As should not surprise anyone, the financial crisis has created opportunities for virtually everyone to promote their own ideas, by blaming the people they don't like for causing the crisis or not seeing it coming.
What did Fannie Mae (the Federal National Mortgage Association), Freddie Mac (the Federal Home Loan Mortage Corporation) and the CRA (the Community Reinvestment Act of 1977) have to do with the financial crisis, and why should we care? Some unhappy campers - the Republicans on the Financial Crisis Inquiry Commission (FCIC) - claim here that Fannie, Freddie, and the CRA had a lot to do with the financial crisis. This guy and Paul Krugman (here and here), among others, claim that the unhappy campers are liars, and that their ideas were debunked long ago. Obviously some people are not agreeing. Let's see if we can learn something here.
The CRA was certainly well-intentioned. Enacted in 1977, the Act was intended to correct problems of discrimination in lending by commercial banks. However, the law does not deal explicitly with discrimination, but instead works on promoting lending by commercial banks in the communities in which they draw deposits. There are no explicit penalties for bad behavior. Instead, the idea is to work through regulators - the Fed, the FDIC, the Comptroller of the Currency, for example - to monitor compliance with the law. Compliance is somewhat vague, and the regulators appear to have some discretion to determine what compliance means. Basically, the thrust of the law is to increase lending by commercial banks to poor people.
Now, the CRA seems like a poor piece of legislation. Straightforward Econ 101 tells us that, if the goal is to help poor people, it is more efficient to do this by simply giving them money rather than coercing someone else to help them. Of course, we know why governments tend to prefer mandates (No Child Left Behind comes to mind) rather than actually putting up the money, as mandates do not show up on the government's balance sheet. In the case of the CRA we have created a substantial bureaucratic cost. For example, every Federal Reserve Bank has a group of people, typically lodged in a community affairs department, whose sole purpose is to monitor compliance with CRA. These people take up space and are paid salaries. Further, it is not clear that CRA is effective. To the extent that banks would otherwise be compliant, the CRA just imposes costs on them - time wasted filling out forms. Further, if complying with CRA means engaging in unprofitable lending practices, this could cause commercial banks to close up shop in poor neighborhoods.
Now, what about Fannie and Freddie? These "government-sponsored enterprises" (GSEs) have a long history. Fannie Mae was created in 1938 as a governmental institution, but became "private" in 1968. Freddie Mac, in turn, was established in 1970. Today, Fannie and Freddie function essentially identically, and are of similar size. They are financial intermediaries that purchase residential mortgage loans from originators and either hold the loans in their own portfolios or package them as mortgage-backed securities (MBS) to be sold. Each institution issues debt (agency securities), and can purchase mortgage related assets, for example MBS created by other financial institutions. Fannie and Freddie receive special treatment, in that their debt is implicitly guaranteed by the federal government (a guarantee made explicit in September 2008), they pay no state or local taxes, and they are exempt from some securities regulations, among other things.
Is there a sound economic rationale for the existence of institutions like Fannie and Freddie? I don't know of any other high-income country where such institutions exist. Did those other countries somehow miss the boat? There are two issues here. The first relates to the role of securitization, and the second to whether securitization is necessarily a government activity. I like to use Canada as an example here, partly because I know something about it. In Canada, there is some securitization of mortgages, but most mortgage lending is done by chartered banks with the loans held in the banks' portfolios. Canadian banks do not securitize because they are large and geographically diversified. The reason securitization is important in the US is that we still have a large number of small banks which, if they held loans backed only by local real estate, would be poorly diversified. But do we need the government to sponsor the securitization of mortgages? Absolutely not. There is no good reason why private financial intermediaries cannot perform the same function. Of course, financial crisis experience highlights in a dramatic way the incentive problems associated with securitization. Indeed, this suggests why a banking system with large banks that hold loans in their portfolios (as in Canada) has advantages over a system with many banks and securitization.
Of course, Fannie and Freddie do not represent only an attempt by the government to replicate an activity that would otherwise be carried out by the private sector. The implicit government guarantees and favorable regulatory treatment are subsidies to the housing sector. In the United States, the housing sector has long been a sacred cow, and receives other subsidies, including the mortgage interest tax deduction. Is there an economic rationale for these subsidies? I have heard some people argue that there is a positive externality associated with home ownership. The idea seems to be that homeowners somehow take a greater interest in their communities than do renters. Baloney. First, Canada has achieved a higher home ownership rate (67%) than in the US (65%) without a mortgage interest tax deduction or any mortgage market intervention on the scale of Fannie and Freddie. This suggests that US housing subsidies show up more in the the quantities of resources allocated to the housing sector in each country rather than home ownership rates. Further, Germany has a home ownership rate of 43%, but I doubt that Germans are less community-minded than Americans. Indeed, people in other countries typically characterize Americans as being much more interested in their large houses than in public amenities like parks.
Now, how are Fannie, Freddie, and the CRA tied together? The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 indirectly affected CRA compliance by requiring (note: another federal mandate) that Fannie Mae and Freddie Mac devote some of their activities to affordable housing. This of course is one of the dangers of financial institutions that are closely allied with the government. The temptation always exists to use these institutions as instruments of policy, once again by using mandates to accomplish policy goals rather than using tools that affect the government's bottom line.
While the CRA seems wrongheaded, the unhappy campers on the FCIC appear to be barking up the wrong tree in attributing an important role to CRA implementation in the financial crisis. I'm sure the banking industry would love to get rid of CRA, and I can see why attaching a goodbye-to-CRA element to a financial industry reform bill would be legislatively practical, but I don't think this one flies.
What about the role of Fannie and Freddie in the crisis? Controversy over this has been brewing for some time. One aspect of that, a few months ago, was Krugman's review of Raghuram Rajan’s book, and Rajan's rebuttal. Here is Krugman's bottom line:
Was government policy entirely innocent? No, but its sins were more of omission than commission. Fannie and Freddie shouldn’t have been allowed to go chasing profits in the late stages of the housing bubble; and regulators failed to use the authority they had to stop excessive risk-taking. But as much as conservatives would like to put soft-hearted politicians at the center of this story, they don’t belong there. And Rajan’s endorsement of the conservative story line, without even an acknowledgment of the problems of that line, comes across as slippery and evasive.There are two story lines. First, the government-as-bad-guy story is that Fannie and Freddie, encouraged by the government, lax regulation, and their implicit subsidy, played a central role in encouraging incentive problems in the mortgage market, thus playing a crucial role in pushing up the prices of houses. This then laid the groundwork for the subsequent crash. The second story line is the private-sector-as-bad-guy story. Private mortgage originators, in league with the shadow banking system and the credit rating agencies, caused the incentive problems, and Fannie Mae and Freddie Mac went along with this to a small extent (so as to retain market share).
The private-sector-as-bad-guy story-tellers give the following arguments:
1. Fannie and Freddie's market share fell during the period leading up to the crisis. See this for example. Figure 1.2 shows a drop in the flow of new MBS by Fannie and Freddie from about 2004-2007, as subprime activity takes off.
2. The bust happened in commercial real estate as well as residential. Fannie and Freddie can only deal in residential-mortgage-related instruments. If the problems were more widespread, it can't be Fannie and Freddie causing the problem.
3. Other countries experienced housing booms and subsequent busts during the same period. Since Fannie and Freddie do not have any direct influence on housing markets in other countries, something else is going on. See (2).
There are counter-arguments to all of these points. With regard to (1), Rajan points out, in his rebuttal to Krugman's review of his book, that looking at MBS issues leaves out an important part of the story, as Fannie and Freddie both purchased substantial quantities of risky loans from originators that sat in their own portfolios, and purchased MBS from other issuers. On (2), residential and commercial real estate are clearly complementary. For example, a new housing development comes with a strip mall. In principle, high demand for housing fueled by indiscriminate lending encouraged by Fannie and Freddie also increases the demand for commercial real estate. On (3), this is neither here nor there. The large runups in house prices in other countries happened for various reasons. Whether those runups happened or not has no bearing on how I think about the role of Fannie and Freddie in the financial crisis. However, consider (again) Canada as an example. This is useful, as real GDP followed a similar path in the US and Canada during the recession, and we can sometimes think of Canada as the 51st state or the the 13th Federal Reserve District. However, the financial systems in Canada and the US are very different. During the financial crisis, there were no incentive problems in Canadian mortgage markets, no banks were severely stressed, no banks failed, and there were no bailouts. The chart shows housing prices in Canada and the US, from 2000 to the present (St. Louis Fed's housing price index for the US, Statistics Canada New Housing Price for Canada). As you can see, prices in Canada rose at a lower rate, on average, prior to 2006, when the housing bust begins in the US. Canada experiences only a dip in housing prices during the recession, with prices in Canada currently back to their peak. What does this tell us? It's certainly consistent with the idea that incentive problems in the US mortgage market drove up prices, it runs counter to the arguments of the private-sector-as-bad-guy story-tellers, but this does not tell me anything about what to attribute to Fannie and Freddie.
Where are we then? Here are my conclusions:
1. Forget about good guys and bad guys. If there was anything that the financial crisis taught us, it is that risks and incentives in the financial market have to be evaluated systemically. For example, a regulator may have considered a bank's holdings of MBS as low-risk, since they were insured by AIG, without taking account of the fact that AIG would in fact not be able to pay out on all its claims in some states of the world. Fannie and Freddie, like all other large financial institutions, played important roles in the financial crisis. Can we quantify those roles? Because of the complicated relationships among financial institutions, I think this is impossible.
2. We need financial reform that will unwind Fannie and Freddie. It has been clear for a long time that Fannie and Freddie are corrupt, inefficient institutions with no important economic role. Fannie and Freddie are currently under government conservatorship and on the receiving end of a flow of bailouts from the federal government. The only question here is how the unwinding should be done.
3. It's all about the government. As Walt Kelly would have said, "we have met the enemy and he is us." Financial crises are not a given. We experience these periodic episodes because of how our financial system was designed, and by virtue of how the regulations were set up. We cannot blame the financial crisis on Wall Street, any more than we can blame children for burning down the house when they are left at home with a box of matches and a can of gasoline. The cause of the problem was faulty design and faulty regulation. The government - i.e. you and me - did it, and we need to fix it.