Monday, September 14, 2015

Housing Tax Policy, A Series: Part 60 - Financial Engineering for Insurance & Speculation

I have sided with defenders of the GSE's.  Fannie & Freddie portfolios sharply leveled off at the end of 2003, and the Ginnie Mae portfolio was as small, in nominal terms, in 2005 as it had been in 1990.  The private mortgage pools were largely filling the gap left by the GSE's.

If private pools hadn't filled the gap, 2004 would have seen a contraction on the order of 1980 or 1990.  It looks to me like a good deal of the new private pool and subprime loans were replacing Ginnie Mae loans.  And, Ginnie Mae loans have long been a source of low down payment mortgage options.  So, to a great extent, low down payment subprime options were simply providing a similar service to what Ginnie Mae had been doing for decades.

Here is a graph of issuances, by pool type.  Here, we can see how private pools grew before 2004 while Ginnie Mae issuances remained low, and then from 2004 until the collapse, private pools barely made up for the sudden drop in Fannie & Freddie issues.

Proportion of total $ outstanding.  Source
And, I think this third graph is striking.  This is a graph showing the proportion of all loans outstanding, by holder type.  Here we can see in sharp relief how the rise in subprime and private pool loans was almost completely in response to the decline of Ginnie Mae loans.  The proportion of loans securitized leveled out in the early 1990s, before home prices began to rise.  Then, from 1998 to 2003, the combined level of Ginnie Mae and private pool loans actually declined.  And, when the combined proportion of Ginnie Mae and private pool loans did grow after 2003, as we see from this graph and from the graphs above, it was making up for the sudden sharp drop in Fanny and Freddie loans.

Part of the Ginnie Mae package of requirements, together with low down payments, is mortgage insurance.  This provides protection to the investor, in case of default, but tends to be somewhat expensive.  I wonder if the expansion in the late 1990s and early 2000s of subprime and low down payment mortgage options came about because private alternatives developed that created less expensive forms of mortgage insurance.  This graph suggests that there wasn't a change in the prominence of low down payment mortgage options; there was just a shift from Ginnie Mae to private loans.  This explains why survey and loan level data for the period doesn't appear to back up the broadly held belief that down payments were unusually low during the boom.  One oddity for me has been that people who worked in the mortgage business tend to agree with the consensus that there was a rise in low down payment loans.  But, if the reality is that those loans were being funded in private pools instead of through the channels that would have facilitated Ginnie Mae funding, then they would have that impression, and all of these apparently contradictory pieces of evidence would be true.

Let's think about what would happen with a Ginnie Mae mortgage.  The mortgage would be issued, and the mortgage borrower would buy mortgage insurance.  A mortgage insurance firm would accept monthly payments from the borrower, which they would pool and invest as a safety net for investors who could then treat pools of Ginnie Mae mortgages as safe securities.

The mortgage insurer sounds a lot like the lower tranches of a private MBS to me.

These are really just two different forms of financial engineering.  Are they that different?

Mortgage insurance seems to me like a sort of equity tranche that is required to keep its income in reserves for the other tranches.  It seems possible that MBSs could be designed to mimic this risk profile.  On the other hand, an MBS without deferred payments on the bottom tranches and with a broader range of lower rated tranches as a result is sharing risk more broadly, in a way that might even be more robust than a traditional mortgage insurer.

And, aren't investors in CDOs constructed from the original pools of securities sort of the equivalent of investors or re-insurers involved with a mortgage insurer?

It seems to me that the greatest difference may be in the market exposure.  On the borrowers side, this might have allowed the cost of these functions to fluctuate more efficiently with changing risk aversion and financial innovation so that the cost of these functions reflected market conditions.  I wonder how much this difference led to the stagnation of Ginnie Mae activity.  The market for MBS investors is much more efficient than the market for mortgage insurers.  Were private MBSs simply outbidding mortgage insurers in the competition for non-conventional mortgages?  I know that one reaction to that statement is that they were outbidding mortgage insurers and Ginnie Mae by offering gross yields that were too low for the risk involved.  But, I don't see how a mispricing would lead to a price collapse followed by a default crisis and a collapse of credit markets.  Why wouldn't that just lead to a shift in yields?  Shifts back and forth in yield spreads happen all the time.  This seems like a problem that normally fluctuating financial markets would be able to handle without a crisis.

On the lenders' end, this efficiency led to more volatility.  A mortgage insurer has natural exposure to a range of cohorts.  The lack of competitive efficiency that kept mortgage insurance costs high also led to a natural sort of diversification.  The millions of pre-2006 mortgages paying fees to the insurer would help buffer the large losses on the 2006 and 2007 cohorts.  In the private MBS market, there might be pockets of funds or investors with focused exposure on the troubled cohorts.  This was especially the case, in practice, since the switch from GSEs to private pools was recent, and young cohorts made up a large fraction of the available pools.  In this way, the sharp pullback in the GSE pools after 2003 increased systemic risk by creating an unavoidable anti-diversification of investment exposure in the private pools.

But, even more importantly, while a mortgage insurer would be treated as a constant in a Ginnie Mae pool, in the private pool, where the insurance was bundled with the investments themselves, the cost of the insurance fluctuated with market prices.  In a way, the advantage of the insurance model here is an accounting fiction.  In a market collapse like we saw in 2006-2008, the health of mortgage insurers will fluctuate, and mortgage insurers have had problems, as have most firms in the mortgage industry over the past decade.  But the opacity of their form of intermediation allows their clients to ignore those fluctuations until they become imminently problematic.

So, in 2007, when defaults were really only beginning to climb, house prices were collapsing in an unprecedented way, and the Fed was making it clear that they were going to do little to stop it, investors in private pools were left holding securities whose prices could collapse as much from falling expectations as from falling current incomes.  That's what functioning financial markets do.  They bring information back in time.

While MBS investors in that context were the first to find themselves in a liquidity crisis, a mortgage insurer in that context would not find meeting their short-term cash needs that difficult.  And, the lack of competitive efficiency might even allow them to raise rates temporarily above competitive levels in anticipation of coming defaults.

In the end, if our consensus public credit and currency policy is to allow a 25% drop in nominal house prices, it probably doesn't matter that much.  I doubt that any realistic credit system with low down payments would withstand that sort of volatility.  But, were the risk profiles of the private pools really that different than the Ginnie Mae pools we had been using for decades?


  1. Excellent blogging. I confess I am skeptical about GSE's, but maybe this case presents an exception.

    OT but fascinating: You have blogged about the criminalization of housing construction in the US, usually in NYC or SF, but I would add every government-zoned single-family detached neighborhood in America. I think we agree that limiting the supply of housing raises costs, and might be measured as inflation.

    That got me thinking. Most cities also zone land commercial, and then perhaps retail. And, of course, in American cities, push-cart vending is routinely criminalized.

    So what does this mean? In the City of Newport Beach, if I want to sell a good, I must obtain a state sales permit, and then a business permit from the City of Newport Beach. Then, I can only sell tangible goods on that land so zoned.

    Oh gee, i wonder what this does to the price of retail rents or the cost of retail land. In other words, to sell in the City of Newport Beach, I must either rent zoned land there or buy zoned land there.

    Multiply this scenario by every US city I know of, with the possible exception of Houston.

    Suppose reality is this: We have measured inflation n the US due to local land zoning and supply constraints?

    1. All good points, Benjamin. I trace a lot of the shelter inflation to the problem metro areas, but you are right, there is still a little bit of excess shelter inflation after accounting for the Case-Shiller 10 cities. Robert Shiller always pushes the idea that home prices should not rise faster than inflation in the long run, but he seems to ignore the fact that shelter inflation itself has been persistently above core inflation for much of the modern era.

      I hadn't thought about your other point, that some real estate inflation could be embedded in retail inflation. Possible. Interesting. I wonder if anyone has done work that would allow this to be estimated.

      On the GSE's I was basically where you are. But, I have started to wonder, if 30 year fixed mortgages are the way we are funding shelter, then maybe they have a place. And, if they have a place, then maybe they should be public, because the aggregate risk of those loans is almost entirely a product of inflation policy, so taxpayers should be the ones to backstop the losses when there are aggregate valuation shocks. And, practically, if banks are basically just pushing papers to meet some strict set of guidelines about which borrowers qualify, and are less and less involved in minor innovations regarding credit risk analysis, what's the point of even having private origination? Just let banks originate loans for their own balance sheets or for private pools and have some public entity pushing papers for GSE loans. I'm not saying that's my preferred world, but realistically, I'm not sure there is a point in a neutered but semi-private mortgage industry.

    2. Kevin--consider this: shelter costs should be going down, and should be deflationary.

      So those single-family detached areas are not as "guilt-free" as you think.

      Were it not for zoning, perhaps a popular housing mode would be manufactured homes with septic tanks. Obviously, the cost of manufactured goods declines continuously. So the cost of a home should fall continuously (adjusted for quality).

      Who knows, perhaps modular apartment buildings would have been built, assembled in a few days, China-style, without pervasive zoning and codes. Stacks of steel shipping containers, modified etc.

      Here is one you might find interesting. In 1926 the US Supreme Court upheld local property zoning. Local zoning of private property only started in 1916. Here is one report on that decision:

      "U.S. Supreme Court Justice George Sutherland, hardly an enthusiast of government regulation, raised the possibility of apartment invasion of single-home districts in his opinion in Euclid v. Ambler (1926), still the leading case on the constitutionality of zoning. Sutherland’s mention of apartments is all the more interesting because the plaintiff, Ambler Realty Company, had not even complained about restrictions on apartments. Ambler’s claim was that part of its industrial land along Euclid Avenue (just east of Cleveland) had been zoned for residential purposes. Sutherland brought up the apartment issue on his own (though amicus briefs had addressed it) and uttered the famous metaphor of apartments as “a mere parasite, constructed in order to take advantage of the open spaces and attractive surroundings created by the residential character of the district” (272 U.S. at 394)."

      Egads. That is from a paper here:

      So much for conservative judges who are not "activist." And with that 1926 decision, you lost the right to develop your property as you see fit.

      I am happy to bash SF, NYC and LA as stupid for restricting housing, and all the stupid things they do to try force builders to build low-inome housing, which no builder wants to do.

      Builders want to build expensive or profitable housing. Single-family detached zoning, and attendant codes, acreage restrictions etc, has probably flummoxed the evolution of deflationary housing construction and services.

      Zoning limited urban land as "commercial" or "retail" probably aggravates costs further.

      Of course, who, comfortably ensconced in a single-family detached neighborhood, want condo towers, ground-floor retail and push-carts?

      Remember, we are against regulations, except for the regulations we are for.

    3. Great stuff. Thanks.

      Keep in mind, one reason I concentrate on those cities is that there are some ways to quantify the damage. Kind of like how I have written a lot more about emergency unemployment insurance than about Obamacare. That's largely arbitrary, because I happen to have ways to isolate the effect of eui. So, it may seem like I want to minimize your points about housing, but I just get drawn into writing about those cities due to statistical convenience.

      Really great comment. Food for thought. I agree that it's hard to imagine how local building codes must be holding back shelter automation.