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private label securitization (PLS) had provided a significant share of funding for mortgages, since 2007, PLS has withdrawn from the market.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

Minority Homeownership During the Great Recession

photo by Daniel X. O'Neil

Print by Andy Kane

Carlos Garriga et al. have posted The Homeownership Experience of Minorities During the Great Recession to SSRN. The paper concludes,

The Great Recession wiped out much of the homeownership gains attained during the housing boom. However, the homeownership experience was very different across racial and ethnic groups. Black and Hispanic borrowers experienced substantial repayment difficulties that ultimately led to a greater share of homes in foreclosure.

Given that home equity often represents a substantial share of household wealth, these foreclosure events severely damaged the balance sheets of minority families. The dynamics of delinquency and foreclosure functioned differently across the income distribution within racial and ethnic groups.

For the majority, higher income was associated with lower delinquency rates and fewer foreclosures as a group. However, for Hispanic families this relationship was surprisingly reversed. Hispanics with the highest incomes fared worse than those with the lowest incomes. This counterintuitive finding suggests how college-educated Hispanic families may have had worse wealth outcomes than their non-college-educated peers: Hispanic families with high income (potentially the result of high educational attainment) had a greater share of home equity lost in foreclosure than lower-income Hispanic families.

Logit regressions suggest that underwriting standards and loan structure explain a significant amount of the greater likelihood of foreclosure among Black and Hispanic borrowers. However, underwriting standards explained more of the gap for Black borrowers, while loan structure was a stronger factor among Hispanic borrowers. Regional concentration and variation in housing markets explained more of the Hispanic-White foreclosure gap than any other group. This is understandable given that Hispanic borrowers in our sample were heavily concentrated in housing markets that experienced some of the largest volatility. Despite accounting for these important factors, sizable gaps remain in foreclosures among Blacks and Hispanics relative to Whites. Incorporating measures of labor market outcomes into the analysis may offer further insights.

In sum, the homeownership experience during the Great Recession proved to be inimical for many families, but far more so for Black and Hispanic families. For these families, financially destructive foreclosure events delayed and potentially derailed the dream of homeownership. (164-65)

I am not sure what this all means for housing finance policy other than the obvious: consumer protection in the mortgage market is a good thing as it ensures that underwriting standards evaluate ability-to-repay and loan structures exclude abusive terms like teaser rates (thanks to the ATR and QM rules and the Consumer Financial Protection Bureau). There are probably other policies that we should consider to reduce the depths of our busts, but they do not seem likely to gain traction in the current political environment.

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.