Posts Tagged ‘mortgage’

The case for fragile regulation

April 7, 2009

Arnold Kling has a very interesting piece on regulation. Crises are endogenous, as economic agents and market participants learn how to game the system. He argues, that we are facing two alternatives: a system that does not break easily, but when it does it is costly and difficult to fix, or a system that breaks more frequently but is easier and cheaper to repair.

Kling argues that measures taken following crises are pivotal in creating the next one. He draws his examples from the mortgage markets from the Great Depression of the 30s, to the Savings and Loans crisis of the 80s, to today’s securitization dead end.

After the Depression it was acknowledged that mortgages with balloon payments are too sensitive to credit shortages. Balloon mortgages have a short term, say 5 years, but the monthly payments are similar to a long term mortgage, say 30 years. This means that in the end of the 5 year period there will be a substantial part of the capital still in place (the balloon), which has to be refinanced. If there is a credit crisis, refinancing might not be an option, leading to foreclosures. To this end long term fixed rate mortgages and adjustable rate mortgages (where refinancing is essentially mandatory) were subsequently encouraged. Such mortgages were given by Savings and Loan associations in the US, or Building Societies in the UK. Fannie Mae was established to promote and guarantee mortgages to families with lower income.

But this shifts the maturity mismatch from the mortgagor (borrower) to the mortgagee (lender). They would borrow short (from their depositors) and lend long in the form of mortgages. In the high inflation and interest rate period of the 70s and 80s, they would receive low cashflows from past mortgages, while at the same time they had to pay higher interest rates to their depositors in order to cling on their deposits. This eventually led to the crisis, where it was made clear that such maturity mismatches were also unsustainable. What emerged from the crisis was securitization, as a means of offloading the long component of their assets. In an ideal world, institutions that had long term liabilities (like insurance companies) would be the buyers of these long term assets.

Unfortunately, it didn’t work as intended with the current crisis being a direct result. Rather than insurance companies, it was investment banks and hedge funds that were left with mortgage backed assets. Also, the originating mortgage providers lost the incentive to monitor the quality of the mortgages they were granting.

The bottom line is that regulation, albeit well meaning, cannot be all encompassing and accommodating. Market participants will eventually work their way around, and there will be unforeseen consequences. It would be better then to have a fast moving framework that keeps the spirit rather than putting rigid constraints.

This is al good in paper of course, but how would such a flexible regulatory framework look like? What capacities should regulatory bodies have to make sure that the system does not descend into chaos? In a world run by politicians that want to cover their bases, the easy option is to talk big and construct a rigid international financial system. Which will probably take us back to the 1930s.

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They told us that they told them to lend

April 1, 2009

James Hamilton in a brilliant post discusses the recent expansion of the monetary base.

As it stands, the Fed has bought an array of securities from the banks, of a varying degree of toxicity. They did not go to the bank headquarters with a truckload of money, they, sort of, wrote a check or an IOU.

Every bank is required to keep some reserves with the central bank. In that way they force banks to keep some of their assets in cash form, thereby reducing the risk of banks over-leveraging themselves (or at least that was the principle). In order to buy these dodgy assets, the Fed did not actually pay for them, they just extended the reserves of the corresponding banks, without the banks putting any money themselves.

To make things more concrete, say that Pitibank is required to keep USD50 with the Fed as reserve. Also, say that the Fed decided to buy from them a bunch of mortgages (of face value USD300), but which they agree to buy at USD200. These are “toxic” because if the bank sold them in the market, then at the moment they cannot find a buyer that will pay more than USD30.

The Fed gets these mortgages from Pitibank, and instead of paying in cash, they just increase Pitibank’s reserve to USD250. It is essentially the same thing, since Pitibank can draw from these reserves if they want to (down to the requirement of USD50). The Fed will then essentially “print” money to give Pitibank when asked.

What politicians are telling us, is that they want banks to start lending again. This essentially means that they want Pitibank to ask for these reserves and lend the money to individuals, small businesses and each other.

But banks don’t appear to be doing that. They prefer to let the money in their reserves with the Fed. Why do they do that? Are they keeping good money idle? Well not really, because the Fed has decided to actually pay interest on these reserves. This increases the opportunity cost of lending the money to you and me, and acts as a dis-incentive for Pitibank.

Does that make sense? Well, no matter what the politicians are saying, central banks are having nightmares of all that money reaching the consumers and sparking inflation. As J Hamilton points out, doubling the monetary base will eventually translate into 100% inflation: all prices will double.

It seems to me that with that interest rate on the reserves, the Fed is trying to control how fast this huge amount of money reaches the real economy. And they don’t seem to be very keen for this to happen.

Already below the adverse scenarios

March 31, 2009

The Federal Deposit Insurance Corporation (FDIC) is an agency “created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.” They were heavily involved in the bailout of Citi and have been active in the so called “Legacy Loans Program”, which is the vehicle via which the US taxpayer is buying all those dodgy “toxic” mortgages.

A few months ago, the FDIC released this FAQ, outlining how they would determine if financial institutions “have sufficient capital buffers”. To do that, they devised two scenarios: a “baseline” and an “adverse” one. The baseline scenario is some sort of expert expectation, while the adverse is a stress that is “unlikely”, but “cannot be ruled out”, as their document explains.

House price scenarios used by the FDIC

House price scenarios used by the FDIC

The index they use is the Case-Shiller index of house prices in 10 US cities. This index is reported monthly with a two-month lag. The average index value over the 3rd quarter of 2008 is 165.92 which is the base of the figure above. Today we got the index value for January 2009, which was 158.04 or a drop of 4.75%. This is the first month of the scenarios that the FDIC constructed, and it seems to me that we are already covered the baseline scenario for the whole quarter. We are also en route to go through the adverse scenario pretty soon.

Well it is only one month, but certainly not an encouraging one. The US taxpayer must be delighted with the guys that buy loans for her…