Editor: David Reiss
Brooklyn Law School

November 10, 2017

How Important Is Skin in The Game?

By David Reiss

Haoyang Liu has posted a paper to SSRN that challenges the effectiveness of skin-in-the-game market discipline: Does Skin-in-the-Game Discipline Risk Management? Evidence from Mortgage Insurance. The abstract reads,

Many mortgage reform proposals suggest replacing Fannie Mae and Freddie Mac (the GSEs) with private entities. A common assumption underlying these proposals is that unlike the GSEs, private insurers will properly manage risk and set fair prices. Inconsistent with this assumption, this paper presents evidence that private insurers less effectively managed home price risks during the 2000-2006 housing boom than the GSEs did. Mortgage origination data reveal that the GSEs were selecting loans with increasingly higher percentages of down payments, or lower loan to value ratios (LTVs), in boom areas than in other areas. These lower LTVs in boom areas reduced the GSEs’ exposure to overheated markets. Furthermore, the decline of LTVs in boom areas stems entirely from the segment insured by the GSEs only, and none of the decline stems from the segment where private mortgage insurers take the first loss position. Private insurers also did not lower their exposure to home price risks along other dimensions, including the percentage of high LTV GSE loans they insured and the percentage of insured mortgage balance. My results highlight that post-crisis reform of the mortgage insurance industry should carefully consider additional factors besides moral hazard induced by the government guarantees, such as mortgage insurers’ future home price assumptions and the industry organization of the mortgage origination chain.

The paper’s conclusions are sobering for those interested in increasing the role of private capital in the mortgage market (including yours truly):

Many mortgage market reform proposals assume that private insurers will set fair prices and properly manage risk. Evidence from this paper suggests that private insurers less effectively managed home price risk during the 2000-2006 housing boom than Fannie and Freddie did.

These somewhat surprising results are nevertheless consistent with the history of the private mortgage insurance industry, including its repeated and concentrated failures. Most recently in the 2008 crash, three out of the eight largest private mortgage insurers failed. However, perhaps 31 overshadowed by the highly publicized and controversial bailout of the GSEs, private mortgage insurers’ failures have received relatively little attention from academics and the popular press. Many post-crisis proposals also assume that replacing the GSEs by private insurers would be a panacea. My results suggest that privatizing the GSEs alone is unlikely to ensure sufficient risk management in the mortgage insurance industry. Additional factors besides private capital, such as assumptions about future house prices and bargaining power of private insurers in front of large lenders, are important in shaping risk management practices. One way to establish reasonable house price assumptions is to stress test mortgage insurers, forcing the industry to consider their exposure to the housing downturn scenarios proposed by regulators.

The mortgage insurance industry plays a crucial role in financing Americans’ mortgages. Their insurance reduces or removes mortgage default risks, thereby enhancing the liquidity of mortgage backed securities and lowering homebuyers’ borrowing costs. The risks they face and the optimal regulatory structure for them deserve more study to prevent them from being a source of systemic risk in the financial system. (31-32)

The paper suggests that we should not expect that private mortgage insurers can play an outsized role in keeping us safe from booms and busts. They have succumbed to bubble thinking in the past and there is no reason to think that they would not in the future as well.

November 10, 2017 | Permalink | No Comments

November 9, 2017

Your Lender, The Federal Reserve Board

By David Reiss

photo by United States Federal Reserve

Federal Reserve Chair Yellen

Laurie Goodman and Bing Bai at the Urban Institute have posted Normalizing the Federal Reserve’s Balance Sheet The Impact on the Mortgage-Backed Securities Market. It is quite extraordinary to realize that the Federal Reserve owns nearly a third of outstanding residential mortgage-backed securities. When we think about the appropriate role of the government in the housing finance market, we cannot forget about this type of involvement. The paper opens,

During the crisis, the Federal Reserve found the traditional tools for monetary policy insufficient to stimulate the economy. From December 2008 to December 2015, the Fed’s primary policy tool, the target Fed funds rate, was set between 0 and 0.25 percent. But the economy remained weak, and there was no room to cut rates further. As a result, the Fed began to purchase large quantities of assets from the private sector. These programs are referred to as quantitative easing or large-scale asset purchases. The Fed owned $1.77 trillion of agency mortgage-backed securities (MBS) and $2.45 trillion of US Treasury securities (Treasuries) in late September 2017 and began to reduce the amount of these portfolio holdings in October 2017.

Some background: Since the Great Recession, the Fed has done three rounds of quantitative easing. From November 2008 to March 2010, it purchased $1.75 trillion in long-term Treasuries, Fannie Mae and Freddie Mac agency debentures, and agency mortgage-back securities (comprising Ginnie Mae, Fannie Mae, and Freddie Mac issuances). From November 2010 to June 2011, the Fed purchased an additional $600 billion of Treasuries. From September 2012 to September 2014, the Fed engaged in its third round of quantitative easing, initially purchasing $85 billion a month in Treasuries and agency debt and MBS, with $40 billion of agency MBS. The Fed began to taper its purchases in December 2013 and ended the program in October 2014. From October 2014 through September 2017, the Fed has reinvested its runoff. Through these actions, the Fed owned $1.77 trillion of agency MBS, nearly 29 percent of all outstanding MBS as of late September 2017.

The Federal Open Market Committee announced on September 20, 2017, that it would begin to normalize its balance sheet in October 2017. The committee has been transparent about the course. It will begin by reducing the reinvestment rates on its portfolio. In months 1 through 3, the Fed would let the System Open Market Account (SOMA) portfolio run off by $10 billion each month, increasing to $20 billion in months 4 through 6, $30 billion in months 6 through 9, $40 billion in months 10 through 12, and $50 billion a month thereafter. The maximum runoff in each month, if met, would comprise 60 percent Treasuries and 40 percent MBS. If there is not enough runoff in that month, the Fed will not sell to meet these targets.

Although this timetable is clear, additional questions arise about the MBS portfolio that the Fed should shed some light on. The largest questions include the following: What size and mix of assets does the Fed eventually want to hold? And how does it intend to get there? In this brief, we argue that this is not an academic exercise. When the Fed reaches its desired balance sheet size, it will hold approximately $1.18 trillion in mortgage assets. It will take a long time for these to run off if there is no selling. This may be fine, but the Fed has made several comments that indicate it could sell the “residual.” For example, the minutes of the September 2014 meeting includes the following statement:

The Committee currently does not anticipate selling agency mortgage-backed securities as part of the normalization process, although limited sales might be warranted in the longer run to reduce or eliminate residual holdings. The timing and pace of any sales would be communicated to the public in advance.

It is not at all clear what constitutes a “residual.”

This brief has four sections. The first shows that under assumptions reasonably close to what the Fed has used, there will still be close to $1.18 trillion of MBS on its books when the Fed balance sheet normalizes. We then review the arguments about the Fed’s long-term desired portfolio mix. If it is Treasuries only, this raises questions about whether and how quickly the Fed should change its mortgage and treasury mix to avoid making asset allocation decisions that distort financial markets. In the third section, we argue that the Fed should do some active portfolio management while they are still doing a small amount of reinvestment. Finally, we make the case that the Fed could play a costless and helpful role in launching the single government-sponsored enterprise (GSE) security. (1-2)

The paper raises some important policy questions:

There has been considerable discussion on what role mortgages should play in the Fed’s portfolio. There is general but not universal agreement that the Fed should not be in the asset allocation business over the long term because it distorts financial market prices. Lawrence White has stated that “government programs that divert credit away from the most productive uses, as evaluated by the marketplace, are inherently wasteful, even if policymakers have the best of intentions.” Charles Plosser, a former president of the Federal Reserve Bank of Philadelphia, sees additional dangers, noting that holding securities other than Treasuries opens the door for Congress (or the Fed) to use the balance sheet for political purposes. The Fed’s balance sheet could be “a huge intermediary and supplier of taxpayer subsidies to selected parties through credit allocation.” For example, if there was an infrastructure bill, the funds could be used to purchase the bonds that support the infrastructure initiative. Similarly, the funds could be used to purchase bonds to keep a municipality from defaulting. (9, citations omitted)

The Fed should address these policy questions head on, before any unintended consequences of such a dramatic policy intervention make themselves known.

November 9, 2017 | Permalink | No Comments

Thursday’s Advocacy & Think Tank Roundup

By Jamila Moore

  • Freedom Debt Relief (Freedom) is in hot water. The Consumer Finance Protection Bureau (CFPB) accused the nation’s leading debt settlement entity of lying to its customers. Allegedly, Freedom misled its customers by claiming the entity’s capabilities to settle debt with third parties. Customers were “led to believe Freedom possessed clout” with creditors across the nation. Freedom purported to consumers it could use its clout to settle debt for lower rates than consumers attempting to do such on their own.
  • The Urban Institute (UI) studied housing issues in rural communities across America. The study found rural communities, much like many Americans, cannot afford the housing in their local areas. For instance, Illinois minimum wage is $8.25 per hour; however, in order for one to afford a two-bedroom in Cairo, Illinois he or she must earn $13 per hour. Further, only 25% of housing is available for rent and new constructs are stale and non-existent.

November 9, 2017 | Permalink | No Comments

November 8, 2017

Regulatory Approaches to Airbnb

By David Reiss

photo by Open Grid Scheduler

Peter Coles et al. have posted Airbnb Usage Across New York City Neighborhoods: Geographic Patterns and Regulatory Implications to SSRN. Two of the co-authors are affiliated to Airbnb and the other three are affiliated to NYU. The paper states that “No consulting fees, research grants or other payments have been made by Airbnb to the NYU authors . . .” (1) The abstract reads,

This paper offers new empirical evidence about actual Airbnb usage patterns and how they vary across neighborhoods in New York City. We combine unique, census-tract level data from Airbnb with neighborhood asking rent data from Zillow and administrative, census, and social media data on neighborhoods. We find that as usage has grown over time, Airbnb listings have become more geographically dispersed, although centrality remains an important predictor of listing location. Neighborhoods with more modest median household incomes have also grown in popularity, and disproportionately feature “private room” listings (compared to “entire home” listings). We find that compared to long-term rentals, short-term rentals do not appear to be as profitable as many assume, and they have become relatively less profitable over our time period. Additionally, short-term rentals appear most profitable relative to long-term rentals in outlying, middle-income neighborhoods. Our findings contribute to an ongoing regulatory conversation catalyzed by the rapid growth in the short-term rental market, and we conclude by bringing an economic lens to varying approaches proposed to target and address externalities that may arise in this market.

I found the review alternative regulatory approaches to be particularly helpful:

City leaders around the world have adopted a wide range of approaches. We conclude by reviewing these alternative regulatory responses. We consider both citywide as well as neighborhood-specific responses, like those recently enacted in Portland, Maine or in New Orleans. A promising approach from an economic perspective is to impose fees that vary with intensity of usage. For instance, in Portland, Maine, short-term rental host fees increase with the number of units a given host seeks to register, and a recent bill from Representatives in the Commonwealth of Massachusetts (H.3454) propose taxes that vary with the intensity of usage of individual units. Such varying fees may help discourage conversions of long-term rentals to short-term rentals and better internalize externalities that might rise with greater use. That said, overly-customized approaches may be difficult to administer. Regulatory complexity itself should also be a criterion in choosing policy responses. (2-3, citations omitted)

We are still a long ways off from knowing how the short-term rental market will be regulated once it fully matures, so work like this helps us see where we are so far.

November 8, 2017 | Permalink | No Comments

November 7, 2017

Insuring Sustainable Housing

By David Reiss

photo by Mark Moz

I posted Insuring Sustainable Housing to SSRN (and BePress). The abstract reads,

Today’s FHA suffered from many of the same unrealistic underwriting assumptions that have done in so many lenders during the 2000s. It had also been harmed, like other lenders, by a housing market as bad as any seen since the Great Depression. As a result, the federal government announced in 2013 that the FHA would require the first bailout in its history. At the same time that it faced these financial challenges, the FHA has also come under attack for the poor execution of some of its policies to expand homeownership. Leading commentators have called for the federal government to stop employing the FHA to do anything other than provide liquidity to the low end of the mortgage market. These arguments rely on a couple of examples of programs that were clearly failures but they fail to address the FHA’s long history of undertaking comparable initiatives. This article takes the long view and demonstrates that the FHA has a history of successfully undertaking new homeownership programs. At the same time, the article identifies flaws in the FHA model that should be addressed in order to prevent them from occurring if the FHA were to undertake similar initiatives in the future.

This short article is drawn from Underwriting Sustainable Homeownership: The Federal Housing Administration and The Low Down Payment Loan, 50 GA. L. REV. 1019 (2016).

November 7, 2017 | Permalink | No Comments

Tuesday’s Regulatory & Legislative Roundup

By Jamila Moore

  • Though the Trump Administration is aiming to dethrone Consumer Financial Protection Bureau’s leader, Richard Cordray. Cordray recently was found not guilty for his alleged Hatch Act violation. As a result, the Trump administration will have to determine another way to eject Cordray from office. Furthermore, the Office of Special Counsel found no evidence to convict Cordray of a violation.
  • The Republican’s Tax Reform plan will not pass without a fight. Tax cuts and the Jobs Act will reek havoc on the mortgage industry by decreasing mortgage interest deductions and reducing the time-frames in which a homeowner may claim a capital gains exemption. According to critics, the impact will affect California more than any other state.

November 7, 2017 | Permalink | No Comments