December 10, 2014
Albert Alex Zevelev has posted Regulating Mortgage Leverage: Fire Sales, Foreclosure Spirals and Pecuniary Externalities to SSRN. The abstract reads,
The US housing boom was accompanied by a rise in mortgage leverage. The subsequent bust was accompanied by a rise in foreclosure. This paper introduces a dynamic general equilibrium model to study how leverage and foreclosure affect house prices. The model shows how foreclosure sales, through their effect on housing supply, amplify and propagate house price drops. A calibration to match the bust shows consumption and housing need to be sufficiently complementary to fit the data. Since leverage plays a key role in foreclosure, a regulator can reduce systemic risk by placing a cap on leverage. Counterfactual experiments show that in a world with less leverage, the same economic shock leads to less foreclosure and less severe, shorter busts in house prices. A 90% cap on loan-to-value ratios in 2006 predicts house prices would have fallen 12% rather than 18% as in the data. The regulator faces a trade-off in that less leverage means less housing for constrained households, but also fewer foreclosures and less severe busts in house prices. A regulator with reasonable preference parameters would choose a cap of 95%.
This is pretty important stuff as it attempts to model the impact of different LTV ratios on prices and foreclosure rates. Now Zevelev is not the first to see these interactions, but it is important to model how consumer finance regulation (for instance, loan to value ratios) can impact systemic risk. This is particularly important because many commentators downplay that relationship.
I am not in a position to evaluate the model in this paper, but its conclusion is certainly right: “Leverage makes our economy fragile by increasing the risk of default. It is clear that
foreclosure has many externalities and they are quantitatively significant. Since borrowers
and lenders do not fully internalize these externalities, there is a case for regulating mortgage leverage.” (31)
December 9, 2014
The Government Accountability Office issued a report, Multiple Factors Influence Extent of Transit-Oriented Development. The GAO writes that
December 8, 2014
Kathleen Engel posted Can Consumer Law Solve the Problem of Complexity in U.S. Consumer Credit Products? to SSRN. The abstract reads,
People like to know and understand the total cost of credit products they are considering. They also like to know and understand products’ terms and features. Given these preferences, issuers of credit should market products with transparent features and simple pricing. That is not the case. In fact, over the last few decades we have seen a plethora of complex terms in products such as mortgage loans, credit cards, and prepaid debit cards.
As credit products have become ever more complex, consumers have more choices and can select products that satisfy their particular needs and preferences. No longer are borrowers limited to a 30-year, fixed-rate mortgage. If they know they will be moving in a few years, a 3-year fixed-rate mortgage with a low interest rate that converts to a 27-year adjustable rate mortgage based on the LIBOR might be the right product for them. However, for borrowers who do not understand the complexities of a 3-27 mortgage loan, the low, initial interest rate could be a costly lure. Confusion is commonplace. In one study giving consumers a choice between two credit cards that varied only in terms of the annual fee and the interest rate, forty percent of the participants chose the more expensive card.
One would expect that consumers, who cannot decipher terms and calculate the cost of complex products, would turn to those with easy-to-understand terms. There are some simple products on the market. Instead, consumers often misperceive that the more complex products are less expensive than the simple ones. They, thus, shun the products that would be in their best interest.
In this paper, I explain why borrowers make sub-optimal choices when selecting credit products. I then analyze whether extant laws could be used to address obfuscating complexity. I ultimately conclude that policy-makers should look to extra-legal remedies to protect consumers against exploitative complexity.
I find those “extra-legal remedies” to be the most interesting part of this paper. Engel writes,
The approach I find most appealing is to use digital technology to help consumers make decisions. A software program would act like an agent, helping consumers determine what they could afford, what product would best meet their needs, and, lastly, would generate bids from providers of the product. Several goals motivate this idea: (1) the approach is preventative; (2) it does not require the courts to interpret vague standards; (3) it is less costly than litigation; (4) it protects unsophisticated consumers without requiring them to become sophisticated; and (5) it permits consumers to “pull” the information they need to select a product, rather than having issuers “push” hundreds of pages of information to them on multiple products. (24-25)
The paper does not explore how consumers would access this “choice agent,” but it is certainly an idea worth exploring. As some of my recent posts suggest, it is hard to rationally regulate for the entire population of consumers as they are a heterogeneous bunch. But it is important that we keep trying. Engel’s paper has some interesting ideas that are worth pursuing further.
December 4, 2014
The Philadelphia Fed has posted a Working Paper, Using Bankruptcy to Reduce Foreclosures: Does Strip-Down Of Mortgages Affect The Supply of Mortgage Credit? The paper’s abstract reads,
December 3, 2014
Fundweb quoted me in Stateside: My Kingdom for a House. It reads in part,
History repeats itself. In 1483, Richard III seized the British crown from his 13-year-old nephew on a trumped up legal sophistry. One justification was to prevent a return to the chaos of the War of the Roses, considered likely to resume under a child king. (Many historians believe he subsequently murdered those princes in the tower to dispense with future claims.)
Five centuries later, the issue of confiscation returns in the form of US government actions taken to stabilise the financial system during the 2008 credit crisis. The usurpation argument repeats that the end justifies the means and the rule of law may be subverted in perceived emergencies for the common good. Recent legal cases are challenging that principle, with momentous long- term consequences for the nation.
Specifically, in 2008, Congress enacted the Housing Economic and Recovery Act, which authorised loans to mortgage agencies Fannie Mae and Freddie Mac known as government-sponsored entities. The HERA law placed the GSEs in a conservatorship, giving the US government senior preferred shares in the companies, which paid the government a 10 per cent dividend.
Eventually, the GSEs became immensely profitable again, having now repaid $30bn more to the government than the original loan. In 2012, the conservator passed a third amendment, which transformed the 10 per cent preferred dividend to a sweep of all profits, forever.
Richard Bove, vice-president equity research at Rafferty Capital Markets, responds: ”If the government has the right to override any contract and can appropriate private property for itself, then contracts mean nothing in the US and the government is like Richard III.”
Politics of populism
Ultimately, the government may determine whether the GSEs survive or in what guise or how their profits are distributed.
“Politicians are carrying out what people want them to do. The public and the media maintain that if the bankers are harming society and the economy, there is no limitation on what the government can do,” says Bove. But beware. Investor confidence further erodes each time the government steps in to act unilaterally in the name of crisis control. The determinant is whether or not the country needs the GSEs to continue to underwrite mortgages and the answer is probably yes. Without them, there will be no one to under-write 30-year mortgages, “the monthly cost of owning a home will go up, prices will go down and it will kill housing in the US,” Bove insists.
Mel Watts, who was appointed this year as a new conservator, may represent a new direction for reshaping the GSEs. His recent speeches suggest he may be planning to merge the two agencies and liberate them from conservatorship status.
David Reiss, professor at Brooklyn Law School, points out another drawback to leaving the GSEs in limbo for six years. Executives, employees and others are now running for the exits, with turnover at the top. The agencies back 60 per cent of residential US mortgages but no longer know who they are. “It’s not healthy for homeowners or taxpayers,” says Reiss.
Investment War of the Roses
A number of hedge fund investors have rebelled, challenging the conservator’s behaviour. Marquee names include Perry Capital, Fairholme Funds and Pershing Square Capital Management. Their claims generally derive from assertions that the conservator illegally expropriated shareholder profits. The plaintiff hedge funds represent a motley crew, some of whom bought the stock after 2009, knowing they were picking up lottery tickets, and others well predating the conservatorship. From the sidelines, smaller investors watched keenly and joined the big boys’ ranks.
“People bought the stock only knowing that Icahn, Berkowitz and Ackmann had positions, so they followed like lemmings,” says Bove. To compound the confusion, most conventional wisdom from commentators lined up on one side. Many were openly remunerated by the shareholders, like New York University’s Richard Epstein.
Reiss adds that, “with no public speakers of equivalent prestige on the other side, it seemed inconceivable the investors might lose, which was a perfect set up for falling hard”.
Indeed they fell, with the recent ruling by Judge Royce Lamberth in the Perry hedge fund case. The court dismissed the suit with complex arguments but one theme undergirded the judge’s ruling: the government had acted forcefully in a financial emergency, authorised by Congress, which he hesitated to unwind.
December 2, 2014
Roberta Romano has posted an essay, Further Assessment of the the Iron Law of Financial Regulation: A Postscript to Regulating in the Dark, to SSRN. The abstract reads,
In an earlier companion essay, Regulating in the Dark, I contended that there is a systemic pattern in major U.S. financial regulation: (i) enactment is invariably crisis driven, adopted at a time when there is a paucity of information regarding what has transpired, (ii) resulting in off-the-rack solutions often poorly fashioned to the problem at hand, (iii) with inevitable flaws given the dynamic uncertainty of financial markets, (iv) but arduous to revise or repeal because of the stickiness of the status quo in the U.S. political framework of checks and balances. This pattern constitutes an “Iron Law” of U.S. financial regulation. The ensuing one-way regulatory ratchet generated by repeated financial crises has produced not only costly policy mistakes accompanied by unintended consequences but also a regulatory state whose cumulative regulatory impact produces over time an increasingly ineffective regulatory apparatus.
This Postscript analyzes the experience with regulators’ implementation of Dodd-Frank since the publication of the earlier essay. After a discussion of broad issues related to the statute and its implementation, the analysis focuses on two provisions by which Dodd-Frank exemplifies the difficulties that are created by legislative strategies conventionally adopted in crisis-driven legislation, off-the-rack solutions along with open-ended delegation to regulatory agencies as legislators, who perceive a political necessity to act quickly, adopt ready-to-go proposals offered by the policy entrepreneurs to whom they afford access: the Volcker rule, which prohibits banks’ proprietary trading, and the creation of the Consumer Financial Protection Bureau. The analysis bolsters the original essay’s contention regarding the inherent flaws in major financial legislation and the corresponding benefit for improving decision-making that would be obtained from employing, as best practice, the legislative tools of sunsetting and experimentation to financial regulation. The use of those techniques, properly implemented, advances means-ends rationality, by better coupling the two, and improves the quality of decision-making by providing a means for measuring and remedying regulatory errors.
This is a foray into the dark heart of financial regulation. Romano finds much to be unhappy with. I disagree, however, with some of her main points. For instance, I think that her assessment of the role of the CFPB in the broader context of financial regulation misses the mark. She argues that the “absence of a designated consumer-product regulator” did “not contribute to the financial crisis.” (28) In fact, regulating exotic loan terms like Option ARMs and teaser rates would have slowed the expansion of the subprime market. Those exotic terms allowed lenders to keep the party going longer than it would have otherwise. And that would have limited the exposure of financial institutions to subprime mortgage-backed securities.
Notwithstanding my disagreements with this essay, I think that Romano’s “Iron Law” of financial regulation remains, unfortunately, quite strong.