Editor’s Note: Reason columnist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.
Myth 1: The government-sponsored housing finance companies Fannie Mae and Freddie Mac had nothing to do with the housing crisis. They were simply innocent bystanders caught in the crossfire. Economist and New York Times columnist Paul Krugman, for instance, has argued that Fannie and Freddie’s role in the housing market was insignificant between 2004 and 2006 because “they pulled back sharply after 2003, just when housing really got crazy.” According to Krugman, Fannie and Freddie “largely faded from the scene during the height of the housing bubble.”
Fact 1: Fannie and Freddie contributed to the housing crisis by making it easier for more people to take out loans for houses they could not afford. Beginning in 2000, Fannie and Freddie took on loans with low FICO scores, loans with low down payments, and loans with little or no documentation.
The federal government’s role in the housing market goes back at least to 1938, but that role changed fundamentally in the 1990s when the government made a push to increase homeownership in the United States. At that time, the federal government pursued several policies that were meant to encourage banks to lend money to lower income earners and to give incentives to low income earners to buy houses. The result, as we now know, was a gigantic amount of subprime mortgages at a time when house prices were starting to go down.
In 2010, Edward Pinto, a resident fellow at the American Enterprise Institute who has served as chief credit officer at Fannie Mae, issued a memorandum on the number of subprime and other high-risk mortgages in the financial system immediately before the financial crisis. In that memorandum, Pinto recorded that he had found over 25 million subprime mortgages (his later work showed that there were approximately 27 million). Since there are about 55 million total mortgages in the United States, it means that as the financial crisis began, half of all U.S. mortgages were of inferior quality and liable to default when housing prices stopped rising, as you can see in the chart below.
Freddie and Fannie were active players in this market.
For instance, as George Mason University economist Russ Roberts explains in his paper “Gambling with Other People’s Money”:
Fannie and Freddie bought 25.2% of the record $272.81 billion in subprime MBS [mortgage-backed securities] sold in the first half of 2006, according to Inside Mortgage Finance Publications, a Bethesda, MD-based publisher that covers the home loan industry.
In 2005, Fannie and Freddie purchased 35.3% of all subprime MBS, the publication estimated. The year before, the two purchased almost 44% of all subprime MBS sold.
In addition, lawmakers in both parties enacted policies directed at increasing home ownership rates, resulting in lower mortgage underwriting standards for Fannie and Freddie. Roberts notes that from 2000 on, Fannie and Freddie bought loans with low FICO scores, loans with very low down payments, and loans with little or no documentation. Contrary to Paul Krugman’s assertions, Fannie and Freddie did not “fade away” or “pull back sharply” between 2004 and 2006.
As the following chart from Roberts’ study shows, during that same time Government Sponsored Enterprises (GSEs) bought near-record numbers of mortgages, including an ever-growing number of mortgages with low down payments.
Moreover, as the chart below shows, while private players bought many more subprime loans than Freddie and Fannie, GSEs purchased hundreds of billions of dollars worth of subprime mortgage-backed securities (MBS) from private issuers, holding these securities as investments.