SOME NOTES ON WHAT CAN BE LEARNED BY OTHER COUNTRIES FROM AMERICAN SECONDARY MORTGAGE MARKETS. By Robert Van Order

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1 SOME NOTES ON WHAT CAN BE LEARNED BY OTHER COUNTRIES FROM AMERICAN SECONDARY MORTGAGE MARKETS By Robert Van Order Mortgage securitization has worked reasonably well in the United States; it has allowed borrowers to raise funds cheaply and quickly because of the efficiency of the U.S. bond market system, which is almost unique (most countries are more bank-oriented). A major change in mortgage markets, one which has been brought on largely by the secondary markets, has been increased division of labor, leading to the unbundling of the four major aspects of mortgage-lending: origination, servicing, funding and accepting credit risks. This is most evident on the investment side. Investors in mortgages need not be involved in originating, servicing, or taking on credit risk. Pools of mortgages (mortgage-backed securities) and mortgage-backed debt now trade in national and international markets, almost as efficiently as U.S. Treasury securities. While these changes have generally increased the efficiency of the mortgage market, they have also generated some special management problems. The main management concerns for Fannie Mae and Freddie Mac are interest rate and credit risk, but there are also management and operations risks. The unbundling that has come with secondary markets has increased the dependence of the various participants in the market upon one another, and it has enhanced these risks. For instance, Fannie and Freddie have to worry about the quality of loans sold to them by originators who might know more about the

2 loans than they do and can select against them and may not have incentives to service the loans properly. This raises principal/agent problems, i.e., the agent is supposed to act in the interest of the principal, but might not have the incentive to do so. Managing these risks has been the major management problem for the secondary market. When risks are unbundled to the extent they are in the U.S. secondary market it is quite important that it be clear who is taking the risks and that the risks be taken by those best able to handle them. Can the benefits of the U.S. secondary market, primarily the ability to raise lots of long term funding at low cost, be exported to other countries while controlling principle/agent problems? Maybe; maybe not. The lessons of the secondary market do not come from the details of how it operates in the U.S. (e.g., the use of sophisticated capital markets instrument like CMO s and automated underwriting systems). These details probably cannot or need not be exported. Depository-based systems can, with the right laws and regulations, do much the same thing that secondary markets do, connect mortgage borrowers with people with money, without the problems associated with selling mortgages. Indeed, about 80% of the increase in homeownership rates that took place in the U.S. from the 1940s until the present took place by 1960 with a system that was largely depository- based, primitive (relative to today s standards) in operation and with virtually no secondary market. The success of Fannie and Freddie has come in part from the fundamental simplicity imposed by charter. The simplicity is that they function primarily as conduits with the

3 capital markets, so that they work with market forces rather than against them. They have focused primarily on a particular part of the bundle, guaranteeing credit risk, primarily of single family mortgages, without taking (much) interest rate risk, and they have done this primarily by relying on others, mainly mortgage originators and servicers, private insurers, and investors to accept and/or manage much of the risk, backed up by the ability to take the property and sell it. As Fannie and Freddie have expanded their debt-funded portfolios (as opposed to pass through funding), however, some of this has been changing; to some extent we are seeing further unbundling as duration and convexity risks are parceled out among different investors via Fannie and Freddie s hedging rather than being bundled up in the pass through security, while Fannie and Freddie take some residual risks (on prepayment models, which drive hedging strategy, and on the ability to use counter-parties) that are not in the pass through market. We are simultaneously beginning to see a move toward rebundling, largely because of innovations in automated underwriting and appraising, which are moving value added away from traditional agents and toward Fannie and Freddie, as a way of getting better control of selection problems. The distinction between a conduit (which is the traditional description of a secondary market institution) and a financial intermediary (the traditional description of a bank) is now rather fuzzy. The important issues revolve around the risks and who takes them. Nonetheless, the basics of what Fannie and Freddie do, take credit (and operations) risk but not much interest rate risk, have not changed a lot; although the sophistication in risk

4 management has increased dramatically. What U.S. experience has shown, both before and after the advent of secondary markets, is that with the right legal and regulatory framework (in particular the ability to foreclose and evict and a good system for recording title to property, which make it possible for houses to act as real collateral) and a reasonably stable macro-economy you can make money in single family mortgages. Linking mortgage markets with capital markets can be done with minimal (if any) subsidy. While government has provided a backup role for both the primary and secondary markets for some time, it can be argued that this role has involved rather small subsidies (when the risk has been credit risk on single family mortgages), which are largely controllable. Applications? Many countries do not currently have effective ways of linking mortgage markets with capital markets. Secondary markets might be a particularly good way of tapping international capital markets, particularly for long-term loans. This can be a significant contribution to developing countries. One of the things that has characterized financial breakdowns like the one in Asia in the late 1990s has been reliance on short term international borrowing, which can be cut off rapidly if there a loss of confidence in the country(s) in question. A reason that foreign investors want short-term investment is the lack knowledge that they have good collateral, so they ll get their money back; they want a chance to get out fast (which, of course, they can t do if they all try to at once). Housing is potentially very good collateral and can be expected to be a way of getting more long-

5 term foreign money, decreasing the dependence on hot money, if it really can be effective collateral. Moreover, a well-run secondary mortgage market can provide stimulus to bond market development in general. As I see it, the key problems in developing secondary markets in other (especially developing) countries are: 1. The selection issues are likely to be more formidable in developing markets, where asymmetric information is likely to be a bigger problem, because mortgage originators will have access to all sorts of local information and where access to things like credit history, historical data and automation will be very difficult. Underwriting will be left to originators who will inevitably be able to select the best loans for themselves. The problem is worse if foreclosure costs are high, in which case a house is not good security. Strong foreclosure laws have been absolutely essential to the development of our secondary market. If you want people to have good housing, you have to be able to take it away from them. Absent such laws you may be better of with locally based institutions with good local knowledge, underwriting consumer credit rather than secured loans. 2. Banks are often in a position to access (or develop) bond markets as well as deposit markets. A Fannie or Freddie-like institution might have no funding advantage over banks. Anything they could do banks could do, funding with deposits or bonds, and without the selection problems a secondary market institution would have. 3. Much of the infrastructure for unbundling would have to start from scratch.

6 4. A whole new regulatory scheme would have to be set up, with possibilities for too much risk-taking. For instance, a major effort to control interest rate risk would be necessary. As was the case in the U.S. in the 1970s and 80s, taking interest rate risk (long term assets funded with short term debt, possibly complicated with prepayment risk) can lead to trouble very quickly. Compounded by adverse selection problems, there is potential for insolvency, bail out costs and/or market collapse. These, of course, are things regulators also have to worry about with banks. A central question is whether new Government-sponsored enterprises, GSEs, (banks are, after all, essentially GSEs too) add to risk and whether existing institutions like banks can do what GSEs can. There is, of course, no reason in principle for not simply equipping the private sector with a legal framework that will let it evolve and securitize as it chooses, competing with banks, perhaps in the form of specialized mortgage lenders. Specialized portfolio lenders do not appear to be the direction in which mortgage markets around the world are moving. For instance, the distinction between thrifts and banks in the U.S. has faded, and the building societies in the U.K. have basically become full service banks. Fully private securitizers (e.g., investment banks and mortgage banks) have not been very successful in most countries, but there is no reason in principle for opposing them. A problem, though, is that financial institutions in general might have automatic implicit GSE status. Hence, new institutions will have the potential to require future bailouts and/or require new regulatory regimes, even if that is not the original intention. In that case explicitly

7 chartered GSEs with accompanying regulation might be preferable. Even without a guarantee failure of financial institutions can have real social costs. There may well be an important role for government, but it might not be in the form of creating a secondary market, or at least not one that looks like ours. Some form of government guarantee might be useful, particularly in attracting long-term foreign investment. A major obstacle to getting a mortgage market off the ground can be the credibility of foreclosure laws, especially in countries where foreclosure laws have recently been adopted and there are questions about the ability to enforce the laws, as well as poor information about risk. It might be possible to provide guarantees designed to promote credibility, for instance by putting the banks in a position to take the first loss on mortgages, according to estimates of a reasonable level for normal losses (assuming the foreclosure laws work) with the government taking the risk beyond that, which the government is better prepared to accept, by covering losses due to unenforceability of the foreclosure laws and other catastrophic losses. Because of their first loss positions banks would have incentives to underwrite loans properly. This might not require creating a Fannie or Freddie, but a GSE structure with private ownership and value-maximizing incentives is likely to be a much more efficient way of providing guarantees and starting up a mortgage market than is a state-owned corporation. State ownership is almost certainly the worst structure. An alternative to a Fannie or Freddie, which is also a GSE, is a liquidity facility like the Federal Home Loan Bank System in the U.S., which takes very little risk, because it lends against over-

8 collateralized pools of mortgages (so that banks take the first loss) but also connects mortgage and capital markets. Clearly a concern with any GSE type setup, or any government intervention, is the details of the charter, responsibilities, incentives, etc., which will be filtered through a political process that may not get everything right. Some Important Lessons 1. It is the function, connecting mortgage and capital markets, especially the long term market, rather than institutional details, that is important, and there are several different ways of getting the function done, securitization being one. Creating a Government-Sponsored is not the same thing as securitizing and vice versa. 2. While working on the back end, e.g., doing some deals and getting some mortgages off banks balance sheets may be a good idea, it is the getting the front end right that is the sine qua non of developing good mortgage markets. It is especially important to have proper registration, foreclosure and eviction procedures. 3. A major lesson in the U.S. has been the importance of taking safety and soundness seriously. The Savings and Loan debacle in the 1980s was a major problem, not only (or even mostly) because of taxpayer losses but also because of the inefficient capital allocation that went along with it (lots of dumb loans due to subsidies that uncontrolled guarantees carry). GSEs have gotten into trouble more than once. Controlling safety and soundness requires serious consideration of

9 risk-based capital, not like the old accounting capital ratios, but really risk-based standards that make companies hold more capital if they do things that increase risk to the company (and taxpayer stakeholders). The stress test-based standards currently being put onto Freddie and Fannie as well as the internal models approach being used to analyze capital requirements of banks are major improvements. It is important to stay away from simple accounting ratios. Frequent audits and applications of stress tests are also important. Along these lines, providing GSEs with some market power, e.g., by making their charters scarce, has some advantages that market power does not have in other contexts, because the existence of a valuable franchise provides incentives to control risk-taking for fear of losing the franchise. A major factor in the Savings and Loan debacle was the existence of a large number of institutions with nothing to lose by gambling for resurrection. 4. An important component of safety and soundness is not taking interest rate risk. Interest rate risk, particularly in the form of short funding a long term portfolio is a very good way of getting into trouble quickly, as was seen in the beginning of the Savings and Loan problem in the late 1970s and Fannie Mae in the early 1980s. A thing that we have learned is that interest rate risk is relatively easy to measure (via stress tests), and so it should be controllable. 5. Finally, there is the lesson of diversification. Fannie and Freddie have benefited because they have been able to spread their risks across a variety of local economies, which are often larger than those of some countries. To illustrate this look at the attached chart, which depicts the incidence of default and house price

10 appreciation in the U. S. across states from Freddie data on 80% LTV loans. What the chart shows is that most of the time for most states default rates are low, but every once in a while they are huge, huge enough to generate bankruptcy for institutions with low capital levels concentrated in those states. On the other hand, consider the dark squares, which depict national experience. These squares are within the range of state experience, but they are much more closely bunched; the national rate has not come close to the worst experience of the states. This provides an important warning for small countries developing mortgage markets, particularly if they are extending guarantees to newly formed institutions. For instance, the Baltic countries, which are trying to set up mortgage markets and mortgage insurers, are smaller than most of the states depicted in the chart and should expect to see a worse scatter than in the picture, especially to the extent they do high LTV loans. At a minimum, the results indicate that reserves/fees for lenders or insurers in smaller countries should be much higher than would be the case if geographical diversification were exploited. Consequently, markets develop lenders and insurance companies should be willing to cede part of their risks to large international banks and reinsurance companies. Of course, none of this is easy. It is a central fact of life that capital is scarce, even more so in developing countries. The most financial markets can do is allocate it efficiently.

11 Default Probability vs. House-Price Appreciation State/Origination Year and National/Origination Year Cohorts ( ) 80% Loan-to-Value, 30-Year Fixed-Rate Home-Purchase Mortgage Cumulative Default Rate 25% 20% 15% 10% 5% AK 1986 CA 1990 AZ 1985 CA 1989 HI 1994 NV 1985 DC 1995 Individual States National 0% -30% -10% 10% 30% 50% 70% 90% 110% 130% 5-Year Cumulative House-Price Appreciation

12 SOME CURRENT ISSUES IN U.S. SECONDARY MORTGAGE MARKETS: DUELING CHARTERS LEGAL FOUNDATIONS (FORCLOSURE AND EVICTION) PRINCIPAL-AGENT PROBLEMS SECURITIZATION VS DEBT FUNDING UNBUNDLING, REBUNDLING AND THE INFORMATION REVOLUTION REGULATION (MISSION AND SAFETY/SOUNDNESS) WHO SHOULD TAKE THE RISK? DIVERSIFICATION LESSONS??

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