Mortgages, Standards and the
Future of Housing Finance
“The GSEs, Housing, and the
Economy” Conference
Susan M. Wachter
Richard B. Worley Professor of Financial Management
The Wharton School
University of Pennsylvania
January 24, 2011
Washington, DC
Key Points
• Origins of the bubble and crash: Pro-cyclicality of
leverage
– Supply-side phenomenon, fee driven, asymmetric
information
– Mortgage finance spreads declined and volume
increased for RMBS in PLS, assets repriced
• Transparency: efficient pricing and allocation of
risk
– 2 risks: interest rate risk and credit risk
– Standardization, disclosure, systemic risk regulation
Increased Leverage
Sectoral Contribution to U.S. Gross
Debt
400%
200
69.5
190
350%
69
180
300%
170
68.5
160
250%
Financial
Companies
68
150
200%
140
67.5
Household
130
150%
120
100%
Nonfinancial
Companies
67
110
66.5
100
2000 2001 2002 2003 2004 2005 2006 2007 2008
50%
Government
0%
1975
 Case Shiller National House Price Index
1980
1985
1990
1995
2000
2005
 Homeownership rates
 U.S. Mortgage Debt Outstanding
3
Growth of Private Label MBS and
Mortgage Expansion
Underwriting standards eroded
as complex, heterogeneous mortgages
were packaged into MBS.
Source: Inside Mortgage Finance, 2010 Mortgage Market Statistical Annual
The Mispricing of Risk
Financial intermediaries lowered PLS yields,
despite the increasing default risk of the mortgage pools.
Quoting WSJ (1/15/11)
• As of 2005, FRB economists estimated that houses were
overvalued by ~20%
– But further interest rate rises were ruled out as a means of addressing
the bubble due to threat of destabilizing the broader economy
– Higher prices themselves, it was hoped, would curtail effective
demand for housing
• Today: “They (the FRB)… have started to discuss whether …
tools, such as consumer regulations or supervision practices,
should be employed to control bubbles before they become
dangerous.”
• But how? With what controls (capital requirements)?With
what identifying data? Discretionary, automatic?
Source: Sudeep Reddy, Wall Street Journal, “Fed Felt Hamstrung by Housing Bubble”, (Jan 15,2011)
Pro-Cyclicality of Leverage
Leverage
drives up
prices. Higher
prices are
expected and
ratified by
further
increases in
underpriced Prices
credit.
…and the
inevitability
both of
bailout, and
further
credit
tightening
Credit
expands,
prices rise
Turning point:
Higher prices
until no room
for credit
standards to
deteriorate
further.
Prices stall;
Credit freezes
rise
Prices fall;
Foreclosures
With freeze
and without
capitalization
of expected
increases,
prices decline
Externality: Foreclosures Drive Pricing in
destabilized markets…
6
10
House price growth,
annualized % chg (R)
5
4
5
0
3
2
-5
1
-10
0
-1
-2
-15
Change in foreclosure share
of sales, % (L)
-20
-3
-25
06
07
Sources: Fiserv, Zillow, Moody’s Economy.com
08
09
Why the Put Option Gets Mispriced
• Why don’t markets correctly price for risk?
– Moral hazard, principal-agent conflict, information
asymmetry necessary….but not sufficient
– Limited ability to short sell the underlying asset or RMBS
• Underpriced credit (rates and terms) impact effective
housing demand and housing prices
– Put option pricing affects efficiently priced assets
– Through breaching constraints
– Makes the underwater loans temporarily look good
• Incentive to go short when put option is in the money
• Rationale for regulatory response: instruments to trade
Implications for Government Role
• Regulation of private RMBS market: disclosure and trading framework
– Data verification, standardization to allow analysis
– Derivatives trading over exchanges of standardized RMBS
• Private and public sector monitoring credit cycle requires identifying
Pavlov-Wachter correlated credit spread compression and asset pricing
errors
• Role of government to provide catastrophic insurance
– To “Buy” control over MBS issuance to provide liquidity backstop: explicitly
priced catastrophic insurance
– Preservation of ability to monitor and maintain limited risk over the cycle
through data standards and verification
Cited Research
• “Explaining the Housing Bubble,” Levitin and Wachter
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669401
• “Subprime Lending and Real Estate Prices,” Pavlov and Wachter,
Real Estate Economics, Vol. 39, Winter 2010
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1489435
• “Mortgage Put Options and Real Estate Markets,” Pavlov and Wachter,
Journal of Real Estate Finance and Economics, Vol. 38, No. 1, January
2009, 89-103.
•
“The Inevitability of Marketwide Underpricing of Mortgage
Default Risk,” Pavlov and Wachter, Real Estate Economics, Vol.
34, Winter 2006
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=910970
Thank You
Susan M.Wachter
Richard B. Worley Professor of Financial Management
Professor of Real Estate and Finance
The Wharton School
University of Pennsylvania
wachter@wharton.upenn.edu