Broback's Blog

Given the recent SEC indictments, I couldn’t resist this passage from Krugman in July of 2008 (emphasis mine:)

“But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.”

Sadly, Krugman is way off base here. It was eventually revealed that Fannie and Freddie purchased an estimated 40% of all private-label subprime mortgage securities.

More:

“So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.“

Two things going on here. Of lesser importance is Krugman being so galactically wrong about the role of Fannie and Freddie in the subprime mess. More important is the blind faith in institutions and the smart, well-intentioned people who create and run them.

Trusting regulations and rules to this degree is a classic case of Sowellian Unconstrained thinking and belief in engineered solutions with goals/intentions at their core. The Constrained view prefers systemic, evolved solutions based on incentives. Consider the thinking behind Fannie/Freddie (and a dozen other like-minded agencies):

“We need to help more people get houses, let’s get those rates down.”

Compare to:

“The interest rates on loans automatically adjust to match the risk of the loan.”

The former is based on good intentions and is a proven failure. The latter is based on the self-interest of individuals, and the more you rely on the latter, the better you do.

I believe history will show that monopolistic government-backed entities (like ratings agencies) are prone to behave irresponsibly — despite the feel-good motives and regulations that frame them. Incentives matter.