Wallison vs. Krugman: How Much are Freddie/Fannie to Blame

Peter Wallison at AEI has out an attempted take-down of economist Paul Krugman ("Fannie, Freddie and You", 7/14/2008), and pretty much anyone else who thinks Freddie and Fannie’s role in this crisis during the 2005-2007 period was irrelevant compared to private actors. It’s provocative stuff, and reasonably nuanced.

At the same time, Wallison introducesexpands a theory for why the two firms acted so destructively: While they were fighting for share, they were mostly trying to impress Democratic overseers post-account scandals. Call it the tail-wagging model of mortgage market implosion.

Table 1 Why did the GSEs follow this disastrous course? One explanation–advanced by Lockhart–is that Fannie and Freddie were competing for market share with the private label securitizers and had to purchase substantial amounts of subprime mortgages in order to retain their position in a growing market. Fannie and Freddie’s explanation is that they were the victims of excessively stringent HUD affordable housing goals. Neither of these explanations is plausible. For many years before 2004, Fannie and Freddie had followed relatively prudent investment strategies, even with respect to affordable housing, but they suddenly changed their approach in 2005. Freddie Mac’s report, for example, shows that the percentage of mortgages in its portfolio with subprime characteristics rose rapidly after 2004. In addition, Freddie Mac’s disclosures indicate that of the loans added to its portfolio of single-family loans between 2005 and 2007, 97 percent were interest-only mortgages, 85 percent were Alt-A, 72 percent were negative amortization loans, 67 percent had FICO scores lower than 620, and 68 percent had original loan-to-value ratios greater than 90 percent. It seems unlikely that competing for market share or complying with HUD regulations–which contained no enforcement mechanism other than disclosure and delay in approving requests for mission expansions–could be the reason for such an obviously destructive course.

Instead, it seems likely that the event responsible for the GSEs’ change in direction and culture was the accounting scandal that each of them encountered in 2003 and 2004. In both cases, they lost their reputation as well-managed companies and began to encounter questions about their contribution to reducing mortgage rates and their safety and soundness. Serious observers questioned whether they should be allowed to continue to hold mortgages and MBS in their portfolios–by far their most profitable activity–and Senate Republicans moved a bill out of committee that would have prohibited this activity.

Under these circumstances, the need to manage their political risk became paramount, and this required them to prove to their supporters in Congress that they still served a useful purpose. In 2003, as noted above, Frank had cited an arrangement in which the GSEs’ congressional benefits were linked to their investments in affordable housing. In this context, substantially increasing their support for affordable housing–through the purchase of the subprime loans permitted by HUD–seems a logical and even necessary tactic.

More here.