A race to the bottom: Understanding the US housing boom

Viral Acharya, Matthew Richardson, Stijn Van Nieuwerburgh, Lawrence J. White, 11 May 2011



Earlier this year the US Financial Crisis Inquiry Commission released its report. With no small amount of irony, a crisis emerged in its inquiry. The majority of the commissioners attributed the credit boom and bust to greedy but incompetent bankers and lazy but ideological regulators. The dissenting commissioners, meanwhile, focused more on poorly designed housing subsidies. Yet while the two groups reached largely polarised views, consensus should have in fact been easy to reach.

There was, during 2003-7, a race to the bottom between the huge government-sponsored enterprises (GSEs) – Fannie Mae and Freddie Mac – and the private financial sector, consisting of too-big-to-fail large complex financial institutions. Both the GSEs and the too-big-to-fail institutions were making highly leveraged bets on the mortgage market at below-market funding rates in credit markets that were implicitly backed by the government. In our recently published book Guaranteed to Fail we describe this as a battle between King Kong and Godzilla.

The mortgage market in the US increased dramatically in size, especially starting late 2003 with the sharp growth of the riskier subprime and Alt-A mortgage lending (see Figure 1 for private-sector mortgage-backed securities growth starting 2003 and Figure 2 for composition of private-sector mortgage originations). Since the too-big-to-fail institutions couldn’t compete directly with Fannie and Freddie because of the GSEs’ access to government guaranteed capital and their roughly 40 basis points lower cost of borrowing, they instead moved along the credit curve, dealing in increasingly shaky mortgage loans that the GSEs had difficulty competing with given the walls, even if somewhat porous, around their underwriting standards. Also, the too-big-to-fail institutions greatly increased their leverage, through use of asset-backed commercial paper and sale-and-repurchase (“rep”) financing, allowing them to expand by issuing cheap debt.

Figure 1. Growth in mortgage market, securitization and percentage share of market, source: inside mortgage finance

Figure 2. Non-GSE issuance by type

Source: Inside Mortgage Finance

The too-big-to-fail firms were not only creating more toxic mortgage-backed securities but also investing in those same securities. Over 50% of AAA-rated non-GSE mortgage-backed securities were held within the financial sector! It was not just the proverbial Norwegian village pension fund that suffered when those securities crashed. It is a mistake to accuse these firms from not having enough skin in the game (but, of course, they did not have enough capital to cover their skin).

This growth in private label mortgage-backed securities was the culmination of the dream of the 1982 “Commission on Housing”. It did, however, have an important and unintended consequence that what would have caused great consternation to that Commission: it encouraged the GSEs to take on riskier portfolios too in order to prevent their market share from being eroded by the private sector too-big-to-fail institutions. See, for instance, in Figure 1, the sharp rise in Fannie and Freddie share of the mortgage market starting 2005, in contrast to the sharp fall in the preceding years when they lost market share to private label mortgage-backed securities.

Prior to 2003, as a fraction of their total mortgage-backed securities portfolio, each year the GSEs purchased approximately 10% in lower-quality loans. From 2004-2007, however, this fraction averaged 50%. While there is little doubt that, starting in the mid 1990s, government-mandated affordable housing goals played an important role in shifting Fannie and Freddie’s profile to riskier mortgage loans, it is an interesting question as to how much of the GSEs’ steeper dive into lower-quality mortgages was driven by those mandates and how much by their desire to maintain and expand their market shares.

Their former regulator James Lockhart testified that both Fannie and Freddie “had serious deficiencies in systems, risk management and internal controls.” Furthermore, “there was no mission-related reason why the Enterprises needed portfolios that totalled $1.5 trillion.” He chalked it up to “the Enterprises’ drive for market share and short-term profitability.” Similar language can be found in Fannie Mae’s own strategic plan document, “Fannie Mae Strategic Plan, 2007-2011, Deepen Segments – Develop Breadth,” in which they outline their 2007 onwards strategy: “Our business model – investing in and guaranteeing home mortgages – is a good one, so good that others want to ‘take us out”… Under our new strategy, we will take and manage more credit risk, moving deeper into the credit pool to serve a large and growing part of the mortgage market.”

The bottom line is that it is not possible to fix the US housing finance without dismantling the GSEs in a phased manner and removing their impact on housing markets, lest another race to the bottom emerge in due course once benign conditions return and capital and credit more readily available. However, it is pie in the sky to believe that systemic risk will not exist in the mortgage finance market once the GSEs leave this world. Too-big-to-fail institutions will gradually build up this risk on their balance sheets. It is unavoidable. As a result, it is crucial that the external costs of systemic risk are internalised by each of these firms, or we will end up with an alternative group of private GSE-financial firms in the mortgage finance area. The Dodd-Frank Act in the US, even if imperfect, serves as a useful step in the direction of focusing regulatory attention on systemic risk contributions of the private financial firms (see a discussion of the Act in Acharya et al. 2010).

Unfortunately, in every crisis, the share of mortgage markets owned by the government-sponsored enterprises only rises. It stands over 90% in the US at present. The situation is not too different in other parts of the world. The Landesbanken, the local savings banks of Germany, and the Cajas, the municipality-controlled savings and loans institutions of Spain, are also operating right now as “bad banks” of the (housing) crisis, just like Fannie and Freddie.

Yes, every crisis has a bad bank. But when governments run their own banks badly in good times, they crowd out private banks and thereby encourage them to take greater risks. A secular credit boom and bust must follow. The seeds of such a new cycle are currently being sown. In our next column, we will propose a reform plan to avoid this outcome and contrast it to the Treasury proposals.


Acharya, Viral, Matthew Richardson, Stijn Van Nieuwerburgh, and Lawrence White (2011), Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance, Princeton University Press, March.
Acharya, Viral, Thomas Cooley, Matthew Richardson, and Ingo Walter (2010), Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, Hoboken, NJ: John Wiley & Sons.


Topics: Financial markets, Global crisis
Tags: Fannie Mae, Freddie Mac, global crisis, housing finance, too-big-to-fail, US

Viral Acharya

Professor of Finance, Stern School of Business, New York University and Director of the CEPR Financial Economics Programme

Professor of Applied Economics, Stern School of Business, New York University

Associate Professor of Finance and the Yamaichi Faculty Fellow at New York University Leonard N. Stern School of Business