A New Theory of the Role of the GSEs in the Housing Bubble

Bill Black has an interesting new take on the role of Fannie and Freddie in the housing bubble. He sees their investment in non-prime mortgages as being driven by executive compensation, rather than a fight for market share against investment bank securitization conduits or govt affordable housing policy. The government affordable housing policy point has been repeatedly debunked (and Susan Wachter and I have a new paper that adds to this debunking via an examination of the commercial real estate bubble, where there was no government involvement whatsoever). Black is not, however, able to disprove the market share theory. What he does point to is that the GSE's involvement with nonprime mortgages was as whole loans kept in portfolio, rather than securitized (and also via purchases of MBS), which he says was a move to increase the short-term yield for the GSEs and thus maximize short-term executive compensation.

I think this is an interesting theory, but there are a few data points necessary to make it work, and I'm skeptical that they all support Black. 

According to Black, the GSEs' involvement in nonprime mortgages grew out of their earlier accounting scandals. Black sees these scandals as the result of efforts to increase executive compensation. He argues that Fannie and Freddie first tried to goose their returns by increasing the size of their whole loan portfolios and thus taking on massive interest rate risk. Fannie bet the wrong direction on interest rates and this resulted in the Fannie accounting scandal as it tried to cover up its losses. Freddie got the bet right, but then tried to set up a "cookie jar" to cover future losses in order to inflate future earnings. The SEC was having none of it, and forced out the CEOs and mandated accounting restatements. In the wake of these scandals, OFHEO (the GSE's regulator) made the GSEs limit their hedging activities and reduce the size of their portfolios.  

Black argues that this boxed in the GSEs in terms of how their could up their returns. In order to increase the returns from their portfolio, they shifted it to non-prime products, and moved more of the prime products into MBS. He further argues that the only thing that kept the GSEs from getting into really poorly underwriting non-prime products was that their risk managers and underwriters had a superior culture of responsibility and fought harder to maintain standards.

I don't doubt that executive compensation could (and probably did) play a role in the GSEs' purchases of nonprime mortgages. But Black hasn't presented a convincing story. His story relies on three pieces of evidence that he has not produced: first, that the GSEs' kept the nonprime in portfolio and securitized only prime; second, that this execution was more profitable in the short term than securitizing the nonprime mortgages; and third, that the GSEs' had a superior culture of underwriting and risk-management that kept things in check.

The first point should be reasonably easy to verify. But I'm less sure about the second, and the third, is entirely speculative. Regarding the second point, remember that the GSEs' bear the credit risk on mortgages regardless of whether they are in portfolio or securitized (via a guarantee). The only difference is whether the GSEs bear the interest rate risk, which they do for portfolio, but not for securitized loans. Unless there was a real difference in yield based on interest rate risk (which is possible) between a securitized and a portfolio nonprime loan, there'd be no reason to securitize the prime and keep the non-prime in portfolio because of higher yields. That matters because Black's argument that the GSE involvement in non-prime was because of higher yields which boosted executive compensation, and if the form of their involvement didn't track with yields, this story falls apart. Certainly the investment banks decided that securitization rather than portfolio was the better execution, and it's hard to believe that the economics would have been different for the GSEs. 

Again, an executive compensation angle is quite possible, but I think there's a lot to be said for the market share theory. Executive compensation (and tenure) depended on GSE share price, and GSE share price was dependent upon market share, which was falling. What happened, then was an insurance rate war. The GSEs are best understood as mono-insurance companies, like MBIA (or AIG): like insurance companies they have an investment portfolio (MBS or whole loans) and they issue bond insurance, in the form of the guarantees on their MBS. The only difference is that the GSEs securitize the products that they insure.

A major insurance regulation concern is preventing rate wars for market share, as a rate war will leave all competitors undercapitalized for paying out future claims. The GSEs got into a rate war with private-label MBS. They did this not by lowering the G-fee that they charge for their guarantee, but by holding the G-fee constant and lowering underwriting standards. The rate that the GSEs charge needs to be understood as a risk-adjusted rate, and while the stated rate stayed constant, the risk-adjustment did not, resulting in a lower risk-adjusted rate.

Bottom line here is that we don't have definitive evidence supporting for any of the theories of the GSEs' involvement in the housing bubble. There's strong evidence against some theories, but little affirmative evidence. The GSEs are themselves sitting on the best evidence; it would be really nice to see FHFA (or the FHFA IG) put out a definitive report on the role of the GSEs in the housing bubble.