Monday, August 15, 2016

Housing: Part 171 - Paulson and the GSEs

Some quotes from Hank Paulson's "On the Brink":
The GSEs presented another case of unintended consequences.  From my first days at Treasury, I had sought to reduce the role and strengthen the regulation of Fannie Mae and Freddie Mac, which owned or guaranteed about half of America's residential mortgages.  Government policies, from the implicit support of the GSEs to tax preferences, had pumped up the housing bubble and exposed the financial system - and taxpayers - to far too much risk. (p. xix)
Please consider time carefully here.  Hank Paulson became Secretary of the Treasury in July 2006.  In the previous two years, when the total value of US residential real estate owned by households had increased by 16% per year, the total amount of mortgages guaranteed or owned by the GSEs had grown by 6% and 5%.  Growth in guaranteed mortgages in GSE MBSs was even lower.  Paulson's first days at the treasury came at the tail end of a sharp and sudden drop of 20% in market share at the GSEs.
Their (Fannie & Freddie) charters exempted them from state or local taxes and gave them emergency lines of credit with Treasury.  These ties led investors all over the world to believe that securities issued by Fannie and Freddie were backed by the full faith and credit of the U.S.  That was not true, and the Clinton and Bush administrations had both said as much, but many investors chose to believe otherwise. (p. 56)
This is said un-ironically, in a chapter that outlines the process by which the US government, at Paulson's request, essentially made the guarantee explicit.  But, the whole idea that there was not a guarantee is incoherent.  The GSEs were required to meet a federal minimum capital requirement.  As is typical in that context, that led the GSEs to keep very low capital levels.  If you are going to regulate firms with capital requirements, you can hardly require them to keep more capital than an unregulated firm facing at-risk creditors would keep.  And, when you have the requirement, the regulated firms have little choice but to generally maximize their leverage under that requirement.  Has it ever worked any other way?

The idea that the guarantee wasn't really true is incoherent because if there was no guarantee, then what were the capital controls for?  What would have happened if the government had determined the GSEs to be out of compliance?  What would have happened if they decided that the firms had to be taken over because of non-compliance, and had said they would not guarantee the bonds?  The investors would have been furious.  If there are haircuts to be taken, bondholders are perfectly capable of demanding a change of control themselves.  If there was no guarantee, then what business was it of the federal government what level of capital the GSEs kept?  The only reason they operated the way they did was because the guarantee and the capital requirements were a clear part of the same package of federal interventions.

The market had presumed that a guarantee was in place because there is no functional way in which federal enforcement could have operated without it.

While the GSEs did fund a small increase in certain adjustable rate and non-amortizing loans, I don't see much evidence of weakened underwriting.  Here is a graph of FICO scores at origination of new business and total book.  Underwriting tightened up during the crisis and continued to be tightened up after conservatorship.  The GSEs have been making very high profits for the government by charging hefty guarantee fees and only lending to the most credit-worthy households.

Certainly, the privatized gains/socialized losses problem with the GSE setup was not optimal.  But, normally, the reason this is cited as a problem is the moral hazard it creates.  I don't see much evidence of a moral hazard problem at the GSEs.  Fannie was doing better than Freddie, to be sure.  But, the GSEs seem to have been among the least aggressive institutions during the housing boom.  Keep in mind that homeownership had risen from the mid-1990s to 2004, and then leveled and dropped off after the GSEs market share declined.  Most net homeownership happened when the GSEs were strong, when home prices were well below their peaks of early 2006.  The GSEs probably had something to do with that.

I don't think the setup where the GSEs own mortgages is optimal, but I think the idea that they have been associated with risk and bubble pricing is pretty weak.  It isn't moral hazard that was the problem, it's that, given the moral hazard issue, when it came time to stabilize the market, the most stabilizing policies were politically unavailable, because they would have led to shareholders potentially profiting from a government guarantee.  That is what bothers the electorate.  Few people seem to have a problem with federal economic policies that allowed a quarter of real estate wealth to evaporate and GDP growth to collapse, then stagnate for a decade.  But, if an implicit guarantee made explicit would lead to a private profit.  Or, if a loosened general monetary policy might cause stock prices to rise or corporate profits to strengthen, there is backlash.  At the heart of the crisis, there are several tipping points where we chose instability over stability in order to either prevent some people from profiting or to ensure that they would be ruined.  These choices were in response to a consensus, not some partisan demand.


  1. This, of course is true. Thanks, Kevin. I have said for a long time that the GSE's have taken a bad rap for the housing bubble and crash. Truth is, they were forced to guarantee loans after the invetsment banks screwed up with bogus AAA rated MBSs. The investment banks packaging bad MBSs allowed non GSE entities to lend money to people who had a pulse, and that was all they had.

    Kevin, I have had a chart up on my website for a long, long time. It comes from the Fed. I don't see it around. I would post the chart itself but blogspot doesn't allow for it. So here is the link. Copy and paste it and see that even the Fed acknowledges that your position is correct. Private labeled ABSs took over completely from the GSE's starting in late 2003/early 2004:

    1. It's funny how there are still many people who claim the GSEs were a source of unsustainable housing demand, even though they basically sat out 2004-2005.

    2. I sent this chart to you by email thinking I posted it on your next article. I am old. I am sorry!! But the chart is what really angered me when Fox news used to continually blame the GSE's. Most of the American public believe the GSE's not the investment banks, were responsible for the toxic loans.

  2. Great post.

    I do have a minor quibble. I often read that a certain arcane government policy is unacceptable politically, and therefore not taken.

    Then I watch the presidential election.

    Where is the public that even knows what is the Fannie Mae or for that matter what is the FOMC?

    For some reason America's leadership likes tight money, even if it means economic suffocation. Why?

    1. Yeah. You're right.

      It's because the one thing that catches everyone's attention now is whether someone is making a profit off of something. We really did choose to create an economic crisis because the consensus in this country is that the one thing we can't do is let somebody profit from nominal expansion. It's frequently stated explicitly by policy makers. Look at the Fed in the summer of 2007. The Treasury was trying to do all sorts of programs to help keep families in their homes, but the Fed couldn't just reduce rates, because then some "speculators" might have been "bailed out". Public policy has been about making sure only the right people are helped.

      It's why this housing thing is so important. Until we solve the core problem leading to economic inequality, there will be this obsession with stopping profit-taking, which, as we have seen, tends to be wildly "successful".

    2. Excellent point about "the Fed couldn't just reduce rates, because then some "speculators" might have been "bailed out""
      It reminded me of a cliche - that we find out who is naked when the tide goes out. And made me think of a twist on that cliche. That the Fed basically forced the tide out so quickly that it ripped the clothes off of a lot of people that weren't naked and never would have been if the Fed had just get NGDP growth on track.

    3. Love it. A visual image immediately forms when you think of it.

  3. Obviously, your are correct about the rabble-rousing about house speculators or evil banksters.

    Still, there is something else going on.

    Why always the recourse to tight money?

    Sure, we had double-digit inflation in the early 1980s, but today we have global deflation and zero-bound. The Fed is below its inflation targets, which are dubiously low anyway, thanks to the housing situation you have pointed out.

    But always, always, pressure for tight money, from the BIS, the Fed, the WSJ.

    I like to say, "Vulgar Marxist analysis is often surprisingly insightful, even though Marxist medicine is poison."

    So why tight money? Who benefits?

    My sophomoric answer (made to sound sillier thanks to Don Trump) is that multinationals like a tight US monetary policy. It keep the dollar higher, aiding imports into the biggest consumer on the planet. It lowers the dollar-cost of setting up factories offshore. It is multinationals who primarily underwrite commentary that chronic $500 billion trade deficits are a blessing.

    It is really stranger. The same people who rail against debt, then say debt it great as long as it is owed offshore. That an economic region can proper by importing. (I thought a region prospered by selling good and services outside the region, by tourism or by taxing in income, like a national capital. Everything else is taking in each other's laundry. See Detroit after it stopped exporting cars. Now I learn a region---the United States---can prosper by importing goods.)

    Then, one can also join an influential mandarin class of enablers, and bring foreign capital to the U.S. to buy assets, and exhibit a cosmopolitan knowingness about the world.

    That is my whack-o theory of the day. I will now retreat to the peanut gallery.

    1. Actually, Benjamin, a weak dollar has weakened the golden goose of world prosperity, the American consumer. This strong dollar stuff is pretty recent, right? Americans have been weakened, IMO, because the powers that be thought Chinese consumers would take over world demand. But they have not. They are not Americans, they are frugal.

      So, now, clearly there has been a rethink. The American consumer must be restored, because no one else will do it. Problem is, the millennials learned not to like stuff. They eat out at restaurants, but they don't buy a lot of stuff. They make bankers fear they will have to get real jobs.

  4. Gary-
    Somehow I knew my conspiracy tbeory would get a comment from you.

  5. You quote GSE FICO scores, but the underwriting requirements never really changed. Similarly, your discussion of the small increase in ARM and non-amortizing loans "funded" by the GSEs misses another avenue the GSEs gained exposure to mortgages, through their non-agency investments.

    My understanding was that the GSEs bought private MBS to meet their housing goals, precisely because they didn't satisfy the underwriting requirements and they could get a juicy return. They ended up suing and settling for billions of dollars after those didn't perform well. I couldn't find a time series but the July 2015 dashboard (Table 5) shows that about 5% of FNMA's portfolio is still non-agency MBS, even though that market is basically dead and has been in run-off for 8 years. What was it between 2000 and 2008?

    Also, would you mind specifying your data sources? I don't know where the FICO numbers came from. I would have started my search there to check this narrative.

    1. Thanks for the input.

      The exposure to non-agency securities did end up creating some losses, but it was never that large a part of their total holdings. I think they mostly held them for income from interest rate risk, because their decline in originations in 2004-2005 caused their portfolio to decline. There was still a market for GSE MBS held by third parties. So, as the total market moved to private securities, the GSEs had to use those securities to gain access to the income/risk profile of portfolio holdings, which was a longstanding part of their business model. In the end, those securities had similar risks to GSE MBSs held in portfolio, plus liquidity risk, which wasn't really an operational risk for the GSEs, but it was a regulatory risk, since they had to take write downs those holdings in 2008, which helped to bust their capital base.

      On this information, I have compiled it from Fannie and Freddie 10-Ks and from the FHFA annual report to Congress. Freddie had more exposure to the non-agency securities. But, I tend to cite Fannie more because their SEC filings appear to go back farther, so that I can sometimes get data back to 2000 or earlier. Sorry. There are other sources for the data, probably even better or deeper sources. But, the only way to confirm my numbers would probably be to spend a few days slogging through GSE filings, as I did.

    2. Oh, here is a post with a graph that shows the various exposures held or guaranteed by the GSEs.

    3. That's helpful, thanks for the reply. I also looked at the SIFMA report and FNMA owned roughly 6% of the outstanding subprime securities in 2007. I think that is more important than the percent of the portfolio since it tells you whether FNMA was driving that market. I don't think 6% is large enough to support that story.

    4. I had the same reaction as you. There are stories about the GSEs controlling nearly half that market, and there might have been parts of the AAA securities market where that was true. I was ready to put some of the blame on the collapse in 2007 on the pressure on the GSEs to get out of those markets. But, when the markets collapsed, there were CDO squared, synthetic CDOs, etc. There was no shortage of investors willing to buy AAA securities backed by mortgages. What there was a shortage of was mortgages.