How could three prominent economists have been so dumb-foundingly wrong about the systemic risk of Fannie Mae and Freddie Mac?
Today’s Wall Street Journal discusses a 2002 paper declaring that “on the basis of historical experience, the risk to the government from a potential default on GSE debt is effectively zero.” It’s authors were Jonathan Orzag, Peter Orszag and Joseph Stiglitz, who had won the Nobel prize in economics the year before. We’ve embedded it below so you can read the whole thing.
As the WSJ edit page explains:
The Stiglitz-Orszag paper’s method was to put the companies through “millions of potential future scenarios,” and then to judge the likelihood of default. The assumptions in the test were said to be “severe.” Even so, the probability of a default was found to be “so small that it is difficult to detect.” Some $111 billion in taxpayer-funded bailouts later, with perhaps hundreds of billions to go, the risks have been detected.
They noted the government officials had tested Fannie and Freddie’s capital against “the financial and economic conditions of the Great Depression” and found the companies could survive.
So what went wrong? Part of the problem seems to be that Stiglitz-Orszag seriously underestimated how large the mortgage portfolios of Fannie and Freddie would grow. More importantly, they didn’t take into account how far down market both institutions would go in pursuit of expanding homeownership to low income and minority households. What’s more, they didn’t take into account the run up in house prices. All of these errors led them to seriously underestimate the level of defaults and the serious problems falling housing prices would pose for recovery values from foreclosures.
In short, they totally failed to predict what would happen.
Is this forgivable? Not really. The confidence of the paper belies the weakness of its stress tests. There were plenty of people warning about the dangerous road Fannie and Freddie were headed down, including the editorial page of the Wall Street Journal. Last year, in fact, a writer from the Journal (my brother Brian Carney) was awarded a Loeb Award for sounding the alarm bell. Stiglitz came around later, but by then it was too late.