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.
December 1, 2014
Smith and Harper have posted Home Equity Insurance & The Demise of Home Value Insurance Corporation to SSRN. The abstract reads,
This study uses the demise of the Home Value Insurance Company (HVIC) to explore whether the concept of home equity insurance is implementable. Shiller, R. and Weiss, A. (1999) and Goetzmann, W., Caplin, A., Hangen, E., Nalebuff, B., Prentce, E., Rodkin, J., Spiegel, M. and Skinner, T. (2003) have provided a platform to evaluate this concept by questioning whether a product that allows homeowners to transfer the risk associated with a decline in housing prices should be structured as insurance. This study explores the cost associated, in the U.S. Real Estate Market, with this risk transfer process in the pre- and post-mortgage crisis periods by simulating the cost of insurance using the theoretical pricing of ATM (at the money) put options based upon the Black Scholes Option Pricing Model from 1989 to 2013. As the U.S. Housing Market transitioned from the pre-crisis to the post-crisis periods the hypothetical breakeven cost of insurance increased from 0.60% to 20.85% of the starting value of the index. The demise of HVIC seems to be a cautionary tale: Given the recent changes in the underlying dynamics of the U.S. Real Estate Market it does not seem prudent (for insurers) to use insurance contracts to transfer the risk associated with a decline in the value of U.S. Residential Equity Wealth.
This is all a bit technical, but basically it is an investigation of a clever idea that did not seem to pan out. Robert Shiller and others proposed that home owners could insure against a decrease in the value of their home. But a company based on that proposal failed in its first year of operation. The article finds that the cost of such insurance would be unsustainable. I am not sure that this article definitively demonstrates that this concept is impossible to implement, but it certainly raises a lot of questions that would need to be answered if someone were to want to give it another go.
November 28, 2014
The Urban Institute’s Housing Finance Policy Center has posted a research report, Measuring Mortgage Credit Availability Using Ex-Ante Probability of Default. This report tackles an important subject:
How to strike a balance between credit availability and risk to achieve a sustainable housing market is a much-debated topic today, but these discussions are not grounded in good measurements of credit availability and risk. We address this problem below with a new index that measures credit availability and risk simultaneously
November 27, 2014
In the morning as the storm begins to blow away
the clear sky appears for a moment and it seems to me
that there has been something simpler than I could ever
simpler than I could have begun to find words for
not patient not even waiting no more hidden
than the air itself that became part of me for a while
with every breath and remained with me unnoticed
something that was here unnamed unknown in the days
and the nights not separate from them
not separate from them as they came and were gone
it must have been here neither early nor late then
by what name can I address it now holding out my thanks
by W.S. Merwin from The Pupil
November 26, 2014
The New York City Council released a report, Engines of Opportunity: Reinvigorating New York City’s Manufacturing Zones for the 21st Century. I am always worried that discussions of increasing manufacturing jobs, especially in a city as expensive as New York, are informed by a romantic vision of a past that cannot be recaptured. This report seems to be aware of that trap. It focuses on marginal improvements that can be made to support the kind of manufacturing and creative economy jobs that can survive the brutal competition for space and skilled employees that New York companies have to deal with.
The report makes three land use policy recommendations:
November 25, 2014
The Urban Institute has posted its November Housing Finance At A Glance. This is a really valuable resource. The introduction provides a nice overview of recent developments in the area: