Did Fannie/Freddie cause this mess?
September 30, 2008 11:44 PM   Subscribe

Did Fannie and Freddie cause the current financial crisis?

A co-worker and I are debating if Fannie and Freddie are at the center of the current financial meltdown we are experiencing.

His hypothesis is something like Fannie and Freddie wanted to loan money to poor people, the democrats didn't want to stop that, and thus Fannie and Freddie made all the bad loans to poor people.. and finally the current meltdown..

My hypothesis (which I have stole and synthesized from a few sources) is that Fannie and Freddie have his issues of the years but the majority of the bad loans were made by unregulated institutions and so Fannie and Freddie are more of a victim of this crisis.. not the cause. The issue really is that these unregulated lenders made a ton of bad loans.. sold them off.. and now no one knows what their piece of the 'shit pile' (h/t atrios) is worth.

Lazyweb, please help me fight this battle. I'll take supporting evidence for either side.. I just want the truth.
posted by cowmix to Law & Government (15 answers total) 12 users marked this as a favorite
Your pretty much right as far as I understand. Here is the best article I found debunking the "it's the poor/black people that cause the crisis" meme.
posted by afu at 12:09 AM on October 1, 2008 [1 favorite]

The Fannie/Freddie/poor/minorities line has had a huge amount of circulation in conservative media, and it's half-part accurate, one part diversion, one part appeal to bigotry. Yes, Fannie and Freddie were very badly managed, and bought into the worst debt at the worst-possible times; yes, the Democrats had an interest in expanding home ownership. But the 'Blame The [racial slur]' line from the usual right-wing suspects is deeply, deeply ugly.

What we're looking at here is almost a fractal relationship. You have liar's loans, people using their equity as income during periods of wage stagnation, over-reliance and abuse of HELOCs, and so on. This is known as the 'housing ATM'. On the other side, you have institutions offering loans because they can sell them on, secondary buyers (including Fannie and Freddie) repackaging them into financial instruments that received a higher credit rating than their components, and highly leveraged trades based upon derivatives and credit default swaps on those instruments.

(Here's a good, if semi-technical summary of Fannie/Freddie's portfolios.)

This isn't just a subprime crunch: what we're getting this year is the whiplash from Option ARMs, Alt-As and a whole host of exotic mortgage products dealing with people trying to buy into already-inflated markets that relied entirely upon yet more years of rising prices to make sense, and that oftentimes Fannie and Freddie weren't permitted to buy. The case studies at Irvine Housing Blog, where you have short sales after five years of literally living on an additional borrowed income, give you more of an insight into the kind of bubble-driven madness going on in the worst-hit areas. It's not Sanford and Son buying an McMansion.

One final point: Fannie and Freddie don't make loans. Never have. They acquired loans from elsewhere and sold CDOs (i.e. mortgage-backed securities) based upon their book.
posted by holgate at 12:32 AM on October 1, 2008 [5 favorites]

Steve Sailer claims to have popularized the idea of a "diversity recession". Here's his blog, here's a summary article where he complains about conservative media taking the name and misrepresenting what it means to pin the blame on Democrats.

Your friend's hypothesis sounds like such a talking-point version of what went on, while your hypothesis seems to miss the fact that the originators of risky loans wouldn't have made them if they had found nobody to take the risk off their hands, so the causal relationship here is not that simple.
posted by themel at 1:09 AM on October 1, 2008

AFU's link is a good debunking of all the talk about the CRA and related issues. I did come across a different argument partially in support of your co-worker, but whether it stands up to scrutiny I don't know - I haven't seen it chewed over anywhere else.

But all the CRA/Acorn/Democrats-and-the-blacks!!1!!eleven!! stuff is pretty dumb. Back in the day, there was a huge profit incentive to give away subprime mortgages to whoever wanted them, which was reason enough for the madness.
posted by so_necessary at 1:14 AM on October 1, 2008

All that you need to see to disprove this asinine meme that Fannie and Freddie caused the credit crisis by giving out insane loans is to look at a graph of origination market share. Between 00-06 their market share got crushed. The graphs are out there. Maybe at Calculated Risk

Additionally I just found this GAO piece that discusses market share of loans originated to minorities. Guess what 96-06 they lost 13 points of total market share for purchase mortgages while they lost 25 points of market share for home purchase mortgages originated by minorites.
posted by JPD at 4:49 AM on October 1, 2008

For a crisis of this size, you're not going to find any one cause (or, for that matter, one solution). There will be a myriad of contributing factors (not all of which are currently known), any one of which wouldn't be sufficient to cause this much damage, but all together resulted in the mess we're in. CRA/Freddie/Fannie may have helped in getting/legitimizing some aspects of the subprime market, but you can also point a finger at the tax change in real estate capital gains in the 1990s, the cultural change on Wall Street over the past few decades emphasizing quantitative models that left out certain system risks (and these sorts of models are only possible because of the rise of computer power; you can't do these calculations without Moore's Law in effect for several decades), the general problem of setting compensation for financial services people so that they don't take risks to make $1bn/year for 8 years only to lose $10bn in the 9th year, the low interest rate environment of the early 2000s, the rise of China/India/etc. leading to that Giant Pool of Money discussed in "This American Life" not too long ago, and so on.

So, no one cause, and financial economists and historians will spend the next few decades trying to untangle what happened.
posted by chengjih at 6:43 AM on October 1, 2008

See also this post by Pastabagel on metatalk.
posted by inigo2 at 6:52 AM on October 1, 2008 [1 favorite]

The GSEs are not without fault:

(1) Rapidly increased the conforming loan limit -- the maximum size of loan they would buy or guarantee. While we talk a lot about the more abusive mortgage product, the increasing size of the baseline 30-year-fixed-good-credit conforming mortgage was a significant factor in pushing up housing prices to unsustainable levels. The rapid increase in housing prices in turn supported (what turned out to be) the toxic appraisals and risk modeling which let subprime and Alt-A mortgage issuance flourish.

(2) Added fuel to the fire of the conforming loan limit by essentially by permitting borrowers to layer on second liens ("piggybacks") to a much greater extent than previously allowed, and exercising no restraint whatever on Home Equity Lines which would quickly drain out any equity that was nominally committed at the closing.

(3) (Ab)used their ability to sell unsecured bonds cheaply (by way of the implied guarantee) to buy mortgages which didn't meet their own guarantee standards, creating an additional (if overall modest) source of demand for those kind of mortgages.

(4) Heavily contributed to the creation of a political culture where "homeownership for all" was a primary virtue, making it hard for anyone to move effectively against evident risks and abuses until it was too late.

"Homeownership for all" did have a strong benfit-to-minorities component to it. Some of this racial argument was cynical -- giving cover for profital business activities -- and some of it was bona fide. Of the bona fide piece, though, there was a pretty strong conservative theme. (Homeownership was, alongside inner city school vouchers, one of the favorite conservative themes that sounded in opportunities for minorities.)
posted by MattD at 7:01 AM on October 1, 2008 [2 favorites]

An assertion that Fannie and Freddie "made all the bad loans" is completely ridiculous. Fannie and Freddie have their share of problems, which have no doubt contributed to the current economic crisis, but they are far from the root of the problem.

For one thing, the *very definition* of a subprime loan (you can look it up) is a loan that does not meet Fannie and Freddie lending guidelines. That means they are loans that F&F could not take on.

For another thing, subprime mortgage loans are only one part of the equation that has led to the economic crisis.

Your co-worker doesn't know what he is talking about, he is just regurgitating right-wing talking points that he has heard on talk radio or FOX News most likely, or else saw in an e-mail forwarded around among right-wingers.
posted by daser at 7:05 AM on October 1, 2008

There is apparently at least one study that suggests that CRA banks were far less likely to issue risky loans, that they kept their loans in their portfolio (rather than selling the risk off to some other financial institution). The study also found that foreclosure rates were lower in the metropolitan areas they studied where presumably the presence of a population that uses CRA banks (and there are more branches) keep the bad loans from being made (because a person could go to a CRA bank branch rather than a mortgage broker who tries to sell him on something insane).
posted by R343L at 7:43 AM on October 1, 2008

1) Rapidly increased the conforming loan limit -- the maximum size of loan they would buy or guarantee. While we talk a lot about the more abusive mortgage product, the increasing size of the baseline 30-year-fixed-good-credit conforming mortgage was a significant factor in pushing up housing prices to unsustainable levels. The rapid increase in housing prices in turn supported (what turned out to be) the toxic appraisals and risk modeling which let subprime and Alt-A mortgage issuance flourish.

Perhaps I am misremembering but the conforming limits were until recently indexed to home prices by law. Additionally those limits were set by OFHEO not FNM and FRE. It was only once the private mortgage industry began imploding that OFHEO succumbed to the pressure to raise the conforming limits.

I agree with your other three points tho.
posted by JPD at 8:14 AM on October 1, 2008

Fannie and Freddie didn't cause it. They participated in it as did the rest of the industry, and as others have mentioned, were in the secondary market, not actually making loans, just buying them.

Lately I've been hearing right wingers talk about how Democrats wanted to force loans on people. Whaa?! These (R's) are the same people that pushed the deregulation that allowed the abuses and excesses that are now coming home to roost. These are the same kind of people who pushed to expand the powers of S&Ls to those of banks in the 80s, but to leave them unregulated unlike banks. What did you get? The collapse of the S&L industry and loads of people's life savings wiped out, and a minimum bailout tab of $125 billion handed to the rest of us to pay (a lot more now, actually). In each of these cases plenty of Democrats voted along too, so they can't be held blameless, but this deregulation push has been an active plank in Republican platforms since at least Reagan and likely in some growing capacity ever since the recovery from the Great Depression.

So here again right wingers, with Phil Gramm as their captain, led the charge to deregulate, or expand powers of but leave unregulated, particular industries and investment instruments. Guess what happened? People once again went for broke... and did indeed break it. There are two major pieces of legislation to look at - one that allowed industries to become too big to fail (set 'em up) and one that allowed unregulated trading in arcane, complex, and risky financial instruments (knock 'em down).

In 1999 Phil Gramm's Financial Services Modernization Act (aka Gramm-Leach-Bliley) repealed parts of the Glass-Steagall Act of 1933, which had been put in place to help prevent Great Depression-style financial industry failures from happening again. Prior to 1999, that act prohibited financial services providers, including banks, securities firms, and insurance companies from affiliating with each other and entering each other's markets. Once that restriction was removed, companies were able to become so large and integrated into multiple sectors of the economy that their failure could cause a domino effect throughout the economy, such that they could not be allowed to fail despite irresponsible business practices and the resulting illiquidity and/or insolvency. That was the whole point of Glass-Steagall.

It's useful to point out here what Democratic Rep. John Dingell said in 1999 during the debate over this bill, "I just want to remind my colleagues what happened the last time the committee on banking brought a bill on the floor which deregulated the savings and loans. It wound up imposing upon the taxpayers of this nation about a $500 billion liability. Having said that, what we are creating now is a group of institutions which are too big too fail. Not only are they going to be big banks, but they are going to be big everything. Taxpayers are going to be called upon to cure the failures we are creating tonight and it is going to cost a lot of money, and it is coming. Just be prepared for those events." Ohh snap! If only he had been wrong. Turns out he was exactly right.

The second piece of legislation was Gramm's Commodity Futures Modernization Act of 2000. It allowed for new kinds of futures trading and sheltered several kinds of relatively new investments from regulation, including derivatives. This unregulated environment led to complex, high risk, irresponsible investments, such as credit default swaps and collateralized debt obligations, much of which came to be ultimately backed by subprime mortgages.

A collateralized debt obligation (CDO), a.k.a. a mortgage-backed security, is an investment instrument that is composed of lots of mortgages (or actually a package of a package of mortgages such as a CMO). The theory is that since there are lots of mortgages, statistically only a small percentage of which will go into default, the risk is diluted and overall the security will do well. And they did do very well. Everybody was buying them despite not understanding them, despite nobody really being able to put a value on them (see all the restatements by the major financial players leading up to the meltdown).

A credit default swap is sort of like an insurance policy for an investment. You invest or lend money to somebody, but buy a credit default swap for a small fee so that if your borrower can't repay the loan, the issuer of your swap will cover it. It makes you very happy to lend money. It makes the issuer of your swap very happy. It makes your crappy borrower very happy.

With no regulation, with such insurance against risk, with such high profit potential, why shouldn't you just invest/lend your balls off? You should! You would. You did. Just give loans to anybody regardless of credit, don't bother to verify employment, don't even ask them to put much down. Don't ask them to put anything down. In fact, go out and actively seek these people, you predatory lender, you. Explain to them that everybody is doing it, it's OK now, and you'll give them a really low rate for a while to start with. If you're a borrower, well it must be OK, right? Everybody around you is doing it and they seem OK. You'll just refinance once your rates go up. If you're a mortgage broker, you don't care - it's not your money. And if you're the actual lender, you don't care either - you're just going to sell that debt to an investment bank the day after you issue it anyway. The investment bank doesn't care either because they know that only some of the loans will go bad and home values will continue to rise (right?) so your CDO backed by the debt will be a great product for you and your institutional customers. So a mass of crappy loans builds up and loads of Flip That House clones show up on TV. Anyone can buy. Everyone buys. The American dream of home ownership.

And if you as a big shot financial institution wind up holding any of this debt, or holding the securities made out of this debt, it's OK. You can get a credit default swap to cover yourself. You can't lose. And not only can you make these riskier and riskier investments, you pretty much have to if you want to compete and stay in business. Because since there is no regulation, everyone else is going to do it, because that's the game - do the best you can to maximize profit using whatever tools are available to you. Even Fannie and Freddie had to increase their risk to stay afloat, because they had shareholders too.

By the way, credit default swaps were meant to be a kind of insurance for investments, but actually became investment vehicles themselves, trading up and up in value, over the counter, not on a visible market, and changing hands so many times that people didn't know who was actually guaranteeing their investment, and people holding the swaps very often could not have covered those promises if called to do so. They really had no idea what they were holding, just that they were hot investments that were paying off.

And then the housing bubble bursts. Home values plummet. People who bought houses with little or nothing down, with no verified credit or employment, are suddenly tens of thousands of dollars poorer on paper. Negative equity, because they still owe everything they borrowed. And then the variable interest rate on their mortgage goes up and now they can't afford the payments. And nobody will lend them anymore money now (refinance), so they can't pay. So foreclosures spike. But all of those crappy mortgages had ultimately made their way into CDOs that people were holding as investments despite not knowing what they were made of. Uh oh.

So the investments start going south. But you have a credit default swap, right? Insurance. Whew. But what happens when everybody calls in their insurance claims at once? The insurance company, or whoever is acting in that capacity as the holder of the swap, doesn't actually have the money to cover all of its promises to pay, especially when they are leveraged by multiples of 10 already, investing borrowed money. See AIG. Suddenly investors begin to doubt that companies like AIG, for example, can actually cover their promises to pay the bad debts if the debtors can't. Suddenly everybody wants their money back and people are afraid to lend money. So the govt sees a credit market freeze looming very close and feels it has to step in and guarantee the continuing flow of credit, on which our economy is based. If someone like AIG fails, they think, it's domino time. AIG was the largest or one of the largest players in the credit default swap market, which at $43 trillion dollars at a minimum, was over half the size of the asset base of the global banking system. (go do some googling on "shadow economy" and "black box economy").

Same deal with a lot of these other big institutions. Thanks to FSMA they are too big to fail. But thanks to CFMA they have built themselves into gigantic houses of cards, with a large amount of the cards made out of junk, opaque junk that almost nobody understands. The bad news is that only subprimes are really getting the media spotlight as the culprits behind a lot of the arcane and complex investments right now. There are more out there based on auto loans, corporate debt, credit card debt, etc.

Thanks, conservative ideologues. Thanks, unrestrained capitalism. Thanks, credit-is-free-money mentality.

Almost as a side note, we can mention that the CFMA also allowed for energy futures to be traded in unregulated private markets. Remember California's energy crisis? A sudden rash of rolling blackouts, price manipulation, wholesale prices through the roof, the system nearly bankrupt, a governor recalled, Enron? That's what resulted from CFMA and other deregulation connected to Gramm in California.

Unregulated capitalism does in fact eat itself. It can work with sensible regulations. Next time you hear the call for deregulation, regardless of who is calling for it, review the history of its results. People will always go for broke. Always. And you will pay for it every time. Literally.
posted by Askr at 8:43 AM on October 1, 2008 [15 favorites]

I disagree with Askr's assessment that this is the natural result of "unrestrained capitalism". The truth is, there was no single cause to the "crisis" we're in; neither party is directly responsible for the crisis but both parties and our monetary institutions are indirectly responsible.

Like the Great Depression, the simple explanation is really inadequate when citing the root causes. You could start your analysis with the sub prime loans, but anyone closely observing our economy has known trouble was coming for at least three years.

It's a chicken and egg deal - yes, banks made stupid, short sighted loans, but they made these loans based on Greenspan's history of keeping interest rates artificially low to promote growth during the ninety's. They assumed this would continue and offered the mortgages. Interest rates were later raised to curb inflation and people default.

Oil prices, a devalued dollar, too many individuals living off of credit card debt, banks giving loans too easily, investor's realizations that the government will give them money, investor's realizations that the Federal Reserve will keep money cheap, certain congressmen (we are now learning) who encouraged Fannie Mae and Freddie Mac to give the loans (although, as far as I know, they did not legislate this), rampant government spending - all of these thing intricately combine to create our current crisis. The Great Depression saw the same effect, and academics are STILL trying to unravel that one.

I'm sorry but the elementary school - heck, even college - summary just doesn't cut it. To simplify things and say "unrestrained capitalism" leads to this is insane, as is blaming it all on one source; America hasn't been a pure capitalism since the creation of the Treasury. As it is, Democrats usually don't want to admit that government policies create incentives for private companies to be irresponsible, and Republicans usually don't want to admit that if the government incentives exist, private companies jump all over them like a dog on raw meat.

If anything else, don't listen to the Newspaper/Newsweek/Radio/TV news analysis of this crisis. These things make economists want to shoot themselves for hearing so many so-called "analysts" try to explain away what's happening in a thirty second sound bite. That's how we get the question: "The market dropped today, who did it, Dems or Reps?" Look for sources that deal with this sort of thing - The Economist, Academic Journals, Books on Economics etc. I'm sorry to be on my soap box here, but the world needs a lot more sanity and a lot less panic!
posted by Me, The Snake at 9:33 AM on October 1, 2008 [3 favorites]

Subprime lending offered high-cost loans to the weakest borrowers during the housing boom that lasted from 2001 to 2007. Subprime lending was at its height vrom 2004 to 2006.

Federal Reserve Board data show that:

_ More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.

_ Private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year.

_ Only one of the top 25 subprime lenders in 2006 was directly subject to the housing law that's being lambasted by conservative critics.
posted by ibmcginty at 9:43 PM on October 11, 2008

Just saw this latest post today by chance.

Obviously the loans were made by private firms. My point is that things such as artificially low interest rates encouraged subprime lending by making money too "cheap". Once again, this is an example of how the issue gets simplified - instead of researching the background economics of the crisis people favor a simplistic "it was these guys" answer.

The long term solution is not more regulation; there already have been regulations in place, and people always find a way around them. The immediate response of government to economic crises has always been more regulation. It just hasn't worked. Are our current leaders the ones who will finally discover the magic solution? I doubt it.

The best thing to do is remove artificial incentives that lead to irresponsible business practices, and when the business cycle hits a trough let it be severe and over quickly. That way markets reallocate back to more efficient practices and the economy starts to grow once again.

This explanation may be more boring than one that gives us a few "witches" to burn at the stake, but it is the more reasoned approach.
posted by Me, The Snake at 11:58 AM on October 20, 2008

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