Sand City

Let’s say there are a million households in Sand City, on Monday, with a mean credit score of 635.

credithist

Each of those households has an underlying probability of default that is dependent on their credit score.

defaultrate

All the households in Sand City with a credit score of 640 or above get a prime loan, a little less than 500,000 households. The next 250,000 households with credit scores below 640 receive a subprime loan.   The majority of people who default are subprime borrowers:

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pie

On Tuesday, thanks to pressure to increase homeownership, Sand City’s government sponsored agencies Crennie Cray and Praddie Prack loosen their standards, so that anyone with a credit score of 610 or above can get a prime loan (and now subprime starts at 609 and below). Now, over 500,000 households have prime loans, and 250,000 households still have subprime loans. Now prime defaults increase from 4300 to 8400 (since prime includes some higher risk borrowers), and subprime defaults increase from 6200 to almost 11000 (since the 250,000 subprime borrowers have shifted 30 points “left” on the distribution.) The majority of defaults are still subprime, but the total number of defaults has gone from 10,600 to 19,400.

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Here’s Paul Krugman in two articles in 2008:

Furthermore, while Fannie and Freddie are problematic institutions, they aren’t responsible for the mess we’re in….But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending… In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble…

 

So I was listening to Arnold Schwarzenegger before doing the This Weak round table, and he was mostly making sense — except for one thing. He asserted, as a simple matter of fact, that “government created the housing bubble”, because Fannie and Freddie made all these loans to people who couldn’t afford to pay them.

This is utterly false. Fannie/Freddie did some bad things, and did, it turns out, get to some extent into subprime. But thanks to the accounting scandals, they were actually withdrawing from the market during the height of the housing bubble — the vast majority of the loans now going bad came from the private sector.

Yet it’s now clear that the phony account of the crisis — that it’s all due to Fannie, Freddie, and nasty liberals forcing poor Angelo Mozilo to make loans to Those People — is setting in as Republican orthodoxy, part of what you have to believe to be a respectable member of the party.

Being a great economist, Paul Krugman understands the difference between stocks and flows, and that one can affect the other. Which is why I never understood why the mere fact that the majority of defaults were in subprime was taken by him and others to mean that the regulation and subsidization of goverment-sponsored borrowing was unimportant. Who receives a subprime loan is determined more-or-less by who can’t receive a prime (or otherwise government-sponsored) loan, and consequently the size of one group determines the riskiness of the other.

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