Tag Archives: financial crisis

Shiller on Primitive Housing Finance

Posted on by

Robert Shiller has posted Why Is Housing Finance Still Stuck in Such a Primitive Stage? The abstract for this brief discussion paper reads:

The institutions for financing owner-occupied housing have not progressed as they should, and the financial innovation that has followed the financial crisis of 2007-9 has not been focused on improving the risk management of individual homeowners. This paper lists a number of barriers to housing finance innovation, and in light of these barriers, the problems of some major innovations of the past and future: self-amortizing mortgages, price-level adjusted mortgages (PLAMs), shared appreciation mortgages (SAMs), housing partnerships, and continuous workout mortgages (CWMs). (1)

The paper is more of an outline than a fleshed out argument, but it has some interesting points (and not just because the author recently won a Nobel Memorial Prize in Economics).  They include

  • Shared appreciation mortgages (SAMs), which offered some risk management of home price appreciation, were offered by the Bank of Scotland and Bear Stearns in the 1990s, but acquired a damaged reputation with the boom in home prices. U.K. homeowners who took such mortgages, and lost out on the speculative gains, were so angered that they filed a class-action lawsuit against the issuers. The suit was dropped, but the reputation loss was permanent. (5)

  • There has been some questioning of the assumption that insuring homeowners against a decline in home value is a good thing. Sinai and Soulelis (2014) have written that the existing  mortgage institutions may be close to optimal given that people want to live in their house forever, or move to a similar house whose price is correlated with the present house, and so are perfectly hedged. But their paper cannot be exactly right, given the sense of distress that homeowners are experiencing who are underwater. They are more certainly not right about all homeowners, many of whom actually plan to sell their home when they retire. (5-6)

  • The difficulties in making improvements in mortgage institutions have to do with the complexity of the risk management problem, coupled with mistrust of institutional players. The Consumer Financial Protection Bureau, created by the Dodd-Frank Act and having authority over mortgages, among other things, seems oriented towards addressing complaints from the public, and has focused its attention so far on such things as unfair collection practices, bias against minorities, and excessive complexity of financial products being used to confuse customers. These are laudable concerns, but complaints that economists might register about the fundamental success of mortgage products to serve risk management well have not yet taken center stage. (6)

  • New Development economics, Karlan and Appel (2011), Bannerjee and Duflo (2012) has shown how carefully controlled experiments can reveal solid steps to take regarding new financial institutions for poverty reduction. The same methods could be used to improve mortgage institutions, as well as rental, leasing, partnership and cooperative institutions, in advanced countries. (7)

These are just brief thoughts. It will be interesting to see how Shiller develops them further.

Mortgage REITs and Other Frights

Posted on by

The Office of Financial Research in the Department of the Treasury has released its 2013 Annual Report. It describes a number of things that should scare you as you put your head on your pillow at night and dream of the financial markets. It also describes some important steps that OFR is taking to get a handle on these potential nightmares.

One of the nightmares, relevant to readers of this blog, are Mortgage REITs. Mortgage Real Estate Investment Trusts (REITs) are “leveraged investment vehicles that borrow shorter-term funds in the repo market and invest in longer-term agency mortgage-backed securities (MBS).” (16) OFR identifies serious problems in this subsector:

Mortgage REITs have grown nearly fourfold since 2008 and now own about $350 billion of MBS, or 5 percent of the agency MBS market. Two firms dominate the sector, collectively holding two-thirds of assets. By leveraging investor funds about eight times, mortgage REITs returned annual dividend yields of about 15 percent to their investors over the past four years, when most fixed-income investments earned far less.Mortgage REITs obtain nearly all of their leverage in the repo market, secured by MBS collateral.

Lenders typically require that borrowers pledge 5 percent more collateral than the value of the loan,which implies that a mortgage REIT that is leveraged eight times must pledge more than 90 percent of its MBS portfolio to secure repo financing, leaving few unencumbered assets on its balance sheet. If repo lenders demand significantly more collateral or refuse to extend credit in adverse circumstances, mortgage REITs may be forced to sell MBS holdings. Timely asset liquidation and settlement may not be feasible in some cases, since a large portion of agency MBS trades occurs in a market that settles only once a month . . ..

Although their MBS holdings account for a relatively small share of the market, distress among mortgage REITs could have impacts on the broader repo market because agency MBS accounts for roughly one-third of the collateral in the triparty repo market. Mortgage REITs also embody interest rate and convexity risks, concentration risk, and leverage. For these reasons, forced-asset sales by mortgage REITs could amplify price declines and volatility in the MBS market and  broader funding markets, particularly in an already stressed market. (17)

Sounds like systemic risk to me.

Happily, the report also contains policy proposals to address some of these systemic risk concerns. First and foremost, it proposes the adoption of a Financial Stability Monitor tool to track financial threats. The OFR also proposes mortgage-specific tools. Reiterating the findings in a recent OFR white paper, the report calls for the creation of a universal mortgage identifier so that regulators and researchers can more quickly identify patterns in the mortgage market. Predicting financial crises is still more of an art than a science but it is a good development that OFR is trying to improve the quality of the data that regulators and researchers have about the financial market.

Borden & Reiss on REMIC Failure, in a Big Way

Posted on by

Brad and I posted REMIC Tax Enforcement as Financial-Market Regulator to SSRN (as well as to BePress). The article is forthcoming in the University of Pennsylvania Journal of Law and Business and it provides our extended analysis of how the organizers of purported Real Estate Mortgage Investment Conduits (REMICs) failed to abide by the requirements necessary to obtain the favorable REMIC tax status. We had addressed this topic in shorter articles here, here, and here, but this is our most comprehensive take on the subject. We look forward to hearing reactions to it.

The abstract reads:

Lawmakers, prosecutors, homeowners, policymakers, investors, news media, scholars and other commentators have examined, litigated, and reported on numerous aspects of the 2008 Financial Crisis and the role that residential mortgage-backed securities (RMBS) played in that crisis. Big banks create RMBS by pooling mortgage notes into trusts and selling interests in those trusts as RMBS. Absent from prior work related to RMBS securitization is the tax treatment of RMBS mortgage-note pools and the critical role tax enforcement should play in ensuring the integrity of mortgage-note securitization.

This Article is the first to examine federal tax aspects of RMBS mortgage-note pools formed in the years leading up to the Financial Crisis. Tax law provides favorable tax treatment to real estate mortgage investment conduits (REMICs), a type of RMBS pool. To qualify for the favorable REMIC tax treatment, an RMBS pool must meet several requirements relating to the ownership and quality of mortgage notes. The practices of loan originators and RMBS organizers in the years leading up to the Financial Crisis jeopardize the tax classification of a significant portion of the RMBS pools. Nonetheless, the IRS appears to believe that there is no legal or policy basis for challenging REMIC classification of even the worst RMBS pools. This Article takes issue with the IRS’s inaction and presents both the legal and policy grounds for enforcing tax law by challenging the REMIC classification of at least the worst types of RMBS pools. The Article urges the IRS to take action, recognizing that its failure to police these arrangements prior to the Financial Crisis is partly to blame for the economic meltdown in 2008. The IRS’s continued failure to police RMBS arrangements provides latitude to industry participants, which facilitates future economic catastrophes. Even without the IRS taking action, private parties can rely upon the blueprint set forth in the Article to bring qui tam or whistleblower claims to accomplish the purposes of the REMIC rules and obtain the beneficial results that would occur if the IRS enforced the REMIC rules.