A debate has erupted anew in Washington over whether Fannie Mae and Freddie Mac caused the credit crisis of 2007 and 2008. Their critics claim that these two Government Sponsored Enterprises (GSEs) deserve a lot of the blame because they encouraged mortgage lending to low-to-middle-income Americans, a goal that Congress required and Bill Clinton advocated. The debate, which faded after a brief fluorescence in 2008, has been revived by a new book, Reckless Endangerment, by the respected New York Times reporter Gretchen Morgenson and the dogged financial analyst Josh Rosner.
Morgenson and Rosner argue that Fannie and Freddie’s affordable lending goals, coupled with their profit-making objectives, were among the most important causes of Wall Street’s collapse. But while the practices of the GSEs are certainly worthy of tough scrutiny, Morgenson and Rosner deflect attention away from Wall Street’s systemic problems to unrelated political questions about affordable lending. The links they draw from the affordable lending mandate and the aggressive profit-seeking of the GSEs to the recent financial crisis contain more assertion than analysis.
Here is a telling sentence from the book: “How Clinton’s calamitous Homeownership Strategy was born, nurtured, and finally came to blow up the American economy is a story of greed and good intentions, corporate corruption and government support.” A phrase like “blow up the American economy” is not the kind of cautious, specific analysis we expect from Morgenson or Rosner. And here is yet another example: “…the home ownership drive helped to plunge the nation into the worst economic crisis since the Great Depression.”
Such assertions have been red meat to columnists David Brooks of The New York Times and George Will of The Washington Post, who were apparently yearning to blame government action, not regulatory inaction, for the crisis. Wrote Brooks: “The Fannie Mae scandal is the most important political scandal since Watergate.” Wrote Will: James Johnson, the head of Fannie Mae from 1991 to 1998, “may be more culpable for the peacetime destruction of more wealth than any individual in history.”
In fact, as abundant data show, Fannie and Freddie’s affordable lending programs had virtually nothing to do with the recent crisis. The crisis was caused by Wall Street’s bad bets on complex securities based on subprime mortgages. These bets were mostly placed during the mid-2000s.
Although Morgenson and Rosner provide some fine examples of mortgage brokering chicanery, they spend far less time discussing the reckless practices of private offenders than those of the government programs they eagerly chastise. Most of their animus is aimed at the GSEs, particularly Fannie Mae, the organization formally known as the Federal National Mortgage Association, and James Johnson, the Fannie Mae CEO and consummate political insider.
Fannie Mae had been formed in 1938 to stabilize the mortgage market, which was devastated by the collapse of the housing market during the Great Depression. In 1968 it was made into a private corporation, adding the goal of profits for shareholders to its focus on keeping the mortgage market flowing. (Freddie Mac, its younger brother, was started in 1970 to package mortgages into securities sellable to big investors.) Morgenson and Rosner show how Johnson took advantage of Fannie Mae’s conflicting mandates, and in particular linked his own compensation to Fannie’s earnings. He won government favor, especially from Democrats, and used affordable lending goals as a cover for warding off stronger regulation and opposing those who wanted to end the federal government’s implicit guarantee of the GSEs’ debt, thus generating more growth and profits for Fannie Mae, and a private fortune for himself.
Johnson probably deserves much of the damning criticism the authors direct at him. But claims that Johnson’s Fannie Mae caused the 2007-2008 crisis by meeting affordable lending goals that were first established and had primary effect in the 1990s are so far-fetched that they require time travel. Home ownership increased during Johnson’s tenure, as did subprime lending, but the surge of risky private lending and securitization that nearly brought down the financial system did not occur until the 2000s, when Johnson was gone.
Nor did Fannie Mae contribute as much to the subprime bubble after Johnson left as is widely thought. The market for home loans shifted away from the traditional, conservative, fixed-rate mortgages backed by Fannie Mae to riskier, subprime, adjustable-rate mortgages sold by private firms such as Countrywide and New Century. In order to meet affordable lending requirements, Fannie Mae did buy some of the subprime mortgages that private lenders made to low-income people with poor credit scores. But even Fannie Mae and Freddie Mac’s purchases combined were always a minority of the subprime mortgage market, and their subprime stake declined substantially as a proportion of the market after 2004.
Moreover, much of what Fannie Mae bought was the safest portion of the mortgage-backed securities. Even when the crisis was underway, Fannie Mae’s losses on subprime loans were minimal, only about 5 percent of its total losses. They were not taking the kinds of risk the private lenders were; for example, they never bought any part of the now infamous collateralized debt obligations.
Fannie Mae’s purchases did not drive up home prices, either, contrary to claims by Alan Greenspan and others. According to Robert Van Order, formerly chief economist of Freddie Mac and now a professor at George Washington University, there was so much demand from other buyers that Fannie Mae’s purchases had almost no effect on home prices.
The GSEs did aggressively buy so-called Alt-A mortgages, those given without documentation of borrowers’ income, and these eventually caused enormous losses at Fannie and Freddie that have rightly attracted so much attention. But Alt-As didn’t satisfy affordable lending requirements because the borrowers often had better credit or higher incomes, so that is not what motivated Fannie and Freddie to buy them. Instead, the GSEs bought large volumes of these loans beginning around 2005 to make up for lost market share. They were playing catch up, not to meet Clinton’s overly “compassionate” goals, as George Will sneeringly described the purchases, but simply to make a profit.
Even so, the default rates on GSE mortgages were far lower than on those bought and issued in the private market. In 2004, the GSE default rate was 4.3 percent of their mortgages compared to a default rate in private industry of 15.1 percent of mortgages. In 2005, the GSE default rate was 7.8 percent—high and disturbing; but in private industry it was 28.7 percent, the source of the severe crisis. In 2006 and 2007, default rates reached 13.2 and 14.9 percent in the GSEs and 45.1 and 42.3 percent in the private market.
We are not defending GSEs: at its core, the GSE model is flawed. GSEs are charged with serving two masters: to keep the mortgage market working but also to maximize profits with the enormous help of an implied government guarantee on their debt. They ignored regulatory requests to raise more capital, instead borrowing at low rates to invest aggressively at the height of the market. As a result, they lost enormous amounts of money once housing prices collapsed, and they are now being bailed out by the federal government to the tune of $150 billion.
But they did not lead the crisis; their collapse followed it. Had Morgenson and Rosner written a more cogent, analytical and detached book, they would have provided a needed service supporting GSE reform. Fannie and Freddie had basically become enmeshed in the culture of greed of the 1990s and 2000s, with Presidential and Congressional approval. But the government had also been facilitating abuses by Wall Street and the private sector and new regulations are not yet in place to stop this. What is disturbing about the currency being given the Morgenson-Rosner argument is that it is supplying ammunition to those who believe government involvement of almost any kind in the markets is bad, and that without a mismanaged Fannie and Freddie all would have been fine.
A new and serious debate is needed about how to reform and reconstitute the GSEs. But it cannot be informed by misleading analysis and over-the-top rhetoric.
Jeff Madrick and Frank Partnoy are preparing a longer essay on these issues to be published in a coming issue of The New York Review.