Paul Krugman on the GSEs

He writes:

But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

In that case, however, how did they end up in trouble?

Part of the answer is the sheer scale of the housing bubble, and the size of the price declines taking place now that the bubble has burst. In Los Angeles, Miami and other places, anyone who borrowed to buy a house at the peak of the market probably has negative equity at this point, even if he or she originally put 20 percent down. The result is a rising rate of delinquency even on loans that meet Fannie-Freddie guidelines.

Also, Fannie and Freddie, while tightly regulated in terms of their lending, haven’t been required to put up enough capital — that is, money raised by selling stock rather than borrowing. This means that even a small decline in the value of their assets can leave them underwater, owing more than they own.

Ex post it would appear that Fannie-Freddie should have had higher capital requirements, if for no other reason than to bolster confidence during periods of stress. But ex ante, stress-testing models showed that Fannie was well capitalized and that Freddie was very well capitalized. Ironically, most of us who followed the companies worried a lot more about interest rate/prepayment risk than default risk.

This is not to say that past Fannie/Freddie senior management did not behave badly with respect to financial reporting, and I find it maddening that some of the worst actors wound up walking away with millions of dollars. While I made good friends at Freddie and learned a lot, the moral obtuseness of company leaders at the time (2002-03) made me very uncomfortable and I looked for a way out (I also discovered within about a week of being there that I really missed being a professor). Daniel Mudd's current silence also makes me wonder if there is a shoe to drop that has not yet appeared in the monthly volume summaries.

But for the reasons Krugman gave, moral hazard did not produce lax underwriting at Fannie-Freddie--regulation (and to be fair, I think corporate culture at Freddie) prevented that from happening. To the extent they are in trouble, it is because of market conditions outside the realm of historical experience. It is, after all, their job to be in the market at all times--no matter what. They is why they have their charters. A government backstop will not it their cases reward bad behavior; it will assure that they can do a job that purely private participants are unwilling to do at the moment.