Saturday, January 29, 2011

Dueling Financial Crisis Commission Reports

The Financial Crisis Inquiry Commission released its massive report today, with a majority group taking the bulk of the report and then two dissents (by Republican members).

Lots of interesting facts, conjectures, and conclusions.

One of the main issues argued between the majority and the dissent is the role of the GSEs, Fannie Mae and Freddie Mac.

The majority downplays their role, accepting that they played a part but not being a primary cause. I guess I would tend to agree with that, but not to the extent of the majority. The majority report notes that
Importantly, GSE mortgage securities essentially maintained their value
throughout the crisis and did not contribute to the significant financial firm losses
that were central to the financial crisis. (page xxvi)

Peter Wallison, in his dissent, argues that the GSEs played a larger role. His Table 1 on page 456 is definitely of interest, showing that the two main GSEs held 39% of the total subprime mortgage principal as of 2008 (definitions of the Table are not precise, but the Pinto document referenced does help).

In thinking about the role of the GSEs, who bought a lot of subprime originations and held them, I thought of mortgage backed securities as a big set of joint products. The GSEs wanted the AAA tranches, and sure enough, as the majority points out, those securities and the similar whole loans the GSEs bought did not have significant actual losses. None of the AAA securities did. But: suppose a set of consumers has a large increase in demand for beef. That will result in an increase supply of cow hides, pushing down the price of hides -- and someone is going to buy the hides. So the GSEs wanted a lot of AAA securities, with the byproduct being a lot of mezzanine B rated paper. That paper had to go somewhere, even at lower prices/higher yields. At high enough yields, it was bought, and it seemed quite profitable to the investment banks who held it (maybe after it was repackaged in CDOs).

Another analogy would be the war on drugs. Isn't it the buyer of drugs who are the real problem? They create the demand, and the suppliers just respond.

So without the GSEs we might not have had so much supply of lower rated MBSs.

I don't want to go so far as to make the GSEs a primary cause of the crisis, but they played a pretty significant part.