First, a simple question - does anyone know what Fannie Mae and Freddie Mac actually did? We recently heard so much blame placed on this company that it might as well be powered by the tears of orphans. But really, do the majority of us know these companies did?

Well, for all those who do not know, here's a small explanation.

Here's the background: Fannie Mae (FNM) -- the Federal National Mortgage Association -- was created in the 1930s to facilitate homeownership by buying mortgages from banks, freeing up cash that could be used to make new loans. Fannie and Freddie Mac (FRE), which does pretty much the same thing, now finance most of the home loans being made in America.

The case against Fannie and Freddie begins with their peculiar status: although they're private companies with stockholders and profits, they're "government-sponsored enterprises" established by federal law, which means that they receive special privileges.

The most important of these privileges is implicit: it's the belief of investors that if Fannie and Freddie are threatened with failure, the federal government will come to their rescue.

The main contention here is that Fannie Mae and Freddie Mac and their ambiguous relationship to the government caused the creation and expansion of the housing bubble. But really, this largely isn't the case.

I think a more interesting question is what sets the stage for a bubble to emerge - what allows the rumor, irrational exuberance, etc., to express itself as a bubble? One thing that is needed is liquidity and credit, some way of substantially increasing demand. This is the air that inflates the bubble. Even if all the other conditions for a bubble to emerge are present, if there is no way to inflate the bubble - no way for speculators to rush in and drive up the price - then it won't inflate.

With respect to the agency issues, there is a long chain between the home buyer, the mortgage broker, and, ultimately, the sliced and diced complex securities that nobody fully understands. Let's take one step in the chain, that of a bank or mortgage broker, either one.

Suppose they are paid a fee, i.e. by the number of mortgages that pass through their hands each month (as, essentially, they were). The more mortgages they can push through, the higher their income. They are required to meet certain guidelines as they do this, but so long as their income depends upon the number of mortgages passing through their hands and not what happens to the mortgages later on - so long as it is a fee-based system - they have every incentive to push the guidelines as hard as they can and to find a way around them whenever possible.

Essentially, the housing bubble was created by a fault of conduct by the loan officers and their methods of payment. Not everyone in the vast, extensive loan program had a stake in the security of the firm so bad practices emerged. These practices didn't start with Fannie Mae and Freddie Mac, whose market share decreased from 2002-2007, the years when bad mortgage practices really expand. These practices began with the private sector, specifically the investment banks created by the Gramm-Leach-Bliley Act, and eventually, Fannie Mae and Freddie Mac had to follow suit to stay competitive.

And, because Mark Thoma understand the housing crisis much better than I do, I'll let his words finish this.

The mis-pricing and mal-distribution of risk played a key role here (along with poor management decisions in cases where alarms were raised). The agency issues above, and the consequences of the failure to predict and distribute risk are much more important than any moral hazard issues arising from the implicit government guarantee granted to Fannie and Freddie.

Institutions in the shadow banking sector were willing to take large volumes of risky loans as they came up through the system. Why?

The people at the top of this complex chain did not fully understand the risks the were assuming when they took on the subprime business, or, rather, when they took on the complex securities derived from the subprime business. When the bubble popped, it shouldn't have been a big problem if the risk assessment models they relied upon had been correct, and if securitization had distributed the risk as promised. As Brad DeLong notes:

• There is $11T of U.S. mortgages.


• There is $60T of global financial assets.


• Even if we had $2T of losses on mortgage-backed securities that shouldn't pose a big problem for Wall Street--actually 48th and Park Avenue.

So if the risks had been distributed fairly evenly, it's much less likely that we'd be in this mess (the losses of $2T - an intentionally high-balled number - are only 1/30th of global financial assets). It wasn't the mis-prediction of the level of risk that was the biggest problem, the losses could have been absorbed, it was the (unintended) concentration of risk through the failure of securitization that was the most problematic.

Fundamentally, then, it was the agency problems and the failure of risk prediction and distribution models that allowed the bubble to inflate and then cause big problems after it popped. (Seeking Alpha)