David Coates: Republican Truth and Real Truth: GSEs and the Housing Bubble

In any wars of words in an election season, truth is often an early casualty. The war of words between Mitt Romney and Newt Gingrich is no exception. The two Republican front-runners are currently telling each other carefully fabricated stories about their own pasts that cover tracks and reinvent reputations. But in the end that is less damaging to the entire democratic process than the accidental and less contrived stories that, in passing, they are also telling us. Right now, as they attack each other with increasing venom, the four remaining Republican presidential candidates are collectively rewriting a critical part of our immediate past — and in the process are seriously misleading us as they battle with each other.

The main rewrite now underway in their twice-weekly televised clashes is a rewrite on housing finance. In Florida, and no doubt soon again in Nevada where the foreclosure crisis is even more severe, the men seeking the Republican nomination persistently blame the housing bubble on public policy and on federally underwritten regulatory agencies: on Fannie Mae and Freddie Mac, and on the evil impact of the Community Reinvestment Act.

They did so in Tampa last Monday in the first of their two Florida debates, and they did so even more starkly in their second debate in Jacksonville on Thursday night. They said this:

Mitt Romney: [to Newt Gingrich, in Tampa] “You also spoke publicly in favor of these GSEs, these government-sponsored enterprises, at a very time when Freddie Mac was getting America in a position where we would have had a massive housing collapse….Freddie Mac did a lot of bad for a lot of people.” [Then, of Newt Gingrich, in Jacksonville] “Fannie Mae and Freddie Mac were a big part of why we have the housing crisis in the nation that we have….He should have stood up and said, look, these things are a disaster. He should have been anxiously telling the American people that these entities were causing a housing bubble that we’re seeing here in Florida and around the country.”

Rick Santorum [in Tampa] “There were several of us in the United States Senate back in 2005 and 2006 who saw this on the horizon, who saw the problem with Fannie and Freddie, and tried to move forth with a bill…we said, if you don’t constrain these two behemoths from continuing to underwrite this subprime mortgage problem, then we’re going to have a collapse. Unfortunately that proved – proved to be true.” [in Jacksonville] “In 2006…in warning of a meltdown and a bubble in the housing market, I stood out, I stood tall, and tried to get a reform….to gradually decrease the amount of mortgage that can be financed by Freddie – or underwritten by Freddie and Fannie over time, keep reducing that until we get rid of Fannie and Freddie.”

Ron Paul: [in Tampa] “…in addition to that, it was an insult to injury, because they kept interest rates especially low with Freddie Mac and Fannie Mae, and there was a line of credit there, and it was a guarantee. As a matter of fact, I had introduced legislation 10 years before the bubble burst to eliminate that line of credit. But then the Community Reinvestment Act added more fuel to it, you know, forcing banks to make loans that are risky loans.” [in Jacksonville] “…we know how the bubble came about. It was excessive credit, interest rates held too low, too long, the Federal Reserve responsible for that. Community Reinvestment Act, which is Affirmative Action telling banks that they have to make these risky loans.”

In focusing on Newt Gingrich’s relationship with Freddie Mac in this fashion, his three main challengers offer us an explanation of the housing crisis that puts full responsibility for it (and its consequences) back onto the GSE’s, the Federal Reserve and the CRA; and they are not alone in this. Theirs is a view recently reinforced by the SEC decision to prosecute senior GSE managers for failing to disclose the scale of the subprime loans on their books; by the widely-read newspaper articles of the GSE’s long-time critic, Peter Wallison; and by the extensive coverage of the new book by Gretchen Morgenson and Joshua Rosner, Reckless Endangerment, one that singles out Fannie Mae for particular criticism and censure.

The only problem with that view is that factually it is, in all its essentials, entirely misleading!

• Blaming a Community Reinvestment Act passed in 1977 for a crisis that emerged only three decades later was always a stretch. If the Act was guilty, its guilt certainly took a very long time to kick in; and it is a claim which recent research has entirely discredited. As Levitin and Wachter have reported on the basis of their careful survey of all the relevant research data, “there is little evidence that the CRA contributed directly to the bubble. CRA subject institutions made a disproportionately small share of subprime mortgage loans,” and “relatively few subprime loans even qualified for CRA credit ,either because they were made outside CRA assessment areas or were made to higher income borrowers.” The findings of the Federal Reserve staffers Avery and Brevoort’s were similar: that “areas covered by the CRA experienced lower delinquency rates and less risky lending,” not higher ones. “According to recent Fed data, 75 percent of higher-priced loans made during the peak years of the subprime boom were made by independent mortgage firms and bank affiliates not covered by the act.” “Only 6% of…subprime loans had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend,” the Financial Crisis Inquiry Report noted, “were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law.” Which is presumably why the Report could definitely conclude, as it did, that “the CRA was not a significant factor in subprime lending or the crisis.”

• Timing matters too in relation to the GSEs and the development of a housing bubble. There is overwhelming evidence that the role of the GSEs in the explosion of housing prices and the spread of subprime lending was, at most, secondary and late. It was definitely not primary and early. The GSE’s did have an implicit government guarantee of solvency that enabled them to borrow at lower rates; and they did defend that special status with heavy lobbying. They also were the source of the securitization of mortgages that slowly transformed US housing finance from a “lend and hold” model of mortgaging to a “lend and sell on” one. But what they did not do was either initiate the lowering of underwriting standards that fueled the explosion of subprime lending, or spread those toxic assets through the U.S. and then global financial systems. Private lenders were responsible for the first of those two crucial drivers of the housing crisis, and private banks were responsible for the second. As Mark Zandi has recently noted, in 2002 before the housing boom, the two agencies held almost 54% of all mortgage debt. By summer 2006, at the peak of the bubble, their market share was down to 40%; and “it is difficult to see how the agencies could have been responsible for inflating the housing bubble at a time when they were losing a full 14 percentage points of market share.” Only as private lenders ran into difficulties did Fannie and Freddie move in to take up the slack, jumping ‘back into the housing market at precisely the wrong time.” It was in competition with private lenders, and in order to recapture market share, that eventually the GSEs did indeed lower their underwriting standards. But that belated lowering was a consequence of Fannie and Freddie being privately-owned, not of being government-sponsored. It was a lowering driven by shareholder pressure, demanded in order to compete with private-label mortgage backed securities “In contrast, the wholly public FHA/Ginnie Mae maintained their underwriting standards and ceded market share.” It is data like this that led the Financial Crisis Inquiry Commission to report that, in their view, “the two entities contributed to the crisis but were not a primary cause.”

• In consequence we would do well to discount both the Wallison thesis, and that advanced by Morgenson and Rosner. The Wallison enthusiasm for the SEC decision to prosecute senior GSE managers – his assertion that the prosecution “has made it clear that the two government sponsored enterprises played a major role in creating the demand for low quality mortgages before the 2008 financial crisis” – has been effectively rebutted by

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