Credit Risk Transfer and Financial Crises

photo by Dean Hochman

Susan Wachter posted Credit Risk Transfer, Informed Markets, and Securitization to SSRN. It opens,

Across countries and over time, credit expansions have led to episodes of real estate booms and busts. Ten years ago, the Global Financial Crisis (GFC), the most recent of these, began with the Panic of 2007. The pricing of MBS had given no indication of rising credit risk. Nor had market indicators such as early payment default or delinquency – higher house prices censored the growing underlying credit risk. Myopic lenders, who believed that house prices would continue to increase, underpriced credit risk.

In the aftermath of the crisis, under the Dodd Frank Act, Congress put into place a new financial regulatory architecture with increased capital requirements and stress tests to limit the banking sector’s role in the amplification of real estate price bubbles. There remains, however, a major piece of unfinished business: the reform of the US housing finance system whose failure was central to the GFC. Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs), put into conservatorship under the Housing and Economic Recovery Act (HERA) of 2008, await a mandate for a new securitization structure. The future state of the housing finance system in the US is still not resolved.

Currently, US taxpayers back almost all securitized mortgages through the GSEs and Ginnie Mae. While pre-crisis, private label securitization (PLS) had provided a significant share of funding for mortgages, since 2007, PLS has withdrawn from the market.

The appropriate pricing of mortgage backed securities can discourage lending if risk rises, and, potentially, can limit housing bubbles that are enabled by excess credit. Securitization markets, including the over the counter market for residential mortgage backed securities (RMBS) and the ABX securitization index, failed to do this in the housing bubble years 2003-2007.

GSEs have recently developed Credit Risk Transfers (CRTs) to trade and price credit risk. The objective is to bring private market discipline to bear on risk taking in securitized lending. For the CRT market to accomplish this, it must avoid the failures of financial assets to price risk. Are prerequisites for this in place? (2, references omitted)

Wachter partially answers this question in her conclusion:

CRT markets, if appropriately structured, can signal a heightened likelihood of systemic risk. Capital markets failed to do this in the run-up to the financial crisis, due to misaligned incentives and shrouded information. With sufficiently informed and appropriately structured markets, CRTs can provide market based discovery of the pricing of risk, and, with appropriate regulatory and guarantor response, can advance the stability of mortgage finance markets. (10)

Credit risk transfer has not yet been tested by a serious financial crisis. Wachter is right to bring a spotlight on it now, before events in the mortgage market overtake us.

Optimizing Principal Modifications

S&P posted How Principal And Interest Rate Modifications Affect U.S. RMBS. Principal modifications — reducing the amount that the homeowner owes on the loan — have not been popular with lenders for obvious reasons. But they have also not been popular with politicians and even with the general populace for reasons that likely derive from variants of moral hazard: it just isn’t fair that some people don’t have to repay their debts. And if we give some people an out, won’t everyone else want one too?

Perhaps the better question to ask is whether principal modifications reduce defaults compared to other steps that lenders have taken with defaulting borrowers. S&P has looked at this question and they found “that even though rate reductions are the most common form of modification, principal reductions offer the most benefit to borrowers looking to avoid default.” (2)

While principal mods are good for borrowers — no big surprise there — their impact on investors is not so clear cut. S&P writes that

When it comes to principal reductions, investors can also have different outcomes based on the deal structure. A write-down in loan principal will cause an immediate reduction in credit enhancement, and bondholders would face greater exposure to collateral losses. But for deals with cumulative loss triggers, senior bondholders can receive extra principal diverted from subordinate classes once the triggers are tripped, thereby accelerating their recovery. . . . [S]tructural provisions and interest and principal payment mechanisms in RMBS transactions influence how loan modifications affect bondholders in RMBS transactions. Any type of modification brings with it nuances that may benefit the borrower while having a varied impact on investors. (5)

As we learn lessons that may apply in the next crisis, it is worth realizing that borrower workouts and investor outcomes are linked in ways that should be explicitly identified so that incentives can be properly aligned. With planning, mortgage-backed securities can be structured to be good for borrowers and investors, perhaps even Pareto optimal.