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private label securitization (PLS) had provided a significant share of funding for mortgages, since 2007, PLS has withdrawn from the market.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.

Evidence and Innovation in Housing

Lee Anne Fennell and Benjamin Keys have posted the Introduction to their new book, Evidence and Innovation in Housing Law and Policy, to SSRN. It opens,

No area of law and policy presents more important and pressing questions, or ones more central to human well-being, than that of housing. Yet academic discourse around housing is too often siloed into separate topical areas and disciplinary approaches, while remaining distanced from the contentious housing policy debates unfolding in communities across the nation. In June 2016, the Kreisman Initiative on Housing Law and Policy at the University of Chicago Law School convened a conference in downtown Chicago with the goal of breaking down these barriers and forging new connections – between different facets of housing law and policy, between different disciplinary approaches to housing issues, between academic inquiry and applied policy, and between the lessons of the past and adaptations for the future.

This volume is the product of that conference and the dialogue it provoked among academics, practitioners, and policy makers. Its baker’s dozen of contributions comprises cutting-edge interdisciplinary work on housing and housing finance from leading scholars in law, economics, and policy. The pieces individually and collectively showcase how research and policy can come together in the housing arena. We hope the end result will have lasting relevance in setting the course – and identifying the obstacles – for housing law and policy going forward.

This book is organized around two interlocking roles that housing serves: as a vehicle for building community, and as a vehicle for building wealth. These facets of housing carry implications both for the households who consume residential services and for the larger economic, political, and spatial domains in which housing plays such a primary and contentious role. Cumulatively, the pieces here confront, and respond innovatively to, the dilemmas that these two facets of housing create for law and policy at different scales of analysis. (1)

This collection of papers brings together an all-star cast of housing nerds. While the papers are an eclectic mix, they are pretty consistent in that they ask important questions about housing policy. Even better, the Introduction contains links to open access versions of each paper. They are listed below:

Part I – Housing and the Metropolis: Law and Policy Perspectives

1 – The Rise of the Homevoters: How the Growth Machine Was Subverted by OPEC and Earth Day By William A. Fischel

2 – How Land Use Law Impedes Transportation Innovation By David Schleicher

3 – The Unassailable Case against Affordable Housing Mandates By Richard A. Epstein

Part II – Housing as Community: Stability, Change, and Perceptions

4 – Balancing the Costs and Benefits of Historic Preservation By Ingrid Gould Ellen & Brian J. McCabe

5 – Historic Preservation and Its Even Less Authentic Alternative By Lior Jacob Strahilevitz

6 – Losing My Religion: Church Condo Conversions and Neighborhood Change By Georgette Chapman Phillips

7 – How Housing Dynamics Shape Neighborhood Perceptions By Matthew Desmond

Part III – Housing as Wealth Building: Consumers and Housing Finance

8 – Behavioral Leasing: Renter Equity as an Intermediate Housing Form By Stephanie M. Stern

9 – Housing, Mortgages, and Retirement By Christopher J. Mayer

10 – The Rise and (Potential) Fall of Disparate Impact Lending Litigation By Ian Ayres, Gary Klein, & Jeffrey West

Part IV – Housing and the Financial System: Risks and Returns

11 – Household Debt and Defaults from 2000 to 2010: The Credit Supply View By Atif Mian & Amir Sufi

12 – Representations and Warranties: Why They Did Not Stop the Crisis By Patricia A. McCoy & Susan Wachter

13 – When the Invisible Hand Isn’t a Firm Hand: Disciplining Markets That Won’t Discipline Themselves By Raphael W. Bostic & Anthony W. Orlando

Housing Booms and Busts

photo by Alex Brogan

Patricia McCoy and Susan Wachter have posted Why Cyclicality Matter to Access to Mortgage Credit to SSRN. The paper is now particularly relevant because of President Trump’s plan to roll back Dodd-Frank’s regulation of the financial markets, including the mortgage market. While McCoy and Wachter do not claim that Dodd-Frank solves the problem of cyclicality in the mortgage market, they do highlight how it reduces some of the worst excesses in that market. They make a persuasive case that more work needs to be done to reduce mortgage market cyclicality.

The abstract reads,

Virtually no attention has been paid to the problem of cyclicality in debates over access to mortgage credit, despite its importance as a driver of tight credit. Housing markets are prone to booms accompanied by bubbles in mortgage credit in which lenders cut underwriting standards, leading to elevated loan defaults. During downturns, these cycles artificially impede access to mortgage credit for underserved communities. During upswings, these cycles make homeownership unnecessarily precarious for many who attain it. This volatility exacerbates wealth and income disparities by ethnicity and race.

The boom-bust cycle must be addressed in order to assure healthy and sustainable access to credit for creditworthy borrowers. While the inherent cyclicality of the housing finance market cannot be fully eliminated, it can be mitigated to some extent. Mitigation is possible because housing market cycles are financed by and fueled by debt. Policymakers have begun to develop a suite of countercyclical tools to help iron out the peaks and troughs of the residential mortgage market. In this article, we discuss why access to credit is intrinsically linked to cyclicality and canvass possible techniques to modulate the extremes in those cycles.

McCoy and Wachter’s conclusions are worth heeding:

If homeownership is to attain solid footing, mitigating the cyclicality in the housing finance system will be imperative. That will require rooting out procyclical practices and requirements that fuel booms and busts. In their place, countercyclical measures must be instituted to modulate the highs and lows in the lending cycle. In the process, the goal is not to maximize homeownership per se; rather, it is to ensure that residential mortgages are made on safe and affordable terms.

*     *     *

Taming procyclicality in industry practices in housing finance is much farther behind and will require significantly more work. There is no easy fix for the procyclical effect of mortgage appraisals because appraisals are based on neighboring comparables. Similarly, procyclicality will require serious attention if the private-label securitization market returns. While the Dodd-Frank Act made modest reforms designed at curbing inflation of credit ratings, the issuer-pays system that drives grade inflation remains in place. Similarly, underpricing the risk of MBS and CDS will continue to be a problem in the absence of an effective short-selling mechanism and the effective identification of market-wide leverage. (34-35)

McCoy and Wachter offer a thoughtful overview of the risks that mortgage market cyclicality poses, but I am not optimistic that it will get a hearing in today’s Washington.  Maybe it will after the next bust.

Borrowing Constraints and The Homeownership Rate

photo by Victor

Arthur Acolin, Jess Bricker, Paul Calem and Susan Wachter have posted a short paper on Borrowing Constraints and Homeownership to SSRN. The abstract reads,

This paper identifies the impact of borrowing constraints on home ownership in the U.S. in the aftermath of the 2008 financial crisis. The existence of credit rationing in the U.S. mortgage market means that some households for whom it would be optimal to choose to be homeowners may not be able to do so. Borrowers with certain wealth, income and credit characteristics are unable to obtain a loan even if they are willing to pay a higher cost of credit (Linneman and Wachter 1989). The Stiglitz and Weiss (1981) canonical model sets up the rationale for this credit rationing. Using data from the 2001, 2004-2007 and 2010-2013 Surveys of Consumer Finance (SCF), this paper measures the impact of changes in the income, wealth and credit constraints on the probability of home ownership. Credit supply eased and then became considerably more restricted in the wake of the Great Recession. The loosening of borrowing constraints was accompanied by an increase in home ownership from the late 1990s until the start of the housing crisis. In this paper we estimate the role the tightening of credit has had on the probability of individual households to become homeowners and the decline in the aggregate home ownership rate following the crisis. The home ownership rate in 2010-2013 is predicted to be 5.2 percentage points lower than it would be if the constraints were at the 2004-2007 level and 2.3 percentage points lower than if the constraints were set at the 2001 level.

This paper builds on some of the other work of the authors (see here for instance) on the homeownership rate. The paper makes a valuable contribution by estimating the impact of credit rationing on the homeownership rate. To the extent we can identify an optimal amount of credit supply, it should help us to determine a target homeownership rate to guide policymakers.

Homeowner Nation or Renter Nation?

Andreas Praefcke

Arthur Acolin, Laurie Goodman and Susan Wachter have posted a forthcoming Cityscape article to SSRN, A Renter or Homeowner Nation? The abstract reads,

This article performs an exercise in which we identify the potential impact of key drivers of home ownership rates on home ownership outcomes by 2050. We take no position on whether these key determinants in fact will come about. Rather we perform an exercise in which we test for their impact. We demonstrate the result of shifts in three key drivers for home ownership forecasts: demographics (projected from the census), credit conditions (reflected in the fast and slow scenarios), and rents and housing cost increases (based on California). Our base case average scenario forecasts a decrease in home ownership to 57.9 percent by 2050, but alternate simulations show that it is possible for the home ownership rate to decline from current levels of around 64 percent to around 50 percent by 2050, 20 percentage points less than at its peak in 2004. Projected declines in home ownership are about equally due to demographic shifts, continuation of recent credit conditions, and potential rent and house price increases over the long term. The current and post WW II normal of two out of three households owning may also be in our future: if credit conditions improve, if (as we move to a majority-minority nation) minorities’ economic endowments move toward replicating those of majority households, and if recent rent growth relative to income stabilizes.

This article performs a very helpful exercise to help understand the importance of the homeownership rate.  This article continues some of the earlier work of the authors (here, for instance). I had thought that that earlier paper should have given give more consideration to how we should think about the socially optimal homeownership rate. Clearly, a higher rate, like the all-time high of 69% that we had right before the financial crisis, is not always better. But just as clearly, the projected low of 50% seems way too low, given long term trends. But that leaves a lot of room in between.

This article presents a model which can help us think about the socially optimal rate instead of just bemoaning a drop from the all-time high. It states that

Equilibrium in the housing market is reached when the marginal household is indifferent between owning and renting, requiring the cost of obtaining housing services through either tenure to be equal. In addition, for households, the decision to own or rent is affected by household characteristics and, importantly, expected mobility, because moving and transaction costs are higher for owners than for renters.  Borrowing constraints also affect tenure outcomes if they delay or prevent access to homeownership. (4-5)

This short article does not answer all of the questions we have about the homeownership rate, but it does answer some of them. For those of us trying to understand how federal homeownership policy should be designed, it undertakes a very useful exercise indeed.

HUD at 50

United States Dept of Housing and Urban Development by Tim1965

The Office of Policy Development and Research at the Department of Housing and Urban Development has issued HUD at 50: Creating Pathways to Opportunity. It is a massive tome, with a lot of interest in it for the housing geeks among us. In the Preface, Deputy Assistant Secretary for Policy Development Lynn Ross writes,

This volume looks back on HUD’s history and looks forward to ways the agency might evolve. If you are familiar with the mission and the work of PD&R, you will not be surprised to learn that this book includes thorough analyses of not only how programs succeeded, but also how they sometimes fell short and what was done in response. I hope you will take the time to engage with the analysis and ideas contained throughout this volume. We’ve organized this book so you can read the thematic chapters in any order—although you can certainly read it cover to cover.

Given that HUD at 50 is more than 250 pages long, only the most dedicated among us will do so. Nonetheless, it is worth skimming the table of contents to see if any of the entries are worth reading in full:

  • Introduction by Julián Castro
  • Chapter 1 The Founding and Evolution of HUD: 50 Years, 1965–2015 by Jill Khadduri
  • Chapter 2 Race, Poverty, and Federal Rental Housing Policy by Ingrid Gould Ellen and Jessica Yager
  • Chapter 3 Urban Development and Place by Raphael W. Bostic
  • Chapter 4 Housing Finance in Retrospect by Susan Wachter and Arthur Acolin
  • Chapter 5 Poverty and Vulnerable Populations by Margery Austin Turner, Mary K. Cunningham, and Susan J. Popkin
  • Chapter 6 Housing Policy and Demographic Change by Erika Poethig, Pamela Blumenthal, and Rolf Pendall
  • Conclusion Places as Platforms for Opportunity: Where We Are and Where We Should Go by Katherine M. O’Regan

I will take a closer look at some of these chapters in the coming days, but feel free to dip in before I do!