The GSEs presented another case of unintended consequences. From my first days at Treasury, I had sought to reduce the role and strengthen the regulation of Fannie Mae and Freddie Mac, which owned or guaranteed about half of America's residential mortgages. Government policies, from the implicit support of the GSEs to tax preferences, had pumped up the housing bubble and exposed the financial system - and taxpayers - to far too much risk. (p. xix)Please consider time carefully here. Hank Paulson became Secretary of the Treasury in July 2006. In the previous two years, when the total value of US residential real estate owned by households had increased by 16% per year, the total amount of mortgages guaranteed or owned by the GSEs had grown by 6% and 5%. Growth in guaranteed mortgages in GSE MBSs was even lower. Paulson's first days at the treasury came at the tail end of a sharp and sudden drop of 20% in market share at the GSEs.
Their (Fannie & Freddie) charters exempted them from state or local taxes and gave them emergency lines of credit with Treasury. These ties led investors all over the world to believe that securities issued by Fannie and Freddie were backed by the full faith and credit of the U.S. That was not true, and the Clinton and Bush administrations had both said as much, but many investors chose to believe otherwise. (p. 56)This is said un-ironically, in a chapter that outlines the process by which the US government, at Paulson's request, essentially made the guarantee explicit. But, the whole idea that there was not a guarantee is incoherent. The GSEs were required to meet a federal minimum capital requirement. As is typical in that context, that led the GSEs to keep very low capital levels. If you are going to regulate firms with capital requirements, you can hardly require them to keep more capital than an unregulated firm facing at-risk creditors would keep. And, when you have the requirement, the regulated firms have little choice but to generally maximize their leverage under that requirement. Has it ever worked any other way?
The idea that the guarantee wasn't really true is incoherent because if there was no guarantee, then what were the capital controls for? What would have happened if the government had determined the GSEs to be out of compliance? What would have happened if they decided that the firms had to be taken over because of non-compliance, and had said they would not guarantee the bonds? The investors would have been furious. If there are haircuts to be taken, bondholders are perfectly capable of demanding a change of control themselves. If there was no guarantee, then what business was it of the federal government what level of capital the GSEs kept? The only reason they operated the way they did was because the guarantee and the capital requirements were a clear part of the same package of federal interventions.
The market had presumed that a guarantee was in place because there is no functional way in which federal enforcement could have operated without it.
While the GSEs did fund a small increase in certain adjustable rate and non-amortizing loans, I don't see much evidence of weakened underwriting. Here is a graph of FICO scores at origination of new business and total book. Underwriting tightened up during the crisis and continued to be tightened up after conservatorship. The GSEs have been making very high profits for the government by charging hefty guarantee fees and only lending to the most credit-worthy households.
Certainly, the privatized gains/socialized losses problem with the GSE setup was not optimal. But, normally, the reason this is cited as a problem is the moral hazard it creates. I don't see much evidence of a moral hazard problem at the GSEs. Fannie was doing better than Freddie, to be sure. But, the GSEs seem to have been among the least aggressive institutions during the housing boom. Keep in mind that homeownership had risen from the mid-1990s to 2004, and then leveled and dropped off after the GSEs market share declined. Most net homeownership happened when the GSEs were strong, when home prices were well below their peaks of early 2006. The GSEs probably had something to do with that.
I don't think the setup where the GSEs own mortgages is optimal, but I think the idea that they have been associated with risk and bubble pricing is pretty weak. It isn't moral hazard that was the problem, it's that, given the moral hazard issue, when it came time to stabilize the market, the most stabilizing policies were politically unavailable, because they would have led to shareholders potentially profiting from a government guarantee. That is what bothers the electorate. Few people seem to have a problem with federal economic policies that allowed a quarter of real estate wealth to evaporate and GDP growth to collapse, then stagnate for a decade. But, if an implicit guarantee made explicit would lead to a private profit. Or, if a loosened general monetary policy might cause stock prices to rise or corporate profits to strengthen, there is backlash. At the heart of the crisis, there are several tipping points where we chose instability over stability in order to either prevent some people from profiting or to ensure that they would be ruined. These choices were in response to a consensus, not some partisan demand.