What Krugman says

In a piece entitled “Things Everyone In Chicago Knows Which happen not to be true”, Paul Krugman writes on his blog http://krugman.blogs.nytimes.com/2010/06/03/things-everyone-in-chicago-knows/

It was deeply depressing to see Rag[h]uram Rajan write this:

“The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans.”

That’s a claim that has been refuted over and over again. But what happens, I believe, is that in Chicago they don’t listen at all to what the unbelievers say and write; and so the fact that those libruls in Congress caused the bubble is just part of what everyone knows, even though it’s not true.

Just to repeat the basic facts here:

1. The Community Reinvestment Act of 1977 was irrelevant to the subprime boom, which was overwhelmingly driven by loan originators not subject to the Act.

2. The housing bubble reached its point of maximum inflation in the middle years of the naughties: [graph omitted]

3. During those same years, Fannie and Freddie were sidelined by Congressional pressure, and saw a sharp drop in their share of securitization:
FCIC
while securitization by private players surged.

Of course, I imagine that this post, like everything else, will fail to penetrate the cone of silence. It’s convenient to believe that somehow, this is all Barney Frank’s fault; and so that belief will continue.

Rajan’s response

I reproduce Paul Krugman’s “econometric” claim above that Fannie and Freddie did not help cause the crisis above (I do not claim the Community Reinvestment Act was a big factor). I respond only because I have received hate mail from his followers. Paul is, of course, a great theoretical Nobel-prize-winning economist, so his attacks must be taken seriously (and I did take his trade theory classes at MIT, in the interest of full disclosure). Unfortunately, much of the “Fannie and Freddie did not contribute to the crisis” battalion makes arguments that have serious holes. Since these arguments are so prevalent they need to be rebutted again and again (the claimed unwillingness to listen to argument can be played on both sides).

The key graph in Paul’s argument is Figure 4. He claims that restrictions on Fannie and Freddie starting in 2004 kept their share of originations of total residential mortgage originations down, even while housing prices inflated. But this is irrelevant to the question. What we care about though is the amount of Fannie and Freddie’s originations in the sub-prime residential mortgages. And from every source I have seen, these took off precisely in 2004. Indeed, as I argue in my book Fault Lines, in the period 2004-2006 these two giants purchased $ 434 billion in sub-prime mortgage-backed securities. A measure of the size of these purchases is that in 2004, they accounted for 44 percent of the market for these securities. Calomiris and Wallison (2008, http://www.aei.org/outlook/28704) argue that Fannie and Freddie’s arms were twisted into doing more of this kind of lending starting in 2004 precisely because Congress had them in a vice because of the scandal.

Readers interested in the relevant data on originations by Fannie and Freddie may also want to see the work of Edward Pinto, a former Chief Credit Officer of Fannie Mae. He offers a detailed analysis of Freddie and Fannie’s lending , and their responsibility for the crisis. His testimony to Congress is at http://www.aei.org/docLib/20090116_kd4.pdf. His analysis of the data can be found on the AEI website.

From a theoretical perspective, the key question the “Fannie and Freddie did not contribute to the crisis” battalion leaves unanswered is why the “greedy” bankers turned to lending to the poor. For as Monika Piazezzi and Martin Schneider of Stanford University show, the housing boom and the bust were most pronounced amongst the lower end of the housing market, unlike previous housing booms. The obvious answer explanation from Progressives is that this was an unexploited segment (in the literal sense) of the population, but the immediate next question is why the greedy bankers did not notice this segment before. I argue that the government and its support to low-income housing made this segment of the market attractive. The government and politicians may have gone in with noble intent (as is usually the case), but with devastating and unintended consequences.

Finally, data are always tricky since they can be, and are, misrepresented. To Progressives like Paul Krugman who want to insist that the government had no hand, perhaps they may be more convinced by this quote from a speech by their bête noire, George W. Bush, to the Department of Housing and Urban Development (http://www.hud.gov/news/speeches/presremarks.cfm) in 2002:

“But I believe owning something is a part of the American Dream, as well. I believe when somebody owns their own home, they're realizing the American Dream…And we saw that yesterday in Atlanta, when we went to the new homes of the new homeowners. And I saw with pride firsthand, the man say, welcome to my home. He didn't say, welcome to government's home; he didn't say, welcome to my neighbor's home; he said, welcome to my home… He was a proud man…And I want that pride to extend all throughout our country.

The goal is, everybody who wants to own a home has got a shot at doing so. The problem is we have what we call a homeownership gap in America… And we need to do something about it… We are here in Washington, D.C. to address problems. So I've set this goal for the country. We want 5.5 million more homeowners by 2010… economic security at home is just an important part of -- as homeland security. And owning a home is part of that economic security. It's also a part of making sure that this country fulfills its great hope and vision.”

“And I'm proud to report that Fannie Mae has heard the call and, as I understand, it's about $440 billion over a period of time. They've used their influence to create that much capital available for the type of home buyer we're talking about here. It's in their charter; it now needs to be implemented. Freddie Mac is interested in helping. I appreciate both of those agencies providing the underpinnings of good capital.”

Perhaps Paul Krugman will read all this instead of bandying graphs that convince only those who need no convincing.