Kong,” and “Godzilla.” They sparked a “Gold Rush,” which precipitated “Falling Off A Cliff,” and  “The End of Days”.

Eschatological imagery seems to be especially popular among critics of the GSEs.  Joshua Rosner wrote that Fannie’s business  practices in the 1990s led to “Economic Armageddon.” Chris Whalen says, “You cannot separate the GSEs from JPMorgan Chase, Citigroup, Wells Fargo and Bank of America — the four horsemen of the financial apocalypse,” because they all, “exercise illegal cartel control,” over the secondary mortgage market.

But sometimes literary virtuosity can give readers the wrong idea.  I read White’s book and Rosner’s book, and came away with the impression that they both believed that the GSEs  caused the financial crisis of September 2008.  White and his colleague at the Mercatus Center, Peter Wallison seemed to confirm that impression at an event held by the American Enterprise Institute, at which Rosner spoke as well.  Wallison argued that both books confirmed and expanded upon the narrative first set forth by his AEI colleague, Edward Pinto, who definitely blames the GSEs for almost everything.

Fortunately, Rep. Scott Garrett gave White and Rosner an opportunity to clear things up. Last Wednesday, at a hearing to examine the role of the GSEs in the 2008 crisis,  they both disabused us of the notion that they believed that the GSEs were the central cause of the crisis.

“I don’t think that the crisis itself would necessarily [have]  been avoided were it not for the GSEs,”  Rosner testified. He was pretty specific:

Forty percent of all home sales between 2004 and 2007, essentially, were second homes and investment properties and the bulk of the rest of the remaining were refinancings.  So the push for homeownership — the goals of increasing homeownership really didn’t have anything to do with the bubble …And so all of the bubble period was really refinancing, second home, and investment property speculation.  The GSE’s purchase during those periods of large portions of private-label securities fostered that speculation and access liquidity unnecessarily.

Another witness, Dr. Susan Wachter of Wharton, underlined this point. “I don’t think there’s anybody on this panel who would agree that it’s Fannie and Freddie Mac who are the primary cause of the meltdown,” she testified, and none of the other witnesses challenged her claim.

White’s written testimony was fairly nuanced. Like the FCIC, Joe Nocera,  and many others, he argues that the GSEs’ relaxation of credit standards in the mid-2000s was in response to increased competition from Wall Street’s private label securities market. He writes:

Some combination of the upward trend in housing prices, especially after 1996, and the GSEs’ expertise in selecting higher-quality borrowers among those with apparently lower qualifications, kept the GSEs’ losses low. From 1990 through 2007 Freddie Mac’s credit losses on its mortgages in portfolio plus guaranteed RMBS never exceeded 0.11% annually; for Fannie Mae the comparable credit losses never exceeded 0.06%.  For the years 1999-2005 (for Fannie Mae) and 2000-2006 (for Freddie Mac) the credit losses were only 0.01% annually!

Around 2003 the GSEs’ involvement in lower-quality mortgages became more substantial. From around 2000 onward, the growth in alt-A and sub-prime mortgage lending and the related private-label securitization threatened the market shares of the GSEs. At first glance, this should not have been so, since the higher quality mortgage standards of the GSEs should have kept them separate and aloof from the sub-prime borrowers and lenders, and vice-versa. However, in the environment of rising prices and the widespread expectations that prices would continue to rise, lenders were encouraging borrowers who otherwise would have qualified for a conforming loan to borrow larger amounts (which would push them into “jumbo” territory) and/or to structure their loans in ways that would not meet the GSEs’ underwriting standards (which would push them into nonconforming territory).

Writing a book is hard, I’m no one to criticize, but I think  Guaranteed to Fail  would have been enhanced a lot by the inclusion of the two foregoing paragraphs. Because the book’s passages about the Roman empire seemed to say something different:

The Rubicon River marks the boundary between the province of Gaul and Italy. It was Roman law that no general could cross this boundary southward towards Rome with his army, lest the general be mistaken for instigating a coup d’etat. On January 10, 49 BC, Julius Caesar did just that, stating the infamous words “alea jacta est” (the die is cast). And history was forever changed.

The entry of Fannie and Freddie into high-risk mortgages had a similar effect… the GSEs had crossed their own Rubicon in the mid 1990s after the passage of the [Federal Housing Enterprises Financial Safety and Soundness Act of 1992]. The moment that the GSEs lowered their underwriting standards, there was no turning back, and as soon as housing prices started falling, their fate was sealed.

Sometimes, theories about historic inevitability go too far. The book seems to say that the 1992 Act, or the  FHEFSSA , changed everything. And somehow, a stellar record of loan performance–Fannie’s credit losses from 1990 through 2007 never exceeded six basis points per year–belied the hidden dangers of affordable housing goals.  In fact, as White makes clear in his testimony, the pivotal event was the decision by Fannie and Freddie was to lower credit standards to compete with Wall Street in the mid-2000s, when the  Bush Administration  and  Alan Greenspan  took a hands-off approach toward protecting the public against mortgage fraud.