Even the normally level-headed Buce—who knows better and lets us know he knows better—tries to give Tyler Cowen’s broadside at Fannie and Freddie the benefit of some (contrived) doubt. I’ve already screamed about the legerdemain of Cowen’s post elsewhere, so let’s go for the philosophical underpinnings.
Let’s give some ground first. Buce is spot-on with:
One is the question whether Fannie/Freddie misbehaved in the years leading up to the pop. On that point, I don’t think anybody can quarrel that Fannie (at least) has an appalling record of institutional misbehavior: rapacious and corrupt and willing to do whatever it could to pervert the lawful structure of good government–in short, they behaved like a money center bank. [emphasis mine]
I can and will quarrel that it depends on how you define “misbehaved.” As Bakho notes chez DeLong:
Freddie/Fannie responded to the housing bubble once they started losing market share. The pressure on the private F/F was to regain market share.
Would a fully public F/F be under the same pressure to increase market share? No. The pressure would have been for a public institution to not compete with the private sector and only write those loans the private sector was unwilling to write.
Again, I’ll quibble that last sentence—it should read “loans the private sector could not make profitably,” but that’s part of the argument below and generally the phrases should mean the same. But if you believe the risk is being managed properly by the money center and investment banks, there’s no reason ex ante to believe that Fannie and Freddie misbehaved. The “non-conforming” products all fill a consumer need, though some have very limited markets that are truly appropriate.
Balloon mortgages, floating-rate mortgages with (and without) long-term caps, or even IO mortgages make sense for a small subset of people. For balloon mortgages, think people who receive regular, annual bonuses. The second is a yield-curve play for the borrower: either the upfront cost of the cap charged to the borrower gives the bank a cushion or the risk of high rates remains with the borrower. (The latter is a bad idea for anyone at risk of being liquidity-constrained.) The third is more difficult to justify—partially because it should carry a higher interest rate—but might be appropriate for second-home mortgages and the like.
Even I won’t try to defend negative-amortization purchase loans. Any bank or firm that believed—and certainly those that still believe—that such a product has any reason to exist should be closed with prejudice, since its managers and directors clearly have no clue how to run a mortgage-related business.
(Exception noted: reverse mortgages are philosophically reasonable, though I personally don’t believe they are either reasonable or valuable as they are currently sold, especially if you consider all of the non-economic reasons. But reverse mortgages do not have the same risk profile for the bank that reverse-amortization loans do, so the argument is more over demand than supply.)
So there might be a market for all of the products that got headlines in the early and mid-Noughts. The problem is that—even with the size of the U.S. housing market—those niche products are likely to be unprofitable, given the fixed costs, reporting requirements, and back-office operations needed to manage and evaluate the products.
To no one’s great surprise (I trust), the first thing that went was conformance to those reporting and management requirements.
But that still wasn’t enough, especially in the case of the Bubble, so people who might have survived bullet loans or even amortizing floaters with or without caps ended up getting, er, encouraged to take loans that had a worse profile for them. Buce carps:
[The GSEs] were willing to make the right noises about serving public purpose but at the end of the day they had no more interest in the larger public good than Stan O’Neal, Dick Fuld or Jimmie Cayne.
That may have been true at the top—my view of Daniel “acts like Harry” Mudd’s guidance of Fannie is no secret—but the risk controls at Fannie were far superior to the controls Jimmy Cayne enabled. Don’t believe me? Ask Paul Friedman:
“It took two or three weeks to mark,” explained Friedman. “It literally took a dozen people on the mortgage desk night and day, and a bunch of our research people night and day and weekends, three weeks to value this stuff, which tells you just how illiquid it was.”
By the time they did figure out what most of it was worth, the firm had miscalculated badly. “We thought there was $400 million-ish of cushion, and in fact, as it turned out, we missed by like $1 billion out of $1.5 billion,” says Friedman. “It was not even close. You would think you could get it to the nearest billion, and a lot of it was the market deteriorating dramatically in that five or six weeks. But it was just a guess to begin with.”
Don’t get me wrong: I consider this the equivalent of the Bancroft family getting all uppity about how Rupert “ruined their brand” or whatever. Instead of paying for projects and systems that could do that work, Bear upper management—not excluding Paul Friedman—took the cash home every year and budgeted their IT department(s) for the next year. The man who controls the purse strings and prioritization complaining about the system inadequacies may well be the 21st century equivalent of the obligatory teen who kills both her parents and pleads for mercy because she’s an orphan.
But, taking Paul Friedman at his word, his systems couldn’t do in 2007 what Fannie Mae’s could do in 2001. And if the risk cannot be evaluated properly, the price isn’t going to be right. Doesn’t mean it’s too high or too low, just that it’s not going to be right.
So when those “bridge securitizations” (as it were)—mortgages purchased to securitize—become “pier loans” because no one wants to buy the security, you better have priced the loan appropriately, because it’s all going on your books and against your capital.
From what I can tell, what made Bear—and very probably Lehmann—different from all others is that they had their own mortgage origination units. So after all the other “private label issuers” (read: non-GSEs) stopped buying mortgages for MBSes around Hallowe’en of 2006, Bear was still buying from its own pipeline for another two or three months. (By February of 2007, even Bear wasn’t buying.)
Note therefore, that
And any economists can tell you what happens when Qs > Qd. But Buce has more fun:
Or, they wanted that until they didn’t want it, which is to say until they started pouring gasoline on a bonfire.
I suspect that’s not exactly true. Looking at the flows, it appears more that the Mudd Dynasty (and a poke or two from the Bush Administration) resulted in the GSEs being basically the only Origination game in town—“extend and pretend” started early. As I* have often noted, by August of 2007, both Lehmann and Bear were issuing debt—and, with due respects to Felix (and Robert multiple times etc.)—the market (as I have noted before) knew that all was not well and any investor who was truly “rational” was paying attention to spreads. (The rest were running “money market funds.”*)
So if you want to argue that the GSEs extended the crisis, you’ll get no argument from me (so long as you note that, even there, they had help from the Administration and its allies).
So where am I quibbling? Try here:
I do think that defenders of Fannie/Freddie get a bit ahead of their skis sometimes, and I suspect the reason is that they fear for the institutions per se; the defenders see their enemies as wanting to put Fannie/Freddie out of business and they don’t want Fannie/Freddie to go. Me, I’m still on the fence on that issue. It’s not obvious to me that we need government-sponsored mortgage market makers. I can see you don’t want to terminate tonight–or there would be no lending at all. But schedule departure for five, ten years down the road, could be a good idea.
Uh, “our enemies” do want “to put Fannie/Freddie out of business.” They have said so. So the quibble is whether it is “obvious we need government-sponsored mortgage market makers.” And the evidence of that—remember the past, live the present—is clear that we do.
But that’s the next post.
*Only someone as deliberately clueless as Tim Geithner acts, or an economist, could believe that just because something calls itself a “money market fund” means it cannot “break the buck.” The number of the Deliberately Clueless has been expanding in recent months.