The GSE Supply Curve for Nonprime Products Kept Shifting to the Right

Brad DeLong rejects “the claim that the crash in the mortgage market was in some sense the fault of excessively risky lending by the GSEs Fannie Mae and Freddie Mac which pulled the private sector along behind them,” based on the observation that “Fannie Mae and Freddie Mac lost market share as all the loans that have now gone bad were made.”  Presumably “all the loans that have now gone bad” refers to the nonprime and ARM loans made between 2004 and 2007.  He concludes that there must have been “a reduction in demand for Fannie Mae and Freddie Mac’s products” and that “the dominant feature of the mortgage market in the 2000s was not an expansion of supply by Fannie Mae and Freddie Mac pushing their implicit government guarantee past the limits of prudence.”

Professor DeLong presents his argument as an application of the logic of supply and demand.  But supply and demand curves deal with prices and quantities, not prices and market shares.  In a booming market, a declining market share is consistent with a growing contribution to supply (a continuing rightward shift in the firm’s supply curve).  His unlabeled chart of market shares, moreover, appears to depict total mortgage market shares, whereas the claim in question is about “excessively risky lending” rather than total mortgage lending.

Fannie Mae and Freddie Mac were in fact expanding their quantities of nonprime mortgages vigorously from late 2004 to 2007.  After parsing the GSEs’ financial statements, Peter Wallison of the American Enterprise Institute finds that:

From 2005 to 2007, Fannie and Freddie bought approximately $1 trillion in subprime and Alt-A loans, amounting to about 40 percent of their mortgage purchases during that period.

The GSEs thus importantly contributed to the overall supply of nonprime mortgage financing, prompting mortgage brokers to originate more nonprime mortgages.  The increased ability to sell nonprime mortgages to the GSEs and their competitors encouraged mortgage originators to dig deeper into the barrel of applicants to accept more of those previously considered non-creditworthy.

Wallison and Charles Calomiris add that:

Although a large share of the subprime loans now causing a crisis in the international financial markets are so-called private label securities — issued by banks and securitizers other than Fannie Mae and Freddie Mac — the two GSEs became the biggest buyers of the AAA tranches of these subprime pools in 2005-07. Without their commitment to purchase the AAA tranches of these securitizations, it is unlikely that the pools could have been formed and marketed around the world. Accordingly, not only did the GSEs destroy their own financial condition with their excessive purchases of subprime loans in the three-year period from 2005 to 2007, but they also played a major role in weakening or destroying the solvency and stability of other financial institutions and investors in the United States and abroad.

As to total mortgage lending from 2000 to 2005, below is a chart released in 2006 [pdf] by James B. Lockhart III, then Director of the Office of Federal Housing Enterprise Oversight, Fannie and Freddie’s regulator.  It shows the steady expansion in their quantities of mortgage-backed securities outstanding through 2005:

Regarding their total portfolios, Lockhart notes:

Fannie Mae’s mortgage assets grew from about $124 billion in 1990 to $905 billion in 2004, and then declined to about $727 billion last year. That’s equivalent to average annual growth of more than 13 percent over the 15-year period… .  Freddie Mac’s mortgage portfolio grew 26 percent per annum from less than $22 billion at year-end 1990 to $710 billion in 2005. In contrast, the residential mortgage market grew at an average rate of 8.5 percent.

Except for 2004 in the case of Fannie Mae, it is clear that this pattern is not consistent with “a reduction in demand for Fannie Mae and Freddie Mac’s products” dominating over increases in supply.  Quantities supplied increased.  They especially increased for nonprime products.

It is thus reasonable to think that the crash in the mortgage market was “in some sense,” i.e. to some extent, the fault of excessively risky lending by Fannie Mae and Freddie Mac.  Whether or not we call it “the dominant feature of the mortgage market in the 2000s” (emphasis added), it is safe to say that it was an important feature.  Fannie Mae and Freddie Mac did push the lending financed by their implicit government guarantee “past the limits of prudence.”

Also from this issue

Lead Essay

  • In the first of this month’s four accounts of the causes of the financial crisis, Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis, makes his case. White argues that the housing boom and bust, and the resulting meltdown of financial markets, cannot have been the result of a laissez-faire monetary and financial system, since we never had one. Nor can deregulation have been the cause, since the most recent relevant deregulation has probably helped contain the turmoil. While admitting that “private miscalculation and imprudence made matters worse,” White argues that “to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects.” He points to two such distorting sets of policies: the overexpansion of the money supply by the Fed, and government mandates and subsidies to write riskier mortgages.

Response Essays

  • In our second anatomy of the financial crisis, William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, says that key to the crisis was perverse compensation schemes that put the incentives of executives at odds with the interests of creditors and shareholders. Drawing on his concept of “control fraud,” Black argues that a failure of regulation encouraged executives to meet short-term earnings goals and to capture large bonuses by encouraging fraudulent mortgages — even when it could be foreseen that this might lead to the destruction of the firm. “When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud — and control fraud causes greater financial losses than all other forms of property crime combined,” Black writes. Fannie and Freddie cannot have been the culprits, Black argues, because they were guilty of less mortgage control fraud than their fully private counterparts. “ ‘Modern finance’ has failed the market test,” Black concludes. “Its policies optimize the environment for control fraud and create perverse dynamics that create recurrent financial crises.”

  • The housing boom and bust stands behind the financial turmoil of 2008. Therefore, in our third analysis of the financial crisis, University of Chicago economist Casey B. Mulligan explores various hypotheses about its underlying causes. Was it changes in tastes and technology? Public policy? Investor “exuberance”? Mulligan describes some of the empirical tests that would be needed to settle the question, and argues that at least part of the answer is already clear. Most of the housing boom, Mulligan finds, was based in expectations about the future, rather than in demand, supply, or subsidies during the boom. Mulligan says that additional empirical tests — especially about the aggregate wealth effects of the boom and bust — would help us form a more educated guess about whether boom expectations were based more to changes in tastes, changes in technology, or exuberance. But those tests have not been done, and therefore, Mulligan concludes we cannot yet reliably predict the future economic damage from the housing boom and bust, or formulate beneficial financial industry regulation.

  • Our fourth and final anatomist, J. Bradford DeLong, notes that “in the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion,” and lays out five reasons why this value might fluctuate. “Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements.” Therefore, DeLong says, we’re left with changes in the discounts for liquidity, default, and risk. The housing crash has increased default risk significantly, but central banks have actually pumped up liquidity. Almost the entire drop of the value of global capital, DeLong argues, comes from an “increase in the perceived riskiness … of income from capital.” The problem, DeLong says, is that “our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.” However, DeLong is confident that Larry White’s story — focusing on the money supply and government policy to encourage bad home loans — cannot be the right one.