by Tanta on 7/14/2008 09:40:00 AM

Paul Krugman has a new column on Fannie and Freddie which I think is important. I'm going to take issue with a fair amount of it, but not with the basic argument that the uproar over the GSEs is "overblown." That, I think is a point worth making.

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Krugman starts with a sweeping claim and a mini-history lesson:

Well, I’m going to take a contrarian position: the storm over these particular lenders is overblown. Fannie and Freddie probably will need a government rescue. But since it’s already clear that that rescue will take place, their problems won’t take down the economy.

Furthermore, while Fannie and Freddie are problematic institutions, they aren’t responsible for the mess we’re in.

Here’s the background: Fannie Mae — the Federal National Mortgage Association — was created in the 1930s to facilitate homeownership by buying mortgages from banks, freeing up cash that could be used to make new loans. Fannie and Freddie Mac, which does pretty much the same thing, now finance most of the home loans being made in America.

Because credit risk is now the front and center concern in everyone's minds, here in this bust of the bubble, I think it's very difficult for people to grasp the primary liquidity function of the GSEs. They have always been about recycling lending capital and taking long-term fixed interest rate risk off depository (and eventually non-depository) lenders much more than about merely absorbing credit risk. This goes against the grain of much current media over-simplification of "securitization" of mortgage loans that sees laying off credit risk as the main or even the only point of selling loans. The GSEs do take on the credit guarantee obligation of the securities they issue, but nobody sells loans to the GSEs just to offload credit risk--in fact, more than a few lenders work hard to negotiate contracts with the GSEs that leave quite a substantial part of the credit risk with the original lender: recourse agreements, indemnifications, servicing options that put a lot of the cost of default on the seller/servicer, not the GSE. They have historically done this because the credit risk of GSE-eligible loans has always been modest, but the benefits of getting 30-year fixed interest rate loans off your balance sheet has been substantial.

It's important to remember that, but not to overstate the case, which I think Krugman does:

But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

Fannie and Freddie had about as much to with the "explosion of high-risk lending" as they could get away with. We are all fortunate that they couldn't get away with all that much of it. It is a fact that their market share dropped like a brick in the early years of this century, except of course for years like 2003, when fixed rates dropped to cyclical lows, refis boomed, and GSE market share shot up again, only to plummet in the years following during the purchase boom.

But they didn't like losing their market share, and they pushed the envelope on credit quality as far as they could inside the constraints of their charter: they got into "near prime" programs (Fannie's "Expanded Approval," Freddie's "A Minus") that, at the bottom tier, were hard to distinguish from regular old "subprime" except--again--that they were overwhelmingly fixed-rate "non-toxic" loan structures. They got into "documentation relief" in a big way through their automated underwriting systems, offering "low doc" loans that had a few key differences from the really wretched "stated" and "NINA" crap of the last several years, but occasionally the line between the two was rather thin. Again, though, whatever they bought in the low-doc world was overwhelmingly fixed rate (or at least longer-term hybrid amortizing ARMs), lower-LTV, and, of course, back in the day, of "conforming" loan balance, which kept the worst of the outright fraudulent loans out of the pile. Lots of people lied about their income (with or without collusion by their lender) in order to borrow $500,000 to buy an overpriced house in a bubble market. They weren't borrowing $500,000 from the GSEs.

Furthermore, both GSEs were major culprits in the growth of the mega-lenders. Over the years they were struggling so hard to maintain market share, they were allowing themselves to experience huge concentration risks. As they catered more and more to their "major partners"--Countrywide, Wells Fargo, WaMu, the usual suspects--they helped sustain and worsen the "aggregator" model in which smaller lenders sold loans not to the GSEs but to CFC or WFC, who then sold the loans to the GSEs. In large measure this was a function of pricing: the aggregators got the best pricing from the GSEs--the lowest guarantee fees, the best execution options--making it more attractive for a number of reasons for small lenders to sell to the aggregators.

The mentality at the GSEs seemed to many of us to have become too focused on letting these "deep pocket" mega-players continue to push the GSEs toward low doc, "near subprime," interest-only ARMs, low-down loans with iffy subordinate financing, etc. If you were Podunk National, you weren't going to get a master commitment with the GSEs to sell "fast and easy" doc-lite ARMs with a razor-thin guarantee fee. But if you were HSBC, you got that, and so Podunk either lost market share or made those loans and sold them to HSBC, who sold them to the GSEs. From the GSE's side it looked like they had the balance sheet and servicer strength of HSBC--or CFC or WFC or BAC or whoever--on the other side of those loan sales. From Podunk's side it often looked like you could take advantage of the GSEs' power to keep the mortgage market liquid only by consolidating the gargantuan servicing portfolios of the 800 pound gorillas, whose seemingly endless appetite for higher and higher-risk products made it hard for you to compete with conservative vanilla offerings.

I think we can give Fannie and Freddie their due share of responsibility for the mess we're in, while acknowledging that they were nowhere near the biggest culprits in the recent credit bubble. They may finance most of the home loans in America, but most of the home loans in America aren't the problem; the problem is that very substantial slice of home loans that went outside the Fannie and Freddie box. But Krugman is right to focus on the fact that it was the regulatory and charter constraints of the GSEs that kept that box closed. In the schizoid reality of the GSEs, when they had their "shareholder-owned private company" hats on they did plenty of envelope-pushing. When they had their "affordable housing" hats on, they rationalized dubious theories of credit quality--like the fervent belief that low or no down payment can be fully offset by a pretty FICO score--to beef up their affordable housing goals, often at the expense not of the poor put-upon "private sector" but of FHA, whose traditional borrower pool they pretty thoroughly cherry-picked. Nonetheless, the immovable objects of the conforming loan limits and the charter limitation of taking only loans with a maximum LTV of 80% unless a well-capitalized mortgage insurer took the first loss position, plus all their other regulatory strictures, managed fairly well against the irresistible force of "innovation." If there has ever been an argument for serious regulation of the mortgage markets, the GSEs are it.

So, as Krugman asks:

In that case, however, how did they end up in trouble?

Part of the answer is the sheer scale of the housing bubble, and the size of the price declines taking place now that the bubble has burst. In Los Angeles, Miami and other places, anyone who borrowed to buy a house at the peak of the market probably has negative equity at this point, even if he or she originally put 20 percent down. The result is a rising rate of delinquency even on loans that meet Fannie-Freddie guidelines.

Also, Fannie and Freddie, while tightly regulated in terms of their lending, haven’t been required to put up enough capital — that is, money raised by selling stock rather than borrowing. This means that even a small decline in the value of their assets can leave them underwater, owing more than they own.

Well, that and the fact that the minute it looked like the party was over, Congress and the administration both fell all over themselves to push the GSEs into jumbo markets they had at least managed to stay out of during the worst of the boom, cheerfully lifting their portfolio caps at the same time. How do you go on a stock-selling binge at the same time you have just become the official lender of last resort (along with FHA), handed the mandate to take out all those toxic ARMs with too-large loan balances into "safe" 30-year fixed that the borrowers in question still can't afford? If credit risk wasn't, heretofore, mostly the GSEs' problems, it will be now.

Krugman concludes:

And let’s be clear: Fannie and Freddie can’t be allowed to fail. With the collapse of subprime lending, they’re now more central than ever to the housing market, and the economy as a whole.

I actually buy the idea that they can't be allowed to fail. I also agree with Atrios:

Actually, Fannie and Freddie can be allowed to fail. Their shareholders can eat shit, and they can be reconstituted as a wholesale federal entities. There are zero reasons that I can think of that we should have shareholder owned entities which "probably but not necessarily" are going to get a government bailout every time they need it.

Both short and long term we might think that having such creatures exist to be mortgage backstops is a good idea. I probably agree with that. But there is no reason for them to be publicly traded companies.

Fannie Mae didn't start out as a "GSE," it started out as a government agency. It can go back to being a government agency if the government needs to further the economic goals of liquidity in the home mortgage market--and maybe it can go back to doing business with Podunk National, rather than lavishing its capital on mega-lenders who aren't going to be subject to regional liquidity crunches. All this uproar over "nationalizing" the GSEs seems to me the part that is really overblown. If they can't raise enough capital as shareholder-owned entities to prevent the necessity of periodic bailouts, then let's end the experiment with "GSEs" and make them agencies of the government. Any "rescue" that doesn't wipe out the shareholders is simply making a bad thing worse.

The irony of the "subprime" situation, it seems to me, is that we probably all would have been better off if the GSEs had gotten into it in a big way. If the GSEs had been able to create a market in "vanilla" subprime--fixed rates, no prepayment penalties, careful documentation requirements, competitive pricing--and forced their seller/servicers into a "subprime box," the subprime loan market would have been a lot better off. The "pseudo-Maes and Macs" have never really been very good at providing the kind of market discipline within their purview that the real Mae and Mac have. But we wanted "innovation" and "choice" and "flexibility," not domesticated subprime and "alt" financing with low margins, uniform loan terms, and front and side airbags.

What we certainly don't need is the GSEs to continue to flirt with the dark side of the mortgage market in the booms in the name of chasing "market share" and then have to clean it all up willy-nilly during the busts.

However . . .