Krugman Error on Fannie and Freddie.--

Over at the Foundry, Conn Carroll is pointing out an apparent error in Paul Krugman's defense of the political entities doing business as Fannie Mae and Freddie Mac.

Krugman wrote in his column today that "Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago" and that "they didn't do any subprime lending."

Conn Carroll responds:

Where to begin? First let's stipulate that Fannie and Freddie never did "any subprime lending" … but not for the reason Krugman states. Freddie and Fannie never do any lending: They buy mortgages from lenders only, so that those lenders have more cash to make other loans (like subprime ones). But Krugman is either lying or being intentionally obtuse when he says "Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income." The Washington Post reports:

In 1995, President Bill Clinton's HUD agreed to let Fannie and Freddie get affordable-housing credit for buying subprime securities that included loans to low-income borrowers. The idea was that subprime lending benefited many borrowers who did not qualify for conventional loans. HUD expected that Freddie and Fannie would impose their high lending standards on subprime lenders.

… In 2000, as HUD revisited its affordable-housing goals, the housing market had shifted. With escalating home prices, subprime loans were more popular. Consumer advocates warned that lenders were trapping borrowers with low "teaser" interest rates and ignoring borrowers' qualifications.

HUD restricted Freddie and Fannie, saying it would not credit them for loans they purchased that had abusively high costs or that were granted without regard to the borrower's ability to repay. Freddie and Fannie adopted policies not to buy some high-cost loans.

That year, Freddie bought $18.6 billion in subprime loans; Fannie did not disclose its number.…

But by 2004, when HUD next revised the goals, Freddie and Fannie's purchases of subprime-backed securities had risen tenfold. Foreclosure rates also were rising. …

In 2003, the two bought $81 billion in subprime securities. In 2004, they purchased $175 billion — 44 percent of the market. In 2005, they bought $169 billion, or 33 percent. In 2006, they cut back to $90 billion, or 20 percent.

Let's review that last paragraph again. Krugman is trying to convince his readers that Freddie and Fannie are only innocent bystanders in the housing bubble. Fannie and Freddie purchased 44 percent of the subprime securities in 2004. Does that sound like the behavior of an innocent bystander to you?

Bpbatista (mail):
Heads must roll for this debacle.
7.14.2008 4:56pm
Posted previously on DB's Fannie and Freddie thread, didn't see this one, sorry. Bpbatista, don't bet on it.

Fannie &Freddie are private companies, listed on the NYSE, and should be allowed to fail. They are the only private companies, apparently, that the Federal Govt. has guaranteed against market failure. The Bush Admin. proposal to offer them cash through the Federal Reserve and through the purchase of stock in F &F is the first step toward eventual nationalization of the secondary mortgage market.

I guess the free market philosophy only goes so far--we will deregulate your market but if you get into trouble, don't worry, we will bail you out (but only if you are a favored industry giant, not a homeowner or small business). Now is time to stop the madness.
7.14.2008 5:04pm
Nathan_M (mail):
There's a much more indepth post at Calculated Risk on this. It's fairly critical of the Krugman piece, but it concludes that

I think we can give Fannie and Freddie their due share of responsibility for the mess we're in, while acknowledging that they were nowhere near the biggest culprits in the recent credit bubble. They may finance most of the home loans in America, but most of the home loans in America aren't the problem; the problem is that very substantial slice of home loans that went outside the Fannie and Freddie box.

The volume of "subprime" or "near-prime" securities Fannie and Freddie purchased is a bit misleading, because they avoided the most dangerous types of mortgages in the subprime market.
7.14.2008 5:08pm
Even if there is some justification to save Fannie and Freddy, doing so should be at the cost of their executtive teams who knew full well what they were doing....
7.14.2008 5:30pm
Thales (mail) (www):
"The volume of "subprime" or "near-prime" securities Fannie and Freddie purchased is a bit misleading, because they avoided the most dangerous types of mortgages in the subprime market."

This is definitely true, and it is because of the stringent set of representations and warranties Fannie and Freddie insist that commercial and investment banks insert in any securitization agreements, even though Fannie and Freddie are almost never directly party to these agreements (but the banks have them in mind as buyers of the mortgage backed securities).
7.14.2008 5:38pm
Robert Arvanitis (mail):
Thomas More says "Why Richard, it profits a man nothing to lose his soul for the whole world... but for Wales?"

With the GSEs we can say "...but for 17 basis points?"

(That's the sum total impact on mortgage lending, for all the billions of cash moved, trillions of notional guaranteed, and tens of millions of executive comp wasted.
7.14.2008 5:49pm
Joe -- Dallas, TX (mail):
I always enjoyed the "Krugman Watch" - Usually found 1-2 substantive factual errors in ever one of his columns. Shortly thereafter the debut of the "Krugman Watch" the NYT took the his column and others to the NYT select readers where you had to pay to read the NYT. I especially loved his argument that the econmic growth of France's socialist policies were better and/or comparable to the US by citing the economic growth of all of europe, with out mentioning the lack of economic growth in France.
7.14.2008 5:55pm
Doc W (mail):
I'll say it again: government interference in markets causes problems that are blamed on markets and become excuses for more government intervention, causing more problems, etc. The end of the line in that process is socialism, which doesn't work. Stop the train and get off. It's that simple.
7.14.2008 6:18pm
A. Zarkov (mail):
Krugman seems misinformed about F &F in that he asserts they were simply taken down by the mortgage debacle. According to Market Ticker F &F was throughly remiss in the loans it purchased.

In truth hundreds of billions of dollars worth of mortgages were sold into Fannie and Freddie using automated underwriting systems from firms like Countrywide, many of them refinances, that literally verified almost nothing more than the applicant's credit score!
If that's true then F &F bought loans that were "piggy backed" meaning the borrower took out a second to pay for the down payment and various closing costs and fees making these loans extremely risky. But perhaps even more egregious Market Ticker says
Even worse, Fannie and Freddie, who guarantee their own bond issues, started buying their own paper. That is, they are writing insurance on a hurricane when they are both the writer of the insurance and the loss payee. This looks brilliant in that the "expense" of providing that insurance effectively disappears, thereby making the entirety of the spread they get from their source-of-funds to their paper issue theirs to keep, but that's the wrong way to look at it.
Now perhaps Market Ticker is a crackpot, but if he's right Krugman is seriously misrepresenting what went wrong.
7.14.2008 7:59pm
Mark Buehner (mail):

They are the only private companies, apparently, that the Federal Govt. has guaranteed against market failure

News to the airline industry.

The only thing interesting about Krugman is how he manages to continue his masquerade as an economist who reports on politics when he is the opposite.
7.14.2008 8:20pm
Toby is absolutely spot on! Their executive teams must 'bleed', otherwise no lesson is learned. Never get in the way of an entity learning from history, otherwise the "lesson" repeats and repeats and repeats and repea..........
7.14.2008 9:15pm
DougS (mail):
Efficiencies of scale make it impossible to let these behemoths go out of business. The consequences to the "free market" would be devastating. Now if we had maintained 10 or 15 companies in the market then letting a couple go bankrupt wouldn't matter. Just think of all the other businesses that are beginning to look like this, telecommunications, electronics, airlines, oil, beer (ha!). Rollerball here we come. Pretty soon none of them will be able to go under without creating significant upheavals in the world economy.
7.14.2008 9:43pm
TruePath (mail) (www):
Doesn't sound to me like anyone here has given good evidence that Krugman is wrong. In particular the claim that Fannie Mae and Freddie Mac were buying subprime loans seems downright contradictory.

Checking on wikipedia I see that Krugman is dead on about the definition of a subprime mortgage.

However, in U.S. mortgage lending specifically, the term "subprime" simply refers to loans that do not meet Fannie Mae or Freddie Mac guidelines. It may or may not reflect credit status of the borrower as being less than ideal and may not even reflect the interest rate on the loan itself. The phrase also refers to bank loans taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and to certain types of self-employed persons.

Thus, as he says straight out in the article, they can not have bought subprime loans. I suspect the washington post piece is mistakenly applying the standard meaning of subprime loans as being those that charge interest less than the prime rate (for some period). Still this is merely a matter of terminology the real question that needs to be answered is whether Fannie and Freddie bought a large portion of the loans that could obviously not be repaid by the borrowers without refinancing or sale.

I agree that Krugman doesn't give good reason to think that they did not do so, defining Fannie Mae and Freddie Mac not to purchase subprime loans doesn't actually mean they can't purchase bad loans, but nor is it the case that observing that they bought many low interest rate loans enough without more data on what type of loans what sort of downpayments were involved what the relevant credit scores and incomes were and so forth.
7.14.2008 10:09pm
Tom Hanna (www):
Much as I hate to defend Paul Krugman, lumping in the full doc Alt-A loans that Fannie and Freddie bought to to the no-doc, no credit, no down, interest only, 0% teaser rate ARMs of 2005 and 2006 is far more misleading than Krugman's piece. Sure they're not prime loans. Choice beef is a grade below prime beef, too, but that doesn't make it a hot dog.
7.14.2008 10:29pm
TruePath (mail) (www):
Ohh, and this "the executives must bleed" nonsense is nothing but revenge politics and is both stupid and uninformed (though it might happen to be correct).

First of all the problem with sacking the executives to teach them a lesson/punish them is that the people who you teach a lesson no longer run the show. Of course you might think this will encourage the next generation of leaders to do a better job but whether or not that is true depends largely on both the reason bad decisions were made and the types of compensation packages offered.

I mean there are really two possibilities here:

A) The leadership of Fannie Mae and Freddie Mac deliberately pursued policies they knew were harmful/bad for their own personal gain. I tend to doubt this but it's possible. Now in this case I agree the executives need to be treated as harshly as their contracts will allow and if evidence can be found of their deliberate intent to make bad choices possibly sued for breech of fiduciary duty or some such. However, what's really important in this case is to change the system so it's not so easily gamed, i.e., reduce the performance bonus or other incentives that bias the executives toward achieving high numbers via risky strategies.

B) The executives at Fannie Mae and Freddie Mac simply made mistakes much like the executives at many other banks. Now perhaps this is evidence that we didn't have good executives in the first place but since so many people fell for this trap one has to ask whether we really think we are likely to get better replacements. In this case what matters is who is least likely to lead us into trouble again. Unless we are using a new selection process to hire new executives I see no reason to expect they will be any better than the current executives and the current executives will at least have the advantage of this experience to make themselves cautious.


Now I understand the outraged feeling at seeing the executives raking in huge contracts during the good times and escaping unscathed during the bad but adopting a compensation policy that inflicts significant economic/professional loss on the executives as a consequence of massive failure would just make things worse. Consider that the very feature we want in our executives is prudence. Ideally we want to hire executives who take safeguards against downturns when times are good and avoid the executives who are inclined to gamble everything and escape before things turn sour. By making the executives pay when things go bad you discourage prudent individuals from taking the job more than the risk takers.
7.14.2008 10:34pm

The end of the line in that process is socialism, which doesn't work.

Is France, according to your extremely broad definition of socialism, socialist?

If so, what does it mean to say that France "doesn't work?"
7.14.2008 10:48pm
On a more interesting note, to me the sort of thinking by Doc W is pretty illustrative of a problem with much conservative thought generally.

It tends towards the extremely simplistic. It substitutes broad labels (i.e. socialism) which encompasses many different things (i.e. the military? the post office? social security?) and applies a simplistic normative label (i.e. socialism bad -- query? post offices bad? social security bad?)

And conservatives wonder why they are "underrepresented" in academia. Well, the reason is simple. In academia, you actually have to have arguments that can be defended using basic logic and reason, and which do not excessively distort reality with simplistic assumptions (the exception being economics, which actually encourages simplistic and false assumptions that destroy nuance in a bizarre and ultimately futile desire to imitate the elegance of physics).

There are intelligent conservatives in academia. But, I think that the ratio of intelligent to unintelligent conservatives is much lower than the ratio of intelligent to unintelligent liberals. Thus, all things being equal, one would expect more liberals than conservatives in academia.

It amazes me what passes for "thought" among some (but definitely not all) conservatives.

Maybe I would be concerned about "discrimination" against conservatives in academia if conservatives were, on average, more intelligent.

It also appears to me that intelligent conservatives (like Eugene Volokh at UCLA or Charles Fried or Jack Goldsmith at Harvard Law School) do not have excessive difficulty obtaining academic positions at or near the highest levels of the profession. (I will exempt any professors from George Mason Law from the analysis, since that school definitely discriminates in favor of libertarians.)

If academia were so unfair to conservatives, how do you explain the conservatives who do make it?

I will tell you how you explain it. Smart conservatives do fine. There just aren't as many of them, compared to their numbers in the general population. It is not that you cannot be highly intelligent and conservative. It is that this combination is more rare.
7.14.2008 11:01pm
Henri Le Compte (mail):
My Lord, Snarky! Do you ever actually listen to yourself? Do you not see the irony of producing paragraph after paragraph of self-congratulatory "logic" without the benefit of a single supporting fact?

(And no, saying "conservatives are stupid" doesn't count as a fact, no matter how many times you say it. And yes, socialism has a lot to answer for, given the history of the 20th century.)
7.14.2008 11:19pm

And yes, socialism has a lot to answer for, given the history of the 20th century.

I would really like to have a word with this "socialism" character.
7.15.2008 12:34am
Doc W (mail):
Snarky, I'll try to boil it down far enough for you to understand...

Um, on second thought, never mind.
7.15.2008 12:38am

I'll try to boil it down far enough for you to understand

This is exactly what is wrong with conservative thought. Always trying to "boil things down" instead of accepting that the real world is a complex place.

There is no such thing as "socialism," really. At least, it is not a discrete entity.

It would be as if I were to say, Starbucks really has to answer for the Enron scandal, because Starbucks is "capitalist" and so was Enron.

That really is not the right level of analysis. That level of analysis has the advantage of being simple. Unfortunately, it has the disadvantage of not usually being all the useful.

The military is socialist. And so is the post office. And so is the FDIC. And so is the institution of public police officers and public prosecutors. So is Amtrak. So is social security. And so on.

These things are not usually usefully clumped together. At least for the kinds of conclusions that conservatives wish to draw.

i.e. It doesn't make sense to say that Amtrak has a lot to answer for, because Stalin killed a bunch of people.
7.15.2008 12:49am
Nathan_M (mail):
Paul Krugman has posted an update on his blog.
7.15.2008 1:37am
A. Zarkov (mail):
Krugman and other economists are promoting the bailout of F &F. What are they worried about? Answer: the flight of foreign capital and a bigger drop in housing prices. Without foreign capital the US taxpayer will have to pay for federal deficit spending either through direct taxation or inflation. We have a large subgroup that lives off and benefits from deficit spending. The public has gone along with it because so they haven't had to pay for it.

Krugman and other academic economists directly or indirectly benefit from federal spending, and they are rightly worried the gravy train might disappear.
7.15.2008 8:34am
The Unbeliever:
There is no such thing as "socialism," really. At least, it is not a discrete entity.
Well then, there is no such thing as "conservative thought" either, not as a discrete entity, and certainly not en bloc for you to pitch stereotypical screeds at.

Back on topic: isn't "Krugman error" a redundant term?
7.15.2008 11:48am
Brian Mac:

Do you not see the irony of producing paragraph after paragraph of self-congratulatory "logic" without the benefit of a single supporting fact?

It was beautiful, wasn't it? I'm bookmarking this thread.
7.15.2008 1:59pm
Harry Eagar (mail):
Hmmm. Well, if F &F bought only good loans, then they have nothing to worry about and we can go back to worrying about whether the Supreme Court intends to allow armed lawyers into chambers during sessions, or something.
7.15.2008 2:12pm