The true size of the American subprime problem was hidden for years by the defective bookkeeping of the GSEs…. Not until the summer of 2007 did the full magnitude of the subprime problem begin to become apparent…. Had Fannie and Freddie not existed, a housing bubble could still have taken hold. But had such a bubble developed, it is likely that in and of itself, it would not have wreaked such devastation in late 2008…. Even given the excess[ive MBS holdings] of the GSEs, had the share of financial assets funded by equity been significantly higher in September 2008, arguably the deflation of asset prices would not have fostered a default contagion, if at all, much beyond that of the dot-com boom…"
OK. Greenspan's argument seems to be:
- The GSEs--Fannie Mae and Freddie Mac--purchased and held lots of subprime mortgages--raw, securitized, and then derivativized.
- Bank equity cushions were too low.
- Financial crisis and depression!
This seems to me to be not the thinking of the Gnomes of Zurich, but rather the Gnomes of South Park. Let's run through the chain of causation here:
- Countrywide finds some sub-prime borrowers and lends to them.
- Countrywide securitizes and derivativizes its loans and sells them on the open market.
- Fannie Mae comes along and buys them and holds them in its portfolio.
- Because Fannie Mae has now taken this subprime mortgage risk off of the private sector's books, spreads on subprime vis-a-vis conforming drop.
- Because spreads drop subprime becomes worth more.
- Countrywide thus sees additional profit opportunities from making more subprime loans.
- It makes them, and so there are more subprime loans and more risk in the market.
- So when the crash comes in 2008, banks' inadequate equity cushions cannot handle the risk.
That is the argument, right?
But… But… But… Supply curves slope up, and demand curves slope down.
Here is the market for subprime relative to conforming before Fannie Mae entered the market:
Fannie Mae shows up and purchases for its portfolio, thus reducing the amount supplied to the private marketplace:
The marginal cost to Countrywide is now less than the marginal value to private sector investors, so there is a profit opportunity open if Countrywide does more subprime:
And so it does more deals, pushing up supply of subprime assets provided to private-sector investors:
Relative to the market equilibrium before Fannie Mae intervened, subprime prices are higher--and so house prices are higher. Fannie Mae's intervention has indeed fueled the housing bubble:
But, relative to the market equilibrium before Fannie Mae intervened, the amount of securitized and derivativized subprime mortgages held by the private sector is lower: the bubble is thus less dangerous to the solvency of the private sector as a result of Fannie Mae's intervention:
Thus Fannie Mae's intervention (a) fueled the housing bubble but (b) did not cause the financial crisis--rather, it (c ) reduced the chances of financial crisis by diminishing the exposure of undercapitalized private-sector banks to subprime risk.
This isn't rocket science: this is supply and demand.
But Greenspan's map does not see this territory. Why not?