Those GSE Subprime Losses

I noticed that Raghuram Rajan is still on the move with the GSE story and the story that the housing bubble was in large part about the government compensating people for poor earnings growth (“I argue that in an attempt to offset the consequences of rising income inequality, politicians on both sides of the aisle pushed easy housing credit through government units [like FHA and GSEs].”)

In some ways I wish this was true, because it would make GSE reform very, very easy. If the problem with the GSE’s losses were that it was giving out too many subprime mortgages as part of an affordability mission….just gut the affordability mission. Problem solved?

No. Not even close. Going to Raj Date’s presentation on GSE reform for the Roosevelt Institute’s Make Markets Be Markets program:

Raj Date (my bold):

But the affordability mission does not explain the vast majority of the GSEs’ credit woes. (See Figure 3)

The $100 billion of subprime securities in portfolio, while astonishing in nominal terms, is roughly 2% of the combined firms’ $5 trillion credit exposure. And within the guaranty business, subprime exposure is actually quite modest. At Freddie, for example, only 4% of the single-family mortgage credit book is tied to borrowers with FICO scores below 620.

Moreover, the very worst performing GSE loans (that is, the loans where losses are the greatest multiple of original forecasts) were made to prime borrowers, not subprime. Again using Freddie as an example, both the “Alt-A” and “Interest Only” portfolios are already facing serious delinquencies of 11% and 16%, respectively, despite having solidly prime average borrower FICO scores of 722 and 720.(5) These were market share-driven loans made to people with good credit; they were not mission-driven loans made to people with bad credit.

Put simply, the subprime fraction of the GSEs’ credit exposure is too small, and the GSEs’ overall credit deterioration too large, to pin their woes on the affordability mission alone. Merely tweaking that mission, therefore, will not remedy the GSEs’ ills. The problem is more fundamental.

(5) 5. See Freddie Mac, Third Quarter 2009 Financial Results Supplement, pages 18-19 (November 9, 2009). The same general trends hold at Fannie Mae as well. See Fannie Mae, 2009 Third Quarter Credit Supplement, pages 11-12 (November 5, 2009).

Remember the GSEs charged a fee to insure these mortgages; losses aren’t bad at all unless they are larger than what they were expected to be, and the real losses greater than expectations are being driven by prime loans.

Three other things.

1. Can we stop using press releases, from either corporate or political PR offices, as statements of fact?

2. In 2005, when he was carefully spending his newfound political capital, the CRA was overhauled in a manner that financial institutions and industry trade associations applauded during comments and community organizers fought against.

3. The research, say The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis, is pointing to a story about securitization driving access to loans for low-credit borrowers. And what is going on with securitization? The latest, and most interesting, research and reporting is finding that conflicts, information problems, and mis-priced derivative credit insurance created a distorted securitization market which amplified the bubble, especially in 2005 (when the real problems really got introduced). This is from people like Yves Smith and ProPublica covering the Magnetar Trade to the latest research from Adam Levitin and Susan Wachter arguing information asymmetries were the smoking gun (I’m working on a larger piece discussing these right now).

You know, the reasons why we regulate a financial system in the first place.