Arnold Kling  

Today's Freddie-Fannie Commentary

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How I Lost My Macro Religion... Will Supplies Last?...

Mark Thoma writes,


if someone without a life-preserver who is struggling in the water grabs someone who is wearing one, and in the process takes them both down, that doesn't mean that the life-preserver failed to do its job.

What he means by this metaphor is that the unregulated Wall Street firms created the housing boom and bust that brought down Fannie and Freddie. The implication is that the GSE's and their regulators were innocent victims.

That's one narrative. Thoma offers it in contrast to Tyler Cowen's narrative, in which government regulation does not work as well in real time as it does in hindsight.

Tyler's view, which I tend to share, receives support from a story in today's Washington Post, How Washington Failed to Rein in Fannie, Freddie. One key sentence:


the great risk to the profitability of Fannie Mae and Freddie Mac was not the movement of interest rates or defaults by borrowers, the concerns of a normal financial institution. Fannie Mae's risk was political, the concern that the government would end its special status.

So the companies increasingly used their windfall for a massive campaign to protect that status.

It's a long story, but well worth reading in its entirety.

I would agree with Thoma that unregulated firms led the way in lending to marginal homebuyers. But note the irony there. Supposedly, we need Freddie Mac and Fannie Mae to expand home ownership, but private firms were the ones pushing the margins.

In fact, if Freddie and Fannie had been willing to take a pass on high-risk lending, they would not be in trouble today. But their shareholders thought they needed to keep growing, regardless. And their friends in Congress thought they needed to do their part to help the "under-served" segment of the housing market. I recall friends of mine who were still at Freddie Mac and who were unhappy with the plunge into the subprime sector grumbling about the "over-served" market.

I stand by my briefing paper for Cato, written before the GSE's were put into conservatorship but which appeared the day after.


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COMMENTS (6 to date)
Steve Roth writes:

Again I am surprised to find discussion of regulation without any reference to the ratings agencies. Weren't they the key crux point, and don't they remain so?

Being paid by securities issuers, and preparing their ratings in collusion with those issuers, they failed to accurately rate the securities.

If they had rated them accurately, it would been harder and more expensive to sell those securities. Which would have made it harder and more expensive--or even impossible--for loan issuers to issue the underlying loans.

What about regulations barring ratings agencies from accepting money from issuers? Or at least, a cigarette-type warning on each rating paid for by an issuer? Would this create a market for less-conflicted ratings?

True, the ratings are free at this point. But they might also be useless...

Steve

Arnold Kling writes:

Steve,
Ratings might have mattered for private issuers. For the GSE's, they were irrelevant.

Steve Roth writes:

>For the GSE's, they were irrelevant.

This is because of the GSE's implicit gov't guarantee? Does that mean irrelevant, or just (far) less relevant?

Truly curious. More please?

Arnold Kling writes:

Steve,
If you are investor in GSE debt, what you care about is the government (implied) guarantee, not what a rating agency says. Five years ago, if a rating agency had said, "This would be AA paper if there weren't a government guarantee," investors would have gone ahead and treated it as AAA. And they would have been rewarded for doing so.

Michael Manti writes:

Arnold, I don't think that Steve was talking about GSE debt. I think he's talking about the securites that the GSEs bought. Isn't the purchase of private-label securities backed by subprime mortgages and rated AAA by the agencies (or by models vended by the agencies) a major part of what has the GSEs (and others) in trouble?

Dave writes:

Steve, when this mess first broke last year, I too blamed the ratings agencies. However, the more I think about it, the less inclined I am to blame them.

It's true that they had poor incentives to rate the securities accurately, but that also assumes they had the ability to rate them correctly in absence of such incentives. Their models, likely using historical data, still probably would have been unable to predict the rate of mortgage default that we have seen recently.

Also, it was no secret as to who was paying the ratings agencies. Why did investors feel no need to perform due diligence before purchasing securities they couldn't possibly comprehend? No one dictates that investors have to listen to the ratings agencies - they do not set prices, they give opinions. I don't believe that there was even a regulatory requirement to rate CDOs (please correct me if I'm wrong on this point), so it's hard to see how the government could fault them for doing a poor job. It would be like punishing me for stating a prediction that later turned out to be false just because other people chose to act on it.

I think your statement that "the ratings are free at this point. But they might also be useless" hits the nail on the head in the sense that investors will cease to listen to their ratings when it comes to these specific products, and they will likely stop being paid to rate them as a result. This would place the responsibility back on the investor to understand what they are buying, which is where it belongs, in my opinion.

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