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private label securitization (PLS) had provided a significant share of funding for mortgages, since 2007, PLS has withdrawn from the market.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

American Bankers on Mortgage Market Reform

The American Bankers Association has issued a white paper, Mortgage Lending Rules: Sensible Reforms for Banks and Consumers. The white paper contains a lot of common sense suggestions but its lack of sensitivity to consumer concerns greatly undercuts its value. It opens,

The Core Principles for Regulating the United States Financial System, enumerated in Executive Order 13772, include the following that are particularly relevant to an evaluation of current U.S. rules and regulatory practices affecting residential mortgage finance:

(a) empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;

(c) foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry; and

(f) make regulation efficient, effective, and appropriately tailored.

The American Bankers Association offers these views to the Secretary of the Treasury in relation to the Directive that he has received under Section 2 of the Executive Order.

 Recent regulatory activity in mortgage lending has severely affected real estate finance. The existing regulatory regime is voluminous, extremely technical, and needlessly prescriptive. The current regulatory regimen is restricting choice, eliminating financial options, and forcing a standardization of products such that community banks are no longer able to meet their communities’ needs.

 ABA recommends a broad review of mortgage rules to refine and simplify their application. This white paper advances a series of specific areas that require immediate modifications to incentivize an expansion of safe lending activities: (i) streamline and clarify disclosure timing and methodologies, (ii) add flexibility to underwriting mandates, and (iii) fix the servicing rules.

 ABA advises that focused attention be devoted to clarifying the liability provisions in mortgage regulations to eliminate uncertainties that endanger participation and innovation in the real estate finance sector. (1, footnote omitted)

Its useful suggestions include streamlining regulations to reduce unnecessary regulatory burdens; clarifying legal liabilities that lenders face so that they can act more freely without triggering outsized criminal and civil liability in the ordinary course of business; and creating more safe harbors for products that are not prone to abuse.

But the white paper is written as if the subprime boom and bust of the early 2000s never happened. It pays not much more than lip service to consumer protection regulation, but it seeks to roll it back significantly:

ABA is fully supportive of well-regulated markets where well-crafted rules are effective in protecting consumers against abuse. Banks support clear disclosures and processes to assure that consumers receive clear and comprehensive information that enables them to understand the transaction and make the best decision for their families. ABA does not, therefore, advocate for a wholesale deconstruction of existing consumer protection regulations . . . (4)

If we learned anything from the subprime crisis it is that disclosure is not enough.  That is why the rules.  Could these rules be tweaked? Sure.  Should they be dramatically weakened? No. Until the ABA grapples with the real harm done to consumers during the subprime era, their position on mortgage market reform should be taken as a special interest position paper, not a white paper in the public interest.

Hope for the Securitization Market

The Structured Finance Industry Group has issued a white paper, Regulatory Reform: Securitization Industry Proposals to Support Growth in the Real Economy. While the paper is a useful summary of the industry’s needs, it would benefit from looking at the issue more broadly. The paper states that

One of the core policy responses to the financial crisis was the adoption of a wide variety of new regulations applicable to the securitization industry, largely in the form of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). While many post-crisis analysts believe that the crisis laid bare the need for meaningful regulatory reform, SFIG members believe that any such regulation must: ƒ

  • Reduce risk in a manner such that benefits outweigh costs, including operational costs and inefficiencies; ƒ
  • Be coherent and consistent across the various sectors and across similar risk profiles; ƒ
  • Be operationally feasible from both a transactional and a loan origination basis so as not to compromise provision of credit to the real economy; ƒ
  • Be valued by key market participants; and ƒ
  • Be implemented in a targeted way (i.e. without unintended consequences).

In this paper, we will distinguish between the types of regulation we believe to be necessary and productive versus those that are, at the very least, not helpful and, in some cases, harmful. To support this approach, we believe it is helpful to evaluate financial market regulations, specifically those related to securitization, under three distinct categories, those that are:

1. Transactional in nature; i.e., directly impact the securitization market via a focus on underlying deal structures;

2. Banking rules that include securitization reform within their mandate; and

3. Banking rules that simply do not contemplate securitization and, therefore, may result in unintended consequences. (3)

The paper concludes,

The securitization industry serves as a mechanism for allowing institutional investors to deliver funding to the real economy, both to individual consumers of credit and to businesses of all sizes. This segment of credit reduces the real economy’s reliance on the banking system to deliver such funding, thereby reducing systemic risk.

It is important that both issuers of securitization bonds and investors in those bonds align at an appropriate balance in their goals to allow those issuers to maintain a business model that is not unduly penalized for using securitization as a funding tool, while at the same time, ensuring investors have confidence in the market via “skin in the game” and sufficiency of disclosure. (19)

I think the paper is totally right that we should design a regulatory environment that allows for responsible securitization. The paper is, however, silent on the interest of consumers, whose loans make up the collateral of many of the mortgage-backed and asset-backed securities that are at issue in the bond market. The system can’t be designed just to work for issuers and investors, consumers must have a voice too.

The Fed’s Effect on Mortgage Rates

Federal Open Market Committee Meeting

Federal Open Market Committee Meeting

DepositAccounts.com quoted me in Types of Institutions in the U.S. Banking System – Investment Banks and Central Banks. It reads, in part,

Central Banks

Think of the central bank as the Grand Poobah of a country’s monetary system. In the U.S. that honor is bestowed upon the Federal Reserve. While there are other important central banks, like the European Central Bank, the Bank of England and the People’s Bank of China. For now, focus stateside.

Think of the central bank as the Grand Poobah of a country’s monetary system. In the U.S. that honor is bestowed upon the Federal Reserve.

The Federal Reserve was created by the Congress to provide the nation with a safer, more flexible, and more stable monetary and financial system. The Federal Reserve was created on December 23, 1913, when President Woodrow Wilson signed the Federal Reserve Act into law. To keep it simple, think of the Fed as having responsibility in these four areas:

  1. conducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices;
  2. supervising and regulating banks and other important financial institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers;
  3. maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
  4. providing certain financial services to the U.S. government, U.S. financial institutions, and foreign official institutions, and playing a major role in operating and overseeing the nation’s payments systems.

You need look no further than the Federal Reserve FAQs to learn more about how it is structured.

The Federal Reserve may not take your money, but be clear it has much financial impact on your life. Brooklyn Law Professor David Reiss gives one example, “The Federal Reserve can have an impact on the interest rate you pay on your mortgage. Since the financial crisis, the Fed has fostered accommodative financial conditions which kept interest rates low. It has done this a number of ways, including through its monetary policy actions. The Federal Reserve’s Open Market Committee sets targets for the federal funds rate. The federal funds rate, in turn, influences interest rates for purchases, refinances and home equity loans.”

Dodd-Frank and Mortgage Reform at Five

"Seal on United States Department of the Treasury on the Building" by MohitSingh - Own work. Licensed under CC BY-SA 3.0 via Wikimedia Commons - https://commons.wikimedia.org/wiki/File:Seal_on_United_States_Department_of_the_Treasury_on_the_Building.JPG#/media/File:Seal_on_United_States_Department_of_the_Treasury_on_the_Building.JPG

The Department of Treasury has issued a report, Dodd-Frank at Five Years: Reforming Wall Street and Protecting Main Street. The report is clearly a political document, trumpeting the achievements of the Obama Administration. It is interesting nonetheless. It opens,

When President Obama took office in January 2009, the U.S. economy was in crisis. The nation was shedding more than 750,000 jobs per month, and confidence in our financial system had been shaken to its core. The worst financial crisis since the Great Depression exposed a toxic mix of excessive risk-taking, shoddy lending practices, inadequate capital levels, unstable funding, and weaknesses in regulatory oversight. A collapsing financial system choked off credit to consumers seeking to purchase a car, a home, groceries, or to finance an education. Nearly 9 million Americans lost their jobs, and over 5 million lost their homes. Nearly $13 trillion of families’ wealth was destroyed, wiping out almost two decades of gains.

In response to the crisis, the Administration released a proposed set of reforms in June 2009. Congress held numerous hearings and crafted legislation based on the Administration’s proposal, incorporating ideas from both Republicans and Democrats throughout the process. On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law, a historic and comprehensive set of financial reforms, which put in place critical new protections for consumers, investors, and taxpayers. Five years later—as a result of Dodd-Frank and other Wall Street reforms—our financial system is stronger, safer, more resilient, and more supportive of sustainable economic growth. Regulators also have better tools to deal with financial shocks when they occur, to protect Main Street and taxpayers from Wall Street recklessness.

Critics of reform have claimed that Wall Street Reform would deter lending and choke off the recovery. But, today it is clear that the opposite is true. Reform has served as a building block for economic growth, providing Americans with safe places to invest their savings and enabling banks to lend to individuals, businesses, and communities. Only a financial system strong enough to withstand a major financial shock is capable of promoting sustainable economic growth. Five years after the President signed Wall Street Reform into law, nearly all of the major elements of financial reform are in place. Today, our financial system is safer and stronger as a result of these hard-won reforms, and our economy is in a far better position to continue growing and creating jobs. (1)

I was struck by the fact that the report does not address the biggest financial reform failure of the last five years, the lack of reform of the housing finance system.  Fannie and Freddie remain in conservatorship, putting the housing finance system at risk of another crisis.

I was also struck by the following passage:

In the run-up to the financial crisis, abusive lending practices and unclear underwriting standards resulted in risky mortgages which hurt consumers and ultimately threatened financial stability. Wall Street Reform bans many of the abusive practices in mortgage markets that helped cause the crisis, and requires lenders to determine that borrowers can repay their loans. (2)

My recollection from academic conferences over the course of the last six or seven years is that many leading academics denied the link between abusive lending practices and systemic risk. It seemed pretty clear to me, but I was in the minority on that one. I am glad to see that at least the Treasury agrees with me.

The Future of Fannie and Freddie: The Definitive Panel!

The  NYU Journal of Law & Business has published The Future of Fannie and Freddie (also on SSRN):

This is a transcript of a panel discussion titled, “The Future of Fannie and Freddie.” The panelists were Dr. Mark Calabria from the Cato Institute; Professor David Reiss from Brooklyn Law School; Professor Lawrence White from NYU Stern School of Business; Dr. Mark Willis from NYU’s Furman Center for Real Estate and Urban Policy. The panel was moderated by Professor Michael Levine from NYU School of Law. Panelists looked at economic policy and future prospects for Fannie and Freddie. My remarks focused on the goals of housing finance policy.

The actual panel occurred some time ago, but it remains current given the limbo in which housing finance reform finds itself.

Countercyclical Regulation of Housing Finance

Pat McCoy has posted Countercyclical Regulation and Its Challenges to SSRN. The abstract reads,

Following the 2008 financial crisis, countercyclical regulation emerged as one of the most promising breakthroughs in years to halting destructive cycles of booms and busts. This new approach to systemic risk posits that financial regulation should clamp down during economic expansions and ease during economic slumps in order to make financial firms more resilient and to prick asset bubbles before they burst. If countercyclical regulation is to succeed, however, then policymakers must confront the institutional and legal challenges to that success. This Article examines five major challenges to robust countercyclical regulation – data gaps, early response systems, regulatory inertia, industry capture, and arbitrage – and discusses a variety of techniques to defuse those challenges.

Readers of this blog will be particularly interested in the section titled “Sectoral Regulatory Tools.” (34 et seq.) This section gives an overview of countercyclical tools that can be employed in the housing finance sector:  loan-to value limits; debt-to-income limits; and ability-to-repay rules. McCoy ends this section by noting,

The importance of the ability-to-repay rule and the CFPB’s exclusive role in promulgating that rule has another, very different ramification. It is a mistake to ignore the role of market conduct supervisors such as the CFPB in countercyclical regulation. The centrality of consumer financial protection in ensuring sensible loan underwriting standards – particularly for home mortgages – underscores the vital role that market conduct regulators such as the CFPB will play in the federal government’s efforts to prevent future, catastrophic real estate bubbles. (44)

While this seems like an obvious point to me — sensible consumer protection acts as a brake on financial speculation — many, many academics who study financial regulation disagree. If this article gets some of those academics to reconsider their position, it will make a real contribution to the post-crisis financial literature.