Did Fannie and Freddie Cause the Housing Bubble?

Who caused the disastrous housing bubble in the U.S.? This question has been asked countless times over the past few years. The right generally blames government-sponsored entities Fannie and Freddie while the left generally blames Wall Street. They're both right.

In fact, there were a number of factors leading to the housing bubble, and those listed above are just two. You could add unscrupulous mortgage brokers, clueless borrowers, etc. On his NY Times blog today, economist Paul Krugman argues against the claim that the GSEs caused the bubble. His argument is pretty straightforward, relying on a few graphs:

The first one shows that the GSEs actually saw their market share decline during the climax of the bubble -- from 2004 through 2006. Meanwhile, private securitization of mortgages ramped up. They gained some of the market share the GSEs left behind. That increase is detailed by the second chart.

The conclusion he makes is pretty straightforward: Fannie and Freddie couldn't have been responsible -- they were pulling back during height of the boom. But this analysis misses a few things.

First, a cause doesn't necessarily need to be coincident to a climax. An arsonist isn't necessarily present as flames engulf a structure: he just starts the fire. In much the same way, the GSEs deserve some responsibility for starting the runaway train that would become the crazy housing market.

The graphs above don't do a very good job of showing this, but here's another created using the data contained in these two graphs. It shows nominal value of mortgage originations for non-agency mortgage-backed securities (MBS), GSE MBS, other origination, and total issuance.

(Note: This chart is approximate, as it was created by eyeing two graphs before it, but it should be pretty close to what the precise data would show.)

As you can see, from 2001 through 2003, GSE issuance took off, while private-label MBS had a much smaller presence. Those were the years annual origination first reached the $2 trillion to $3 trillion threshold where it would remain for the rest of the boom. This is when the housing market began to really take off. In 2004, however, the market share began to change. What happened? Wall Street realized that the housing market could be a huge source of profits if they started competing with the GSEs. So they did.

What followed made matters worse. Now, there wasn't only demand for additional mortgage originations from Fannie and Freddie, but also from the big Wall Street banks. The cost of funding for mortgage underwriters declined even further. And remember -- it was quite low to begin with, as the GSEs' implicit government charter made investors very comfortable with their MBS. But Fannie and Freddie kept chasing profits so they now began to compete with the banks. Both the GSEs and Wall Street demanded more and more origination, providing cheaper and cheaper funding to mortgage originators. Then, in 2007, the music stopped.

Does Wall Street deserve some of the blame? Absolutely. It was concentrating on the profit that could be made and ignoring risk. Mortgage underwriters, investment banks, rating agencies, and investors all made this mistake. Of course, the GSEs did the same thing. And remember, they also got the party started to begin with. It was their incredible performance from 2001-2003 that made banks take notice.

So were the GSEs the only cause of the housing bubble? Of course not. But it doesn't make any sense to say that they weren't a central cause or didn't play a major role. If you look at their enormous quantity of originations over the past decade, their presence is undeniable. And if you look at the losses they've sustained since then -- which have led to a $148 billion bailout so far -- it's hard to keep a straight face and say they paid enough attention to risk.