Loan Loss Only Part of Financial Crisis Story

With the release of Peter Wallison’s new book, Hidden in Plain Sight, debates about the role of Fannie Mae and Freddie Mac in the financial crisis have heated up again. As I’ve written elsewhere, I believe there’s a lot more to the story than the GSEs’ housing goals. While there are a number of omissions in Peter’s otherwise fine book, I want to address a particular criticism of his work that strikes me as simply confused and mistaken.

I’ve often heard that Fannie and Freddie couldn’t have been a cause of the crisis because their loan loss rates (and totals) were far below those of banks. Robert VerBruggen recently repeats this in his review of Peter’s book. 

For this claim, Robert relies on loss estimates by David Min and Mark Zandi. The latter repeated this criticism at an AEI event for Peter’s book, and you can find Zandi’s estimates here (page 8, table 1). Zandi states that as a percent of debt, the GSEs witnessed a loss rate of 2.7 percent on their holdings of residential mortgages. Combined with the Federal Housing Administration’s losses, this comes to around $206 billion. In contrast, depositories (banks & thrifts) had a loss rate of 5.8 percent for a total of $217 billion—both the rate and total are obviously greater than that for the GSEs and FHA.  

So far, so good; I don’t disagree with any of the above. But Zandi’s estimates suffer from a massive omission: the other side of the balance sheet—equity. If you think losses are all that matter, consider that the dot.com bubble erased about $8 trillion in wealth, whereas losses on mortgages, according to Zandi, were just under $1 trillion. So if losses are the issue, why wasn’t the dot.com bubble so much worse than the subprime crisis? Because of leverage.

Yes, the GSEs’ losses on mortgages were less than that for depositories, but the differences in capital were far greater. The GSEs had far less shareholder money to fall back on if mortgages started to sour. Again bear in mind that total losses were similar between the GSEs and the depositories. In the 4th quarter of 2007, Fannie and Freddie held about $70 billion in shareholder equity, behind $1.7 trillion in assets and around $5 trillion in debt and guaranteed mortgage-backed securities. By contrast, depositories held $1.3 trillion in shareholder equity, or about 19 times the equity of the GSEs. Mortgage losses were not enough to sink the entire banking system, even if some banks did sink, whereas the GSEs were toast because of their low levels of capital. 

Why does that matter? Because it takes insolvencies to drive a financial crisis. The banking system, as a whole, was not driven to insolvency, but the GSEs where. Losses (and loss rates) only make sense relative to the capital ready to absorb those losses. And of course the failure of the GSEs was magnified through the system in a uniquely harmful manner. 

Did other banks hold Citibank equity?  Of course not, but they did hold GSE preferred shares. This all isn’t to say that the GSEs were the only cause of the crisis; they weren’t. It is to say that loss rates presented out of context are meaningless and could even be misleading.