Nick Timiraos extracts from the new Geithner book.
But the erosion in underwriting standards, the rush to provide credit to Americans who couldn’t have gotten it in the past, was led by consumer finance companies and other nonbank lenders that did not have to comply with the Community Reinvestment Act—which, after all, discouraged redlining for nearly three decades before the crisis. These firms took credit risks because they wanted to, not because they had to; they believed rising home prices would protect them from losses, and their investors were eager to finance their risk-taking. Fannie and Freddie lost a lot of market share to these exuberant private lenders, and while they did belatedly join the party, the overall quality of mortgages they bought and guaranteed was significantly stronger than the industry average.
That strikes me as beside the point. The comparison to make is not between risk of the mortgages Freddie and Fannie bought with some industry average. The comparison that matters is between the mortgages that they bought and their capital and loss reserves. With enough capital, they could have taken on the worst of the subprime mortgages and survived. Conversely, even relatively safe mortgages can take you under if you do not maintain the loss reserves and capital that are needed in an adverse house price scenario.
This defense of Freddie and Fannie comes across to me as purely rhetorical. I hope he is too smart to really believe it. Otherwise, I would say that if this is the way that high government officials think about finance, then anyone who thinks that such people can prevent crises is making a really unsound wager.
Having said that, much of the rest of the article makes Geithner sound a lot more sensible than the typical progressive housing policy type. He recognizes that the key to housing finance reform is bringing back a reasonable down payment. He also seems to be one of the few people who gets it that the attempts to bail out homebuyers were based on unrealistic expectations of the mortgage servicing industry.
The other comparison that gets overlooked is between mortgage rates and financing costs (or performance benchmarks) for different types of investors. That’s not only dealers (covered in your excellent recent posts), but all yield-seeking mandates in the investment world that exploded in the boom – “enhanced cash”, “alpha transport”, all kinds of investment strategies, many levered, that ramped up the supply of mortgage credit far beyond what commercial and investment banks provided.
You’ve emphasized, as does Geithner, overoptimistic house price expectations, which was surely a big part of the surge in mortgage demand. But the story behind credit supply starts with the fact that the Fed lowered financing costs for the carry trade to the point that it sucked in huge amounts of capital, at the same time that the Fed was at best disinterested and at worst enthusiastic about the decline in lending standards (and chose not to use its authority to stop it).
(This is my main objection to your argument that market rates are independent of policy rates, limiting the Fed’s impact on credit markets. As I see it, the Fed’s control over bank financing costs and other short-term rates is a powerful lever, since most credit suppliers are essentially carry traders, either completely or at the margin. When loan rates follow deposit rates lower, the distortions created by the Fed play out in the traditional way. When loan rates don’t fall as much, then the distortions materialize as falling lending standards, which is a rational response by credit suppliers. Wider carry spreads mean that you can take on more default risk before you lose money. Obviously, you won’t hear this from Geithner.)
It is certainly true that inadequate capital in relation to risk taken created the main vulnerability for all the lenders involved in the bubble. But capital in relation to risk taken was not nearly adequate for the non-CRA lenders either.
Arnold, you make a good point about the importance of capital but I don’t think it conflicts in any way with the comments quoted here by Geithner. Several European countries had spectacular housing bubbles without Fannie or Freddie or CRA.