The Miraculous Continuous Workout Mortgage

Professor Robert Shiller

Nobel Prize winner Robert Shiller et al. have posted Continuous Workout Mortgages: Efficient Pricing and Systemic Implications to SSRN. The paper opens,

The ad hoc measures taken to resolve the subprime crisis involved expending financial resources to bail out banks without addressing the wave of foreclosures. These short-term amendments negate parts of mortgage contracts and question the disciplining mechanism of finance. Moreover, the increase in volatility of house prices in recent years exacerbated the crisis. In contrast to ad hoc approaches, we propose a mortgage contract, the Continuous Workout Mortgage (CWM), which is robust to downturns. We demonstrate how CWMs can be offered to homeowners as an ex ante solution to non-anticipated real estate price declines.

The Continuous Workout Mortgage (CWM, Shiller (2008b)) is a two-in-one product: a fixed rate home loan coupled with negative equity insurance. More importantly its payments are linked to home prices and adjusted downward when necessary to prevent negative equity. CWMs eliminate the expensive workout of defaulting on a plain vanilla mortgage. This subsequently reduces the risk exposure of financial institutions and thus the government to bailouts. CWMs share the price risk of a home with the lender and thus provide automatic adjustments for changes in home prices. This feature eliminates the rational incentive to exercise the costly option to default which is embedded in the loan contract. Despite sharing the underlying risk, the lender continues to receive an uninterrupted stream of monthly payments. Moreover, this can occur without multiple and costly negotiations. (1, references omitted)

If it is not obvious, this is a radical idea.  It was not even contemplated before the financial crisis. That being said, it is pretty brilliant financial innovation, one that should not just be discussed by academics. The paper provides a lot more detail about the proposal for those who are interested. And if you want to avoid taxpayer bailouts of the housing market in the future, you should be interested.

Treasury Gives RMBS a Workout

The Treasury has undertaken a Credit Rating Agency Exercise. According to Michael Stegman, Treasury

recognized that the PLS market has been dormant since the financial crisis partly because of a “chicken-and-egg” phenomenon between rating agencies and originator-aggregators. Rating agencies will not rate mortgage pools without loan-level data, yet originator-aggregators will not originate pools of mortgage bonds without an idea of what it would take for the bond to receive a AAA rating.

Using our convening authority, Treasury invited six credit rating agencies to participate in an exercise over the last several months intended to provide market participants with greater transparency into their credit rating methodologies for residential mortgage loans.

By increasing clarity around loss expectations and required subordination levels for more diverse pools of collateral, the credit rating agencies can stimulate a constructive market dialogue around post-crisis underwriting and securitization practices and foster greater confidence in the credit rating process for private label mortgage-backed securities (MBS). The information obtained through this exercise may also give mortgage originators and aggregators greater insight into the potential economics of financing mortgage loans in the private label channel and the consequent implications for borrowing costs.

While this exercise is very technical, it contains some interesting nuggets for a broad range of readers. For instance,

The housing market, regulatory environment, and loan performance have evolved significantly from pre-crisis to present day. Credit rating agency models appear to account for these changes in varying ways. All credit rating agency models incorporate the performance of loans originated prior to, during, and after the crisis to the degree they believe best informs the nature of credit and prepayment risk reflected in the market. Credit rating agency model stress scenarios may be influenced by loans originated at the peak of the housing market, given the macroeconomic stress and home price declines they experienced. The credit rating agencies differ, however, in how their models adjust for the post-crisis regime of improved underwriting practices and operational controls. Some credit rating agencies capture these changes directly in their models, while other credit rating agencies rely on qualitative adjustments outside of their models. (10)

It is important for non-specialists to realize how much subjectivity can be built into rating agency models. Every model will make inferences based on past performance. The exercise highlights how different rating agencies address post-crisis loan performance in significantly different ways. Time will tell which ones got it right.