Conference on the GSEs, Housing, and The Economy: Synthesis and Summation
By Albert S. “Pete” Kyle
January 24, 2011
Ronald Reagan Building
Washington, DC
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Why the Financial Crisis Occurred
• Irrational Exuberance: Belief that housing prices would not fall.
– Encouraged lax lending standards.
– Fed housing bubble.
– Proven wrong when housing prices did collapse.
• Risk Shifting: Belief that creditors would be bailed out if housing prices collapsed.
– Encouraged banks to use debt financing instead of equity financing.
– Inadequate capital requirements led to collapse of financial system when housing bubble ended.
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Role of GSEs: Doubly Bad
• Irrational Exuberance:
– Although GSE market share fell, GSEs ramped up risk taking by purchasing riskier mortgages.
– Subsidized borrowing costs seem to have raised housing prices faster than borrowing costs fell, leading to poor affordability during bubble.
• Alternative interpretation is Ponzi finance.
• Risk Shifting:
– GSEs were more levered than banks and had more concentrated risk.
– Collapse of GSE more costly to taxpayers than everything else put together.
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Financial Crisis Not Caused By
• Securitization: Allows slicing and dicing risks without reliance on leverage.
• Originate‐to‐Distribute Model: Originators got stuck with inventory and failed (Countrywide, WaMu, Bank of America, Merrill, Lehman, Bear Stearns, Citigroup)
• Derivatives and Short‐selling: Performed valuable service on ending bubble earlier rather than later.
• Ratings Agencies: Assigned ratings consistent with market prices.
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What the Government Does Poorly
• Pricing credit risk:
– “Actuarily fair” prices for credit risk are likely to fluctuate greatly with market conditions and geography.
– Stable prices of credit risk destabilize housing prices.
– Implies bad risk management.
– Implies difficulty verifying market prices.
– Implies poor evaluation of long‐term costs when
back‐loaded.
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“Risk Premiums”: Three Different Meanings
• “Default Premium” = Credit Risk Premium
– Price of insurance contract protecting against default
• “Risk Premium”
– Expected return (over risk‐free rate) needed to justify risk‐taking
• Not an actuarial calculation.
• “Liquidity Premium”
– Extra asset value (lower required return) needed due to high market trading liquidity (bid‐ask spreads and market impact).
• None of these are easily observable.
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Mortgage Spreads between Conforming and Jumbo
• Typically around 25 bp before financial crisis?
– How much is default premium versus liquidity premium?
• Spreads rose to more than 100 bp after crisis?
– How much is default premium (GSEs underprice insurance) versus liquidity premium (QE by Fed applied to conforming, not jumbos)?
• Hard to measure costs of various components of GSE activities.
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Government versus Market Credit Risk Premiums
• Government faces pressure to have prices which are too low, too stable across geography and types, too stable over time.
– How to explain why price is 200 bp for Miami condo but 10 bp for Lubbock, TX, home?
• Market prices vary seemingly randomly across time and borrowers. – Appears to be unfair.
• Government prices do not take account of difference in enforcement of property rights across states.
– Does this encourage “soft” policies at state level?
• Government has bad track record pricing other risks:
– Floods in Florida.
– Bank capital requirements with implicit bailouts.
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Can Government Fix “Market Failures”?
• Systemic Risk? No.
– This is a pecuniary externality, not market failure.
• Moral Hazard? No.
– What technology does government have for dealing with moral hazard that market participants do not have?
• Neighborhood effects? Yes.
• Network externalities? Yes.
• Adverse selection? No.
– Government can pool good credit risks with bad credit risks in mortgage pools, but beware of negative externali
effects of bad types.
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Bank Capital Requirements
• Capital requirements were too low leading into crisis.
• Capital requirements are intrinsically too inflexible:
– Risk‐based capital requirements a failure.
• Low capital requirements create high default probability, which becomes an underpriced risk if there is an explicit or implicit guarantee (put option).
– Encourages risky lending since bank does not bear downside.
• Created bad dynamics: As financial crisis became more likely, value of put option increased.
• This created a “moral hazard” problem, did not fix a market failure.
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Three Types of Moral Hazard
• Renter or under‐water homeowner does not have incentive to maintain property.
• Pump‐and‐Dump: Originator in originate‐to‐
distribute model has incentives to get rid of bad assets.
• Risk‐Shifting: Banker with too‐low capital requirements has incentive to take too much risk because it is subsidized by taxpayers.
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Different Levels of Leverage
• Risky tranches of securitizations have built‐in leverage.
• Banks have incentives to overleverage when this increase the value of bailouts to their debtors.
• Household leverage affects sensitivity of consumption to asset value shocks.
• Bank leverage and household leverage interact to amplify macro fluctuations.
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Dynamics of Pricing of Risks
• Market appear to underprice risk at some times (2006) and overprice risk at other times (2009).
– But market pricing of risks affected by government policies.
• Both underpriced insurance fees and too low capital requirements should exacerbate risk taking.
• But too‐stable insurance fees and inflexible capital requirements induce prices of credit insurance to fluctuate in manner which exacerbates systemic risks.
• Implicit and explicit insurance protected bondholders, not equity holders.
– This encouraged excessive reliance on debt financing.
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What Government Can Do Well
• Create liquidity.
– The Fed can swap Treasury securities for other assets to make the other assets more liquid.
• Define standardized non‐predatory mortgage contracts.
– Market forces tend to operate so as to make product choice excessively complicated for consumers.
• Define property rights – Electronic transferability of property rights. – Set data standards for electronic record‐keeping as a public good.
– Structure default and foreclosure process to bilateralize bargaining in default, so that second mortgages and dispersed securitization holding do not lead to inefficient outcomes.
• Mandate centralized clearing and trading of mortgage assets – To achieve network economies, scale economies, and reduce information asymmetries.
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Create Liquidity
• Market liquidity: helped by securitization.
– GNMA invented “pass‐through” securitization, not GSEs.
– Wall Street (Salomon Brothers) created “slice‐and‐dice” securitization, not GSEs
• Funding liquidity: – Fed is the better provider of funding liquidity, in fact supports mortgage market with quantitative easing strategy.
– Fed has special structure insulating it from politics.
– GSEs have self‐interested shareholders.
– Do not want two central banks printing money.
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Standardized Terms
• Harness forces of competition by defining standardized term sheets for non‐predatory consumer mortgages:
• Many consumers will never understand the cost of their mortgages
• But consumers can understand that a lower rate is better if all other terms of the mortgage are the same.
• Standardized term allow consumers to shop for best deal, even if they cannot price the securities like a rocket scientist.
• Big problem: How many standardized mortgage types? – Problem for Consumer Financial Protection Board.
– GSEs can encourage standardization by insuring only certain types.
– But better strategy has nothing to do with insurance, only securitization.
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Define Property Rights
• Electronic transferability: GSEs have not been innovators in this technology. Better role for Fed.
• Data Standards: Much of this effort may take place in Office of Financial Research.
– GSEs not the leaders they could have been in this area.
• Structure default process:
– This is a matter for legislators, both state and federal levels.
– Not a role for GSEs here.
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Centralized Clearing and Trading
• GSEs could have helped structure market to achieve transparency in clearing and trading, but did not do so.
• Repo market is also a good candidate for central clearing and trading.
– GSEs probably not the best institutions to do this.
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Securitization
• Allows risks to be “sliced and diced” so that large risks are concentrated in risky first‐loss tranches, while highest tranches effectively have AAA ratings.
• Importantly, securitization allows risky securities to be created without leverage.
– Related to idea that “replicating portfolio” is not needed with a securitization.
• Lack of leverage of risky tranches tends to reduce systemic risks associated with lack of liquidity.
• If lowest tranches are financed with 100% capital (1250% RWA), then capital requirements do not induce bad incentives to hold on to risky assets when values decline.
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Derivatives and Short‐Selling • Creation of synthetic securities (especially pay‐as‐
you‐go) allows shorting housing risk.
• This can lead to more efficient aggregation of information and less inflated prices.
• John Paulson hedge funds performed valuable service by helping end bubble earlier rather than later.
– Was Goldman Sachs doing God’s work with Abacus synthetic CDO‐squared?
– Markets could bet on Case‐Shiller index but do not seem to do so in large volumes.
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Originate‐to‐Distribute Model
• Theory is that originators need to season assets, bearing much of the risk as they do so, and this aligns incentives correctly.
– Counter‐theory is that originators dumped risky assets on less informed buyers.
– Counter‐theory applies well to dot‐com bubble, not to housing bubble.
– Big originators of mortgages died eating their own cooking (WaMu, Countrywide, Bear Stearns, Lehman, Citigroup, Bank of America, Merrill Lynch).
– Lehman’s move from the “moving” to the “storage” business illustrates how the model worked.
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Ratings Agencies
• GSEs could have competed with ratings agencies, but did not do so.
• Why?
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Path to Fixing Housing Finance System
• Primary problem is that capital requirements are too low.
• Exacerbated by problem that bank capital are strained by write‐offs of bad loans.
• GSEs and FHA now effectively have unlimited amounts of capital they can lose.
• Fixing banking system requires more tier 1 equity, fast resolution of failures, contingent capital.
– Probably need 20% capital requirements.
– Real estate assets are usually the biggest problem in financial crises, so capital requirements on real estate assets need to be much higher.
• Deal with GSEs after making sure banking system is well capitalized.
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Ways to Subsidize Housing?
• Worldwide savings glut tends to make cost of housing cheaper in long run.
– But housing market may react inefficiently in short run as housing prices risk faster than interest rates fall.
• Subsidies through tax system encourage homeowners to buy houses that are inefficiently big.
– But significant deadweight cost offset by relatively high property taxes.
• Subsidies through GSE intermediation in market redistributes home ownership towards younger, poorer, more highly levered borrowers
– But extent depends on stringency of underwriting standards.
– GSE subsidies amplify systemic risks.
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Phasing out GSEs
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Lower conforming loan limit
Limit size of loans
Disallow portfolio investments
Raise fees charge to insure credit risk
• These all phase out GSEs gradually
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Do Markets Have Risk Appetite to Absorb Credit Risk?
• Risk on prime mortgages may be small compared to junk bond market, sovereign debt market, commercial real estate, and real estate development.
• Market for junk bonds has come back, indicating appetite for risk.
• Historically, interest rate and prepayment risks greater than credit risks on prime mortgages:
– Fed is now bearing interest rate risk with quantitative easing.
• Is quantitative easing more efficient way to subsidize housing finance than underpricing credit risk?
– Good reasons why Fed only tries to invest in near AAA assets.
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What happens with no GSEs?
• Banks originate and securitize large pools of prime mortgages.
• Banks retain equity state in own portfolio, say bottom 4% financed with 100% equity (1250% RWA)
• Safest tranches (top 80%) are effectively AAA
– Easy for Fed to intervene to keep spreads low relative to Treasuries.
• Tricky Part: The 4%‐20% loss bearing tranches need to be sold to market
– Buyers might be bond funds, hedge funds, or banks themselves.
– If a crisis occurs, these second loss tranches might lose value, creating need for some entity like GSEs to be re‐invented.
– If bailout inevitable, keep them mothballed, but inside the Fed?
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Where do Risks Go?
– When government bears risk, it effectively transfers it to taxpayers, in particular those who cannot or do not hedge the risk the government is dumping on them.
– This risk does not go away.
– In most general equilibrium models with “Ricardian equivalence,” government policy does not affect the price of the risk in the market, unless the government “manipulates” (corners) the market by driving out all competition.
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Is Europe Really So Great?
• Banking system in Scandinavia failed in 1990’s due to real estate bubble.
• Ireland, Spain, Greece may not statistically have large numbers of foreclosures, but many homeowners cannot pay their mortgages in these countries.
– Furthermore, mortgages are far underwater.
– Euro does not allow inflation option to bail out homeowners.
• UK has artificially constrained housing supply, with prices too high for young people to afford.
– No political path to cheaper housing policies, except inflation.
• Some European countries have poorly functioning rental markets.
– Forces young people to live at home.
– Are they classified as renters (from their parents)? I doubt it.
– Homeownership statistics probably distorted by poor rental markets.
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Housing Subsidies
• Deductibility of mortgage interest and property taxes offset by the high level of property taxes in the U.S.
– State and local governments undo the subsidy.
• Important issue is subsidies of renting versus buying.
– Depends on assumptions about marginal investor in real estate, including homeowner.
• Issue needs to be re‐thought if we move to a consumption tax.
– Also needs to take into account endogeneity of contributions to tax‐exempt retirement savings.
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Comment on Housing Subsidies
• Subsidies are very political:
– Large subsidies in CA and Northeast, where wealthy Democrats live in expensive cities with NIMBA land‐use planning which increases house price sensitivity to policy changes.
– Low subsidies in Republican heartland, where poor Republicans live in cheap house priced off new construction costs.
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A Proposal: Mortgage interest only deductible if mortgage is no‐recourse.
• Eliminates incentives for inflated appraisals to justify moving credit card debt to mortgage
– Provides more transparency to home buyers.
• Making default easier implies larger downpayments, thus reducing leverage and systemic risk.
– Easier defaults provides better geographic risk sharing.
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Is Homeownership a Worthwhile Policy Goal?
• People may underestimate returns to “investing” in housing.
• Renters are short‐run participants in communities.
• Do homeowners invest more in neighborhood?
• Do homeowners get stuck in declining neighborhoods they need to leave?
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Foreclosures
• Difficult questions of two‐sided asymmetric information between borrower and lender.
• Exactly the kind of process that the government does poorly.
• GSEs in conservatorship probably a bad structure for making efficient decisions.
– Unless “commitment” to be soft but arbitrary is desirable.
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