It seems like you’re making the very mistake Smith is warning about. I don’t think historians looking at the newspapers of 2005 would be struck with the high level of trust we had in financial intermediaries. We imposed our distrust on them politically. The GSEs had four CEOs during the 2000s. All four were driven out. Ironically the second pair are accused of understating loss reserves in 2007. The first pair were paying fines in 2007 because they had been accused, among other things, of overstating loss reserves to manage earnings. It was impossible to be a GSE executive in the 2000s without being accused of fraud. The idea that the housing boom happened because of too much trust in financial intermediaries is laughably implausible. The only reason it seems plausible is because communal distrust is so ubiquitous that you will always find support for the idea that we trust them too much.
I agree that political meddling with Freddie and Fannie was harmful, and that they were better run before their CEOs were forced out in scandals that were either minor or perhaps not scandals at all. However, once that happened, confidence in Freddie and Fannie to invest in quality mortgages was unwarranted. More important, the confidence in the private mortgage securities market, based on AAA-ratings for mortgage tranches, was quite unwarranted. That form of financial intermediation got out of control.
Thanks for your input, Arnold. The 2004 accounting scandals seem fairly bogus on their face to me. I was curious what your insider’s view might be.
On GSE underwriting, I find that they were generally countercyclical. They appear to have slightly tightened standards in 2004-2005, and definitely slowed down originations. They were filling in the gap left by private securitization in 2007. FICO scores and LTVs on GSE business returned to pre-bubble levels and originations rose (especially to first time buyers). But, after conservatorship, they sharply curtailed lending to the bottom half of their book. Most of the price declines in low priced zip codes happened after late 2008, after the GSEs closed down their middle-income lending practice. Before conservatorship, the GSEs appear to me to be two of the few institutions who were actually supporting stability.
As for the AAA-ratings, I suspect if you asked any of those buyers in 2006 whether they expected 100% payouts if home prices across the nation fell by 25%, they would have said no. It wasn’t their faith in the financial products that was out of whack. It was the size of the real shocks they ended up facing.
http://idiosyncraticwhisk.blogspot.com/2016/06/housing-part-163-some-notes-on-fannie.html
Actually, a AAA rating implied that a security *could* survive a nationwide home price drop. Not all investors believed that the AAA ratings were justified, and some of investors no doubt thought that a large nationwide home price drop would not happen.
But the AAA ratings were not really designed for profit-seeking investors. They were designed to fool regulators into thinking that institutions were adequately capitalized. And they worked to do that.
The regulators set up a system of risk-based capital regs that relied on the rating agencies, and the regulators ended up basically fooling themselves.
I was working at an insurance company that sold mainly Equity Index Annuities when the crash came. They had put a decent chunk of their investment assets into these subprime-AAA mortgage securities. Ended up doing massive layoffs and getting sold.
I can tell you at the time that greed played a role. These investments paid more then other AAA securities, even if just a tiny amount more. I don’t know about the capital requirements issue but I assume they could have bought the less risky traditional AAA securities to do the same thing. In the meetings they were quite happy with how these subprime-AAA securities were making the investment return cell in the spreadsheet go up a little, which made profit go up a little, which made everyone happy and justified bonuses.
I doubt they knowingly though housing prices would fall 25% or that the bonds were bogus AAA. Though, I think a better way of phrasing it is they never really though about it at all. It said AAA and therefore its just free money, right? Some slick salesmen said it was the hot new thing, aren’t I smart for being in on the hot new thing. And I get a cut of the extra money generated from my recognizing the hot new thing because I’m so smart.