An insightful op-ed in yesterday’s Financial Times by Raghu Rajan (who will be presenting his latest book soon here at Cato), apparently was too much for Paul Krugman to bear. What was Rajan’s great crime that so upset Krugman? Rajan, correctly, pointed out that US policies, such as Fannie Mae and the Community Re-investment Act, were direct contributors to the financial crisis and that bankers shouldn’t be blamed for simply reacting to perverse government incentives.
Now Krugman cannot bear to see CRA and Fannie questioned. He claims that Rajan is relying on some blind faith that has been disproven by all thinking people. Krugman offers two points (his supposed “facts”) that prove Fannie Mae and CRA are innocent.
First, he argues that the bad lending was done not by banks covered by CRA, but by non-banks that were exempt from CRA. Now in Krugman’s defense, there is a grain of truth to this. For instance, up until its purchase of a thrift, Countrywide, the largest subprime player, was not covered by CRA. However, comparing Countrywide to say Bank of America, which was covered by CRA, misses a crucial point: these non-CRA lenders were selling their loans to Fannie and Freddie, who were getting housing goal credit for those loans. For instance, 25% of Fannie’s whole loan purchases were from Countrywide. So rather than, as Paul claims that CRA didn’t matter, what the comparison shows is that the GSE housing goals were more damaging than CRA.
Krugman tries to cover this base by claiming that Fannie and Freddie were “sidelined by Congress” during the worst years of the boom. As someone who spent the boom years as staff on the Senate Banking Committee, I found that claim to be insane. For every Senator Shelby who tried to sideline the GSE’s, there was 10 Senators Sarbanes, Dodd and Schumer who pushed the GSEs to do more. Krugman needs to move past empty assertions and offer some, any, evidence that Congress sidelined Fannie and Freddie.
What evidence he does offer is to show that during the boom, the percent of the market that was securitized by Fannie/Freddie fell, while the percent securitized by the private-label market increased. Krugman has that fact correct, yet he misses a critical point. That increase in private-label securities was being funded/purchased by Fannie and Freddie.
As my chart illustrates, the more involved were Fannie and Freddie in purchasing subprime MBS, the more the subprime market grew. During the bubble years, Fannie and Freddie were the largest single source of liquidity for the subprime market. And the chart doesn’t even take into account all the subprime whole loans being purchased by the GSEs.
We have little hope of avoiding a future financial crisis if we do not undo all the perverse government incentives for irresponsible lending. Krugman’s presentation of selective and misleading data only makes true and meaningful reform all the more difficult.