Did Fannie Cause the Disaster?

Gretchen Morgenson and Joshua Rosner have produced a book titled Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon. Whatever the intention of the authors’, their work has been latched onto by a number of people whose goal is to shift blame for the subprime-mortgage generated crisis from the mortgage lenders and financial institutions to the government itself. If they had tried to generate a document that would undermine the drive for increased regulation of financial institutions they could not have done a better job.

Consider the Mayor of New York City announcing that our financial problems were caused not by the banks but by the government. Sample this comment from a Wall Street Journal review of the book.

"But Americans who read this outstanding history of the financial crisis will know, by the end, exactly who created the meltdown of 2008 and how they did it. This is a story, the authors say, ‘of what happens when Washington decides, in its infinite wisdom, that every living, breathing citizen should own a home’."

"At the center of the drama is Fannie Mae, a private company that used its special government backing to dominate the mortgage market and become the nation's second-largest debt issuer, after the U.S. Treasury itself. Encouraged by politicians to expand home lending—not least to minorities and to households with few assets—the company ignored reasonable standards of underwriting and piled up fugitive profits almost as fast as it increased risk to taxpayers."

So Fannie Mae somehow corrupted all those mortgage lenders and turned them towards their greedy and dangerous pursuits. The author of the article would have us believe that one of the greatest unpunished villains is Barney Frank—that will teach him to try and regulate the financial industry.

Even Robert Reich buys into this narrative in his desire to castigate the government for its close ties with financiers. He contributes this:

"The authors....deftly trace the beginnings of the collapse to the mid-1990s, when the Clinton administration called for a partnership between the private sector and Fannie and Freddie to encourage home buying."

"All this gave Fannie’s executives free rein to underwrite far more loans, further enriching themselves and their shareholders, but at increasing risk to taxpayers as lending standards declined. A company called Countrywide Financial became Fannie’s single largest provider of home loans and the nation’s largest mortgage lender. Countrywide abandoned standards altogether, even doctoring loans to make applicants look creditworthy, while generating a fortune for its co-founder, Angelo R. Mozilo."

So it’s all Bill Clinton’s fault! And of course it is all driven by this insidious notion that it would be nice if more people could afford to own a home. Reich also seems to suggest that it was Fannie that drove outfits like Countrywide to lower their impeccable standards and get down in the gutter with Fannie. Reich was the last person I would have expected to allow himself to become a tool of the right-wing financial industry.

Several other reviews of the book end up drawing similar conclusions. Somehow all the problems started with government activism, and with incompetent and corrupt people enabled by the government. Where have we heard this story before?

Jeff Madrick and Frank Partnoy provide a more balanced view of the book’s contents and the conclusions of its authors in a New York Review of Books article: Did Fannie Cause the Disaster? Madrick and Partnoy partially fault the structure of the book as well as its conclusions.

The first two thirds of the book document the wheeling and dealing of Fannie and its leadership, particularly that of James Johnson. There is no argument presented to suggest that Fannie’s leaders were anything but accomplished politicians who used their positions to protect themselves and their incomes. But that is in no way equivalent to saying they caused the whole mess. Morgenson and Rosner seem to imply that a lowering of mortgage down payment requirements by Fannie was somehow the greatest of all evils. Madrick and Johnson use the term GSE (government sponsored enterprise) to refer to both Fannie and Freddie.

"In particular, the authors blame the crisis on the goals set by the Clinton administration in the early 1990s to make lending "affordable" to more middle- and low-income home buyers. These goals were raised several times over the next dozen years so as to include more people, with the result that loans became cheaper. The authors write, ‘The homeownership drive helped to plunge the nation into the worst economic crisis since the Great Depression.’ They add, ‘How Clinton’s calamitous Homeownership Strategy was born, nurtured, and finally came to blow up the American economy is a story of greed and good intentions, corporate corruption and government support’."

"This bold claim, however, is not substantiated by persuasive analysis or by any hard evidence in the book. The GSEs did generate large losses, but their bad investments in housing loans followed rather than led the crisis; most of those investments involved purchases or guarantees made well after the subprime and housing bubbles had been expanded by private loans and were almost about to burst."

"Even then, the GSEs’ overall purchases and guarantees were much less risky than Wall Street’s: their default rates were one fourth to one fifth those of Wall Street and other private financial firms, a fact not made clear by the authors. A further review of other literature shows that Clinton’s goals to increase "affordable lending" had little to do with the risks the GSEs took. The FCIC, for example, argued that in several years these goals were largely met by the GSEs’ standard loans with traditional down payments."

A number of facts—including sources for those facts—are presented to counter the mainly undocumented conclusions of Morgenson and Rosner.

"But the key point—which is largely missing from Reckless Endangerment —is that private lenders made far riskier loans than GSEs bought or guaranteed, especially during the 1990s, when subprimes issued to borrowers with low income and poor credit were relatively new. You will not read in Reckless Endangerment that the GSEs bought very few subprimes in these years. Rather than leading the way, Fannie’s market share of the low-income home buyers fell behind private industry’s far riskier lending to poorer home owners and others."

"David Min, an analyst with the Center for American Progress, shows that the after-crisis delinquency rates on the large additional portion of GSE mortgages that Pinto claimed were high risk, and that was termed "toxic" by Morgenson and Rosner, was roughly 10 percent, far lower than the 25 to 30 percent default rate of true subprimes. In fact, the rate of delinquencies for all GSE securities in 2004 was 4.3 percent, compared to a delinquency rate in private industry of 15.1 percent of mortgages. In 2005, the GSE rate was 7.8 percent compared to 28.7 percent, and in 2006 and 2007, the rates reached 13.2 and 14.9 percent in the GSEs and 45.1 and 42.3 percent in the private market. None of these figures are cited in Reckless Endangerment."

"The GSEs did buy subprime mortgages in the 2000s, but contrary to the impression given by Morgenson and Rosner, their purchases were always a distinct minority of those sold by Wall Street. As Jason Thomas and Robert Van Order of George Washington University further point out, the subprimes the GSEs bought in these years were from the safer triple-A tranches of basic mortgage-backed securities, i.e., the highest quality of groups of mortgages rated by their risk of default. The GSEs never bought the far riskier collateralized debt obligations (CDOs) that were also rated triple-A and were the main source of the financial crisis. (The triple-A classifications of some of those CDOs were conferred on them very dubiously by the credit-rating agencies, Standard & Poor’s and Moody’s.) It turned out that subprimes accounted for only 5 percent of the GSEs’ ultimate losses, according to Thomas and Van Order."

The picture Madrick and Partnoy convey is one of the GSEs being swept up in a frenzy created by greedy financiers and criminal mortgage brokers rather than one in which the government sponsored agencies led the way. These authors were astonished to discover that after spending the majority of their book castigating the GSEs, Morgenson and Rosner finally get around to issuing this statement:

"Of all the partners in the homeownership push, no industry contributed more to the corruption of the lending process than Wall Street."

Authors with honorable intentions—or good editors—would have made sure that point came through loud and clear right up front. But then again everyone already knew that—what would be the value in repeating the obvious? One can sell many more books by creating bogeymen that don’t really exist.