Chicken or the Egg
Brad DeLong and Arnold Kling have been going back and forth on Fannie Mae and its culpability, or lack thereof, for worsening the recent bubble and financial crisis. DeLong originally argued, if I remember right, that the default rate for Fannie Mae conforming loans were not worse than those being bought by other groups. Kling argued that even their based default rate of 7% was awful (How do you make money on a pool of debt paying 5% if there is a 7% default rate). DeLong countered
Arnold Kling's response is simply not good. It is silly enough to make me think he has not thought the issues through. a 7% delinquency rate on a mortgage portfolio is horrible in normal times, but is actually very good if you are in a depression--ever our Lesser Depression. For an investment with a 15-year duration that's a cost of less than 50 basis points in a "black swan" near worst case scenario. A portfolio that does that well under such conditions is a solid gold one.
I may not be thinking about this right, but I think DeLong is making a mistake in this analysis. In the comments I wrote
First, I have no clue what a "reasonable" default rate is in a black swan event, and my guess is that, almost by definition, no one else does either.
However, it strikes me that DeLong's argument is a bit off. If mortgage default rates went up in an economic crisis that was wholly unrelated to mortgages, ie due to an oil shock or something, that would be one thing. But in this case, the black swan is in large part due to the mortgages issued. I guess it is sort of a chicken and egg problem, but the mortgages started defaulting before the depression, not the other way around, and helped precipitate the depression.
Remember, we are not talking about how well a portfolio survived the economic downturn. We are talking about if a portfolio contributed to the economic downturn.
