GSE Debates Show How Little We've Learned

Pssst. Fannie and Freddie caused the entire financial crisis!

That was the adamant conclusion of an event held last week at the American Enterprise Institute. Cast as an attempt to "break through the wall of media ignorance and bias" by host and AEI Fellow Peter Wallison, the event received scant press coverage. But it went a long way toward demonstrating how shoddy the discussion of the government-sponsored enterprises and housing policy has become.

There are plenty of good arguments for winding down Fannie and Freddie, but blaming them for the global financial crisis isn't one of them.

Each side of the conversation has failed to carry its weight. Depending on who's doing the attacking, the GSEs are invariably assailed as either a nasty government housing policy intrusion into the financial sector or a nasty financial-sector intrusion into government housing policy. It's the pro-market team versus the pro-housing subsidy team, and Wallison's an unabashed member of the former.

"We still read routinely in the press and hear on television that the financial crisis was caused by Wall Street. It's stated as a fact as if there really wasn't any doubt about it," Wallison said by way of introduction.

Trying to pin all the blame on Fannie and Freddie can get rough, however. The star guest at the AEI panel was Oonagh McDonald, a former member of the British Parliament who has written a book pinning the genesis of the housing crisis on Bill Clinton's 1995 National Home Ownership Strategy.

Yet for someone with such an excellent recollection of history, McDonald appeared to botch some extraordinarily basic elements of GSE securitization in her speech. How did the U.S. housing decline touch off a worldwide financial crisis, for example?

"Well, because Fannie and Freddie, having bought all these loans, packaged them into mortgage-backed securities, retained too many of them in their own portfolio, sold the rest to banks and mortgage banks, who packaged and repackaged them and sold them throughout the world," she told the AEI gathering.

(Readers of American Banker probably don't need to have the numerous errors in the sentence above corrected. For one thing, Fannie and Freddie never sold whole loans to banks. More broadly, investors in GSE-guaranteed securities never lost a penny on credit; it was the implosion of private-label MBS – packaged and sold by securities firms, diversified large banks and finance companies like Countrywide – that precipitated the crisis.)

The tragedy of the AEI event is that there are plenty of factual things to criticize Fannie and Freddie about.

Two speakers at the event, Graham, Fisher & Co. Managing Director Joshua Rosner and New York University Professor Lawrence White, framed the GSEs' pre-crisis operations as a misguided attempt to combine private-sector risk taking with a public-policy goal. Fannie and Freddie were never very good at making housing finance cheap, and the GSEs successfully lobbied to take more risk while enjoying an implied guarantee. They became huge pools of dumb money, buying garbage mortgage-backed securities outside of their core guarantee business and lowering their standards for loan underwriting to compete with private-label securitization.

"It looks like a free lunch until it isn't. And that's the whole essence of Fannie and Freddie," White said. "They were making mortgages a little less costly, and there was no apparent budgetary consequence. This was a politician's dream."

So far, so good. These arguments mesh well with banks' history of selling grossly deficient collateral to entities with clear contractual rights to force their repurchase; with the private sector's market-share growth as the bubble reached its peak; and with the wholesale collapse of the private residential securitization market.

For White and Rosner, these facts suggest that regulation should be strong and any subsidies should be direct.

"You cannot have subsidies delivered through private market players without the creation of distortion," Rosner said. "And going forward, if we're going to have any subsidies, it really needs to be on balance sheet to avoid the political arbitrage that we saw Fannie as masters of."

But Fannie and Freddie's natural critics – groups like AEI – reject any theory of the crisis that places less than 100% of the blame on the GSEs and the Community Reinvestment Act. Just get rid of those, they say, and the market will solve everything.

What they're promising is something for nothing. And in that, they appear to see eye to eye with those who still believe the GSEs can subsidize housing at no public cost.

Jeff Horwitz is a co-editor for risk management at American Banker. The views expressed here are his own.