Friday’s Government Reports Roundup

Wednesday’s Academic Roundup

Mortgage Leverage and Bubbles

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)

Mortgage REITs and Other Frights

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.

Leverage and the Foreclosure Crisis

Dean Corbae and Erwan Quintin have posted Leverage and the Foreclosure Crisis to SSRN (behind a paywall; available here for free). They ask how “much of the recent rise in foreclosures can be explained by the large number of high-leverage mortgage contracts originated during the housing boom?” (1) Their model and counterfactual experiments suggest that “the increased availability of high-leverage loans prior to the crisis can explain between 40% and 65% of the initial rise in foreclosure rates.” (1)

In their introduction, they note that
The increased availability of loans with low downpayments made it possible for more households to obtain the financing necessary to purchase a house. At the same time however,because these contracts are characterized by little equity early in the life of the loan, they are prone to default when home prices fall. Not surprisingly then, mortgages issued during the recent housing boom with high leverage have defaulted at much higher frequency than other loans since home prices began their collapse in late 2006. (2, citations omitted)
Their finding are, as they note, not so surprising, although it is interesting to see them try to quantify the effect of low-downpayment mortgages.
More importantly, their paper will help inform the ongoing debate as to whether federal regulators should impose strict down-payment underwriting requirements upon lenders or whether they should allow lenders to develop more dynamic underwriting models for which downpayment requirements are just one factor.