Tuesday, June 8, 2010

Fannie and Freddie Must Die! Some guy in Chicago Takes on Paul Krugman's Version of the Mortgage Mess (FNM; FRE)

Okay so the guy in Chicago is Raghu Rajan, Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Booth School of Business and (from his bio) ...Dr. Rajan was the Economic Counselor and Director of Research (in plain English, the Chief Economist) at the International Monetary Fund (from 2003)....
...and on the Comptroller General of the United State’s Advisory Council. Dr. Rajan is the President (elect) of the American Finance Association and a member of the American Academy of Arts and Sciences. In January 2003, the American Finance Association awarded Dr. Rajan the inaugural Fischer Black Prize, given every two years to the financial economist under age 40 who has made the most significant contribution to the theory and practice of finance....
Yeah, but where's your Nobel for your work in International Trade? From his Fault Lines blog:
Response to Paul Krugman

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....

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.....MORE

HT: Real Time Economics
Kill 'em both. (The former GSE's, that is)