The Duelling Guarantee
The myth is that mortgage securitization reflects the genius of Wall Street. The reality is that it reflects the stupidity of the way that regulatory capital requirements are calculated.
The market for low-risk loans is dominated by Freddie and Fannie because the GSE’s are required to hold less capital than banks for taking the same risk. The market for high-risk loans is dominated by private securitization because capital requirements encourage banks to buy securitized loans that they could never originate on their own. Freddie and Fannie were relatively minor players in the high-risk market, but what little they did undermined their safety and soundness, against the warnings of mid-level staff.
The economic fundamentals of the mortgage market are best understood using Robert Van Order’s theory of the duelling guarantee.I first introduced Bob Van Order when I wrote my chapter describing my early experiences at Freddie Mac. Van Order, along with Chet Foster, came up with the approach for calculating mortgage credit risk using an option pricing framework.
Van Order also had a theory to explain how mortgages ended up held by different institutions. He pointed out that depository institutions (banks as well as savings and loans) had their liabilities guaranteed by the government. So the fact that Freddie and Fannie enjoyed an implicit guarantee did not give the GSE’s any inherent advantage.
Is it more economical for a depository institution to hold its own loans or to hold securities created by Fannie and Freddie? In the absence of regulatory incentives, the pure economics of the choice are as follows:
1. Fannie and Freddie have greater geographic diversification, which lowers their risk and their cost.
2. Fannie and Freddie have specialized expertise (including people like Van Order) to fine-tune credit risk modeling more accurately.
3. On the other hand, depository institutions who hold their own loans face fewer agency costs. Their loans are being originated by their own employees, not somebody else’s. They can give their employees training and incentives to screen loan files carefully. When you buy loans from someone else, their employees are trained to “produce” loans. For the mortgage broker, every loan that gets passed on to a buyer represents production, whether the loan is underwritten properly, improperly, or fraudulently.
4. The loans held by depository institutions include fewer transaction costs. You do not pay Wall Street to package the mortgage into a security and to trade it. If you need to get a pension fund to proviide money to fund the loan, you can issue debt to the pension fund (of course, the pension fund won’t enjoy the same guarantee as a depositor who stays under the $100,000 FDIC limit that was in place until the emergency legislation that was passed just recently).
Overall,I believe that factor (3) is most important. That is, Freddie and Fannie would not exist if all they had going for them was the same guarantee of liabilities that is enjoyed by depository institutions.
In practice, the main difference advantage enjoyed Freddie and Fannie concerns capital requirements. Their capital requirements are calculated using a methodology that differs from that of depository institutions.
Banks and savings and loans have to hold a minimum ratio of capital to risk-weighted assets. Even a low-risk mortgage loan, where the borrower puts down between 20 and 40 percent of the purchase price, has a 0.35 weight, where 1.0 would be the riskiest.
Freddie and Fannie do not use a risk-weighted capital ratio. For credit risk, their capital requirement is determined by a stress test. How much capital would they need to survive a specific downturn in house prices? This varies by the type of mortgage.
For low-risk mortgages (down payments of 20 percent or more), the capital required by the stress test is less than the capital required for banks in their risk-based capital formula. Because of these different capital requirements, Freddie and Fannie should dominate the market for low-risk loans, as indeed they do.
For high-risk mortgages, as I pointed out, the FDIC gives the advantage to private securitizers. That is, for a high-risk loan that is laundered through the mortgage securitization process, the FDIC requires less capital for a bank than even a low-risk loan originated and held the old-fashioned way.
I believe that the stress test makes high-risk loans prohibitively costly for Freddie Mac and Fannie Mae. The question is not why Freddie Mac and Fannie Mae were less active than private securitizers in the subprime market. The question is why Freddie and Fannie were involved at all. The answer, to repeat, is that senior management ignored safety and soundness considerations, in part to satisfy political pressure, in part to satisfy market share goals, and in part because they did not believe what their staffs were telling them about safety and soundness risks. On the latter point, history has shown that the staffs were correct.
In my opinion (and this may reflect my experience at Freddie Mac), the most appropriate way to calculate capital requirements is the stress test. If the stress test methodology were used for depository institutions, then in my judgment they would have no disadvantage in holding low-risk loans, and they would drive Freddie and Fannie out of the market. If the stress test were applied to high-risk loans and to private securities (rather than the moronic rating-agency ratings), then the market for high-risk loans (a) would be limited to loans originated and held by depository institutions and (b) would be much, much smaller.
In retrospect, if capital requirements had been rational, we would never have had the nontransparency of mortgage securities. Moreover, we would have had fewer mortgages with low down payments, which would have meant a smaller rise in house prices and a much less dramatic crash.
Why did the irrational pattern of capital requirements survive? Perhaps the folks at the FDIC were just plain stupid. I doubt that is the case. My guess is that there were plenty of career civil servants who were not happy with what the capital requirements were doing. But at higher levels, and with Congress, what mattered was the increase in home ownership and the campaign contributions from Wall Street, for whom the transaction costs of securitization represented profits.
That is the reality. It is not widely understood, and most people would rather believe a different narrative. The Left wants to blame deregulation. The Right wants to blame lending to minorities. But this blog is giving you the true narrative. I have not seen anyone refute it.