Are we heading towards a new subprime crisis?

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William Poole: Nine years ago an oblivious Fed had to bail out Bear Stearns, which had invested in risky mortgages

Poole says there are signs again that subprime mortgages are a problem and the Fed isn’t paying enough attention to it

Editor’s note: William Poole is a Senior Scholar at the Cato Institute and Distinguished Scholar-in-Residence at the University of Delaware. He retired as President and Chief Executive Officer of the Federal Reserve Bank of St. Louis in March 2008. The opinions expressed in this commentary are his own.


The Federal Reserve bailed out Bear Stearns on March 14, nine years ago. What did the Fed learn from this mistake? Not enough, maybe.

A little-understood part of Bear’s story is that in March 2008, the Federal Open Market Committee, or FOMC, ignored critical facts about Fannie Mae and Freddie Mac. Unfortunately, the Fed could make the exact same mistake today.

Bear’s problems stemmed from excessive investments in bonds based on subprime mortgages, which carry higher risk for one or more reasons, such as the borrower’s poor credit rating. Fannie and Freddie were the main housing lenders, having been organized into “Government Sponsored Enterprises” or “GSEs”, and they were responsible for originating much of the subprime mortgages.

Yet FOMC transcripts and staff documents prepared in March 2008 suggest that no one at the Fed bothered to read the GSE’s 2007 annual reports, released on February 28, 2008. FOMC March 10, there is mention of Fannie/Freddie in the context of their declining stock prices, but no mention of material disclosures revealed in their annual reports.

And those reports showed that Fannie and Freddie were both essentially insolvent at the end of 2007, at the peak of the business cycle before the recession began. These two companies had outstanding obligations almost as large as the total amount of Treasury debt outstanding, far larger than Bear Stearns and Lehman Brothers combined.

The possibility that households would reduce their consumption of goods and services as they tried to cope with risky mortgage payments – triggering a deep recession – was never mentioned during FOMC meetings around Bear. Thus, ignoring the poor state of Fannie and Freddie’s mortgages was a Fed mistake that compounded the mistake of bailing out Bear Stearns.

Today, the Fed is again ignoring GSEs and their potential contribution to future instability. According to Freddie’s 2016 Annual Report, “Expanding access to affordable mortgage credit will continue to be a top priority in 2017.” Fannie/Freddie redefined “subprime” as a credit rating below 620; previously, these companies and banking regulators had used 660 as the dividing line that defined a subprime borrower. Now, using the lower figure, they can buy even lower mortgages than before the financial crisis.

GSEs wrap new subprime mortgages in mortgage-backed securities that they sell in the market. Fannie and Freddie guarantee these securities, and because the federal government backs the GSEs, there is little market discipline. Think about it: when it comes to subprime mortgages, we may be in a worse situation now than before the crisis.

During the crisis, the Fed was overwhelmed by events because it did not pay enough attention to subprime debt and did not have contingency plans. Timothy Geithner, president of the New York Fed at the start of the crisis and then secretary of the Treasury, was one of the managers of the financial crisis. He explained Fed policy with great clarity in his 2014 book, “Stress Testing:” “…We were teetering all over the place, and no one knew what to expect next. Skein [Paulson] said he wouldn’t need to inject capital into Fannie and Freddie, then did what needed to be done and injected $200 billion. Collectively we helped keep Bear from failing, then we seemed to suggest letting Lehman fail on purpose, then we turned around and saved AIG from crashing. … Our unpredictability undermined the effectiveness of our response.

Where are we today ? Few observers believe that the Fed has a clearly articulated strategy on its adjustment to the fed funds rate, which should be the subject of its announcement at the end of its meeting tomorrow. This rate is its main policy tool determining the degree of monetary policy stimulus. Equally important, how and when will the Fed deal with its bloated portfolio? Over the past few years, the Fed has accumulated a considerable number of Treasuries and Fannie/Freddie bonds that it cannot hold indefinitely without creating a huge risk of future inflation.

Alan Greenspan had disassociated the Fed from its maximum support for the GSEs. Now, with its huge portfolio of mortgage-backed securities issued by Fannie and Freddie, the Fed is aiding and comforting the affordable housing lobby that created the subprime mortgage mess and the financial crisis.

In Freddie’s 2016 annual report, the agency says 36% of its bonds are “credit-enhanced,” meaning they carry mortgage insurance of one type or another, which is typically used for lower mortgages. Default insurance is not as good as improving companies, and none are rated above BBB+. If these low-risk mortgages start failing in large numbers, so will the insurance companies.

There is a critical difference between the situation today and that of 2008: there is very little private capital that would be at risk if there were another subprime mortgage failure. Before the crisis, there was some market discipline, imperfect as it was, as potential buyers of mortgages carefully scrutinized their quality. Now only Fannie and Freddie review the quality of mortgages. And it is the taxpayers who would bear the burden of bailing out Fannie and Freddie, since their bonds are guaranteed by the US government.

According to the Fannie/Freddie annual reports for 2016, there is no doubt that the issuance of subprime mortgages is again one of the drivers of house prices – up around 30% in the last four years and now on the verge of returning to the high peak of 2006.

Will subprime debt start collapsing again when house prices stabilize?

Why isn’t the Fed talking about this case? Someone please convince me that “this time is different”.