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Raghu Rajan: Response to Paul Krugman June 04

What Krugman says

In a piece entitled “Things Everyone In Chicago Knows Which happen not to be true”, Paul Krugman
writes on his blog http://krugman.blogs.nytimes.com/2010/06/03/things-everyone-in-chicago-knows/

It was deeply depressing to see Rag[h]uram Rajan write this:
http://www.ft.com/intl/cms/s/0/9daee5e0-6e70-11df-ad16-00144feabdc0.html#axzz2LqUgSvyC

~~~~~~
[Note: the link there links to the article of the 'tiny' in the post this post replies to in this bit

"Paul Krugman .. http://krugman.blogs.nytimes.com/2010/06/03/things-everyone-in-chicago-knows/ ..
caught a whiff of it in a recent commentary by Raghuram Rajan .. http://tiny.cc/xdp5rw ..
in the FT, and quickly denounced it."]

but that 'tiny' may be inaccessible now for any without a digital subscription to FT. Like me.]
~~~~~~

“The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans.”

That’s a claim that has been refuted over and over again. But what happens, I believe, is that in Chicago they don’t listen at all to what the unbelievers say and write; and so the fact that those libruls in Congress caused the bubble is just part of what everyone knows, even though it’s not true.

Just to repeat the basic facts here:

1. The Community Reinvestment Act of 1977 was irrelevant to the subprime boom, which was overwhelmingly driven by loan originators not subject to the Act.

2. The housing bubble reached its point of maximum inflation in the middle years of the naughties: [graph omitted]

3. During those same years, Fannie and Freddie were sidelined by Congressional pressure, and saw a sharp drop in their share of securitization:



while securitization by private players surged.

Of course, I imagine that this post, like everything else, will fail to penetrate the cone of silence. It’s convenient to believe that somehow, this is all Barney Frank’s fault; and so that belief will continue.

Rajan’s response

I reproduce Paul Krugman’s “econometric” claim above that Fannie and Freddie did not help cause the crisis above (I do not claim the Community Reinvestment Act was a big factor). I respond only because I have received hate mail from his followers. Paul is, of course, a great theoretical Nobel-prize-winning economist, so his attacks must be taken seriously (and I did take his trade theory classes at MIT, in the interest of full disclosure). Unfortunately, much of the “Fannie and Freddie did not contribute to the crisis” battalion makes arguments that have serious holes. Since these arguments are so prevalent they need to be rebutted again and again (the claimed unwillingness to listen to argument can be played on both sides).

The key graph in Paul’s argument is Figure 4. He claims that restrictions on Fannie and Freddie starting in 2004 kept their share of originations of total residential mortgage originations down, even while housing prices inflated. But this is irrelevant to the question. What we care about though is the amount of Fannie and Freddie’s originations in the sub-prime residential mortgages. And from every source I have seen, these took off precisely in 2004. Indeed, as I argue in my book Fault Lines, in the period 2004-2006 these two giants purchased $ 434 billion in sub-prime mortgage-backed securities. A measure of the size of these purchases is that in 2004, they accounted for 44 percent of the market for these securities. Calomiris and Wallison (2008, http://www.aei.org/outlook/28704) argue that Fannie and Freddie’s arms were twisted into doing more of this kind of lending starting in 2004 precisely because Congress had them in a vice because of the scandal.

Readers interested in the relevant data on originations by Fannie and Freddie may also want to see the work of Edward Pinto, a former Chief Credit Officer of Fannie Mae. He offers a detailed analysis of Freddie and Fannie’s lending , and their responsibility for the crisis. His testimony to Congress is at http://www.aei.org/docLib/20090116_kd4.pdf. His analysis of the data can be found on the AEI website.

Continued: http://forums.chicagobooth.edu/faultlines?entry=11

====== Paul Krugman comments on Rajan's use of Edward Pinto there ..

May 21, 2011, 2:41 pm 70 Comments

Origins of the Crisis, Fake and Real

I don’t spend too much time these days talking about the origins of the financial crisis [my bold] — right now the burning question is what comes next. Still, history is a battlefield, and the usual suspects are trying hard to rewrite that history in their interests.

In fact, for a lot of people that has already happened: it’s orthodoxy on the right that Fannie and Freddie caused the housing bubble and bust. It was all the government’s fault!

And where does that idea come from? Well, a lot of it turns out to rest on publications by Edward Pinto at AEI, who claims that Fannie and Freddie held a large proportion of “subprime and other high-risk mortgages” — an assertion often transformed in casual discussion into the claim that F&F held a large fraction of subprime mortgages.

So it’s good to have Mike Konczal reminding us .. http://rortybomb.wordpress.com/2011/05/18/peter-wallison-discusses-fannie-and-freddie-for-the-american-spectator-or-where-are-the-fact-checkers/ .. that Pinto’s definition of “subprime-like” mortgages is just something he made up — and that it turns out that his supposed high-risk categories weren’t that risky at all, that in fact they look more like traditional conforming mortgages than like true subprime:



The paper from which this figure is taken, by David Min .. http://www.americanprogress.org/issues/2011/02/min_pinto.html , makes it clear that Fannie-Freddie loans were much less risky than those originated in the private sector — and in particular that “private-label” mortgage-backed securities, which were essentially unregulated, were vastly riskier than anything the government was promoting.

The whole “the government did it” claim is, in short, based on deeply misleading numbers — and it’s hard to read this story without believing that these numbers were deliberately constructed to mislead.

http://krugman.blogs.nytimes.com/2011/05/21/origins-of-the-crisis-fake-and-real/

Agree .. enough on these origins .. just wanted to include Krugman's comment
on Rajan's use of AEI's Edward Pinto and "the government did it" claim..."