In a recent article in Inside Sources, Josh Rosner — and now Barry Ritholtz in Bloomberg View — challenge my view that the film, The Big Short, provides a false narrative about the 2008 financial crisis. I have argued since 2008 — and most recently in my book, Hidden in Plain Sight: What Caused the World’s Worst Financial Crisis and Why it Could Happen Again — that the US government’s housing policies were the underlying cause of the crisis. Rosner and Ritholtz take the view that it was the private greed on Wall Street, displayed in the film that was the ultimate source of the crisis.
Rosner is one of my heroes—he was among the very few people who foresaw that the low quality of the mortgages building up in the financial system in the 2000s would eventually cause a serious financial problem. Unfortunately, the data in his recent op-ed shows that he hasn’t been following the data that has become available since 2008.
In 2009, for example, Fannie Mae published a credit supplement to its quarterly report to the SEC. This readily accessible report shows on page 5 that in June 2009 Fannie alone held $878 billion in subprime and other risky loans, and that these loans accounted for 81 percent of Fannie’s losses in 2008. Freddie Mac held roughly the same percentage of loans and probably suffered roughly the same percentage of losses, although it did not report its loss percentages in its own credit supplement.
The fact that both Fannie and Freddie had become insolvent at this point, and had been taken over by the government, shows that their losses on these subprime and other risky loans were severe. But most of these losses did not come from the private mortgage-backed securities, as Rosner writes; Fannie and Freddie together bought only $707 billion of these securities, a fraction of the subprime mortgages they held.
Fannie and Freddie’s losses — as bad as they were — were not the cause of the crisis; it was the fact that government housing policies had forced Fannie and Freddie to significantly reduce their underwriting standards between 1992 and 2008. As the leading players in the housing finance market, this caused a general deterioration in all underwriting standards and ultimately the mortgage meltdown of 2008.
Why did Fannie and Freddie buy these bad loans? This, of course, is the central question. In my book, I show that government housing policies — and especially the affordable housing goals enacted in 1992 —required Fannie and Freddie to reduce their underwriting standards in order to provide more housing credit to borrowers below median income. Before 1992, both firms were famous for buying only prime loans, which required 10-20 percent down payments and FICO credit scores of at least 660, but after the adoption of the affordable housing goals they began to acquire subprime mortgages and mortgages with low down payments and other deficiencies. This began to occur in the early 1990s, not in 2004 as Rosner asserts. Moreover, as the affordable housing goals were raised by HUD between 1992 and 2008, Fannie and Freddie had to buy more and more of these risky loans, accounting for the enormous number they held in 2008.
The purchases of these risky loans were no small matter. Fannie and Freddie were the dominant players in the housing market in the 1990s and 2000s. When they lowered their underwriting standards in order to acquire the subprime and other risky loans necessary to meet the affordable housing goals, the rest of the market followed suit. If the major buyers in the market would accept mortgages with no down payment, how was a bank to persuade borrowers to make a 10 to 20 percent down payment, even if they could afford a prime loan?
This is why the quality of the mortgages in the whole market deteriorated. By 2008, more than half of all mortgages — 31 million loans — were subprime or otherwise risky because of deficiencies like low or no down payments. Of these, 76 percent were on the books of government agencies, primarily Fannie and Freddie — and not on the books of private institutions. This shows, without question, that the government created the demand for the mortgages that eventually caused the crisis.
The narrative of the left — adopted by the Financial Crisis Inquiry Commission — is that Fannie and Freddie did not begin to acquire these low quality and risky mortgages until 2004, when they lost market share to the banks in one area of their activity — the securitization of mortgages. The fictitious tale is that Fannie and Freddie decided to do something truly crazy by lowering their standards just to regain market share, essentially committing financial suicide.
This is as much a fantasy as The Big Short, because it ignores all the data before 2004. Even Rosner — who notes in his article that the saw the deterioration in mortgage standards in 2001 — falls for this, asserting that “it was not until the Wall Street banks ramped up their private label securitization in 2004 that they lowered their standards and became meaningfully exposed to questionable loans.”
In my book, I show that Fannie and Freddie began acquiring risky loans in 1993, right after the adoption of the affordable housing goals. I provide example after example in which employees of Fannie state that they were buying these loans in order to meet the goals — not for profits or market share. “Everybody understood that we were now buying loans that we would previously have rejected,” said one former employee of Fannie quoted in the New York Times, “but our mandate was to stay relevant and to serve low-income borrowers. So that’s what we did.”
By 2007, Fannie and Freddie were toting up losses they expected on these loans, but nonetheless kept on buying, even after the market for private mortgage backed securities had collapsed. They had no choice. HUD would not relent, and the Democrats in Congress — led by Barney Frank — had made it clear that their continued opposition to tougher regulation of Fannie and Freddie depended on both firms showing that they were meeting the goals.
The left’s narrative is seductive, because its greed narrative is so easy to describe and to portray in a Hollywood film. If Josh Rosner has accepted it, anyone can be misled. The relevant facts — which are notably absent in Rosner’s and Ritholtz’s stories — tell a different story. They indict the policies of the US government over two presidential administrations. Until the American people understand these facts, we will be vulnerable to another crisis born of the same set of policies.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI. His most recent book is Hidden In Plain Sight: What Caused the World’s Worst Financial Crisis and Why It Could Happen Again (Encounter 2015)
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