The Art of Distraction

Prof. Mishra has a knack for changing the subject.

When asked about income taxes, he talked about corporate taxes. When asked about the Federal Reserve, he brought the conversation around to Glass-Steagall. When asked about the Community Reinvestment Act (CRA), his focus turned to the “government-sponsored enterprises” (GSEs): Fannie Mae and Freddie Mac.

Here’s how he did it:  

In 1992, the Federal Housing Enterprises Financial Safety and Soundness Act…required Fannie Mae and Freddie Mac to purchase a percentage of mortgages going to low and moderate income borrowers — CRA eligible loans. In 1996, the Department of Housing and Urban Development set a target for Fannie and Freddie that 42 percent of their investment must go to CRA-eligible borrowers. The same target was increased to 50 percent in 2000 and then to 52 percent in 2005.

Fannie securitized close to $400 billion of CRA mortgages between 2000 and 2002. Fannie and Freddie were the primary drivers fueling the demand for secondary market subprime securities.

But prior to 1992…Fannie Mae and Freddie Mac would not purchase these loans because the loans didn’t meet their guidelines. However, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 changed this by requiring Fannie and Freddie to purchase CRA loans.

This policy, according to Prof. Mishra, “caused the failure of…Fannie Mae and Freddie Mac, and their failure is at the heart of the housing market meltdown.”

Yet again, he offers zero evidence to support his conclusions.

The 1992 law had nothing to do with the “subprime securities” that Fannie and Freddie purchased. Fannie and Freddie did not purchase any subprime mortgage-backed securities (MBS) until 2001.

As a result, their market share shrank from 57% of the mortgage market in 2003 to 37% in 2006:

In other words, the influence of Fannie and Freddie was drastically falling during the peak years of the housing bubble. During those years, Wall Street securitized over 30 percent more loans than Fannie and Freddie:

As a result, Wall Street’s asset growth accelerated, while Fannie and Freddie’s decelerated:

Even when Fannie and Freddie did get involved in the subprime business, they barely dipped their toes in the water. To this day, only 2 percent of their credit exposure consists of subprime securities. At Freddie, only 4 percent of their single-family mortgages belong to borrowers with FICO scores below 620. As a result, only 5 percent of their losses have come from subprime loans:

Wall Street, in contrast, put the majority of their MBS business — 71 percent, as of 2006 — into subprime and alt-A loans:

As, a result, subprime mortgage originations exploded at exactly the same time as Wall Street’s market share:

It’s rare in economics to find such a clear arrow pointing to who and what caused something. But there it is: Wall Street’s securitization of risky mortgages caused the housing bubble. Not Fannie and Freddie, whose participation was minimal, declining, and late in the game.

Even when Fannie and Freddie did participate in the subprime market, it was not to satisfy HUD targets, but rather to profit and regain market share.

The U.S. government’s Financial Crisis Inquiry Commission (FCIC) investigated these affordable housing targets, both by analyzing the securities purchased and by interviewing the employees and regulators involved. They didn’t find a shred of evidence to blame the targets for the subprime boom:

In 2003 and 2004, Fannie Mae’s single- and multifamily purchases alone met each of the goals; in other words, the enterprise would have met its obligations without buying subprime or Alt-A mortgage-backed securities. In fact, none of Fannie Mae’s 2004 purchases of subprime or Alt-A securities were ever submitted to HUD to be counted toward the goals.

Estimates by the FCIC show that from 2003 through 2006, Freddie would have met the affordable housing goals without any purchases of Alt-A or subprime securities, but used the securities to help meet subgoals.

…all but two of the dozens of current and former Fannie Mae employees and regulators interviewed on the subject told the FCIC that reaching the goals was not the primary driver of the GSEs’ purchases of riskier mortgages and of subprime and Alt-A non-GSE mortgage–backed securities. Executives from Fannie…pointed to a “mix” of reasons for the purchases, such as reversing the declines in market share, responding to originators’ demands, and responding to shareholder demands to increase market share and profits…

only about 4% of all loans purchased by Freddie between 2005 and 2008 were bought “specifically because they contribute to the goals” — loans it labeled as “targeted affordable.”

In fact, as of late 2008, [these targeted affordable loans] had performed better than expected in relation to the whole portfolio. The company’s major losses came from loans acquired in the normal course of business.

In other words, Fannie and Freddie didn’t purchase subprime securities because the government told them to. Rather, they did it for the same reason as everyone else: Because it was profitable, and the regulators didn’t stop them.

And yet, Fannie and Freddie still performed better than Wall Street:

In 2004, the GSE default rate was 4.3 percent of their mortgages compared to a default rate in private industry of 15.1 percent of mortgages. In 2005, the GSE default rate was 7.8 percent—high and disturbing; but in private industry it was 28.7 percent, the source of the severe crisis. In 2006 and 2007, default rates reached 13.2 and 14.9 percent in the GSEs and 45.1 and 42.3 percent in the private market.

Another way to measure their riskiness is VaR, a statistic that estimates how much money a company would lose if the economic environment changes (as it did in 2007 and 2008). Since VaR was a mediocre predictor of the recent crisis, economists Tobias Adrian and Markus K. Brunnermeier created CoVaR, a measure of the company’s effect on the entire financial industry when it’s in distress. Compared to Wall Street, Fannie and Freddie have average VaR‘s and lower CoVaR‘s than any of the other major players:


No matter how you measure it, every one of Prof. Mishra’s conclusions is wrong. Neither the Community Reinvestment Act nor Fannie Mae nor Freddie Mac nor HUD’s affordable housing targets caused the real estate bubble and subsequent recession. I’ve said it before, and I’ll say it again:

This debate is called a “red herring,” and it’s how bad politicians get elected. They distract you with the wrong culprit for a very real crime. And you know what? It works.

But there’s a way to stop them: Don’t let them change the subject.