Bethany McLean Slips

In her new book, Shaky Ground: The Strange Saga of the U.S. Mortgage Giants, she writes,

Originally, Fannie and Freddie owned the mortgages they purchased. but over time, as the capital markets in this country evolved, Fannie and Freddie began to package up the mortgages they purchased, stamp them with a guarantee. . .and sell them as securities to investors.

This is true of Fannie. But for Freddie the history is the opposite. They were in the securitization business from the beginning in 1970, and only around 1990 did they start to hold a substantial share of mortgages and mortgage securities as assets. There were several reasons that Freddie shifted to holding a large portfolio, funded by debt.

1. By 1990 Freddie was a shareholder-owned company (before that, they were basically a government agency), and shareholders were interested in profits. Having a large portfolio was profitable.

2. Prior to that, Freddie was concerned about the risk of holding mortgage portfolio. If you fund with short-term debt and interest rates rise, you end up paying more in interest expense than you earn on mortgages. If you fund with long-term debt and interest rates fall, borrowers refinance at lower rates and you are stuck with the high long-term debt costs. But Fannie Mae found a solution, which consisted of issuing callable debt. For example, they might issue a 10-year bond that can be called in 5 years. The market charged a surprisingly low interest rate on such securities, so Freddie started issuing them. Combining callable debt with some interest-rate derivatives gave Freddie and Fannie something close to an arbitrage profit in portfolio lending. They were helped, of course, by their “too big to fail” status, which made investors treat their debt as risk free–until the summer of 2008.

Anyway, I am sorry McLean slipped up on this. I really liked her book with Joe Nocera, All the Devils are Here, and I still have high hopes for her new one, which I have just started. I expect to post more on it.

I found this interesting:

When they were taken over, Fannie and Freddie had a combined $5.3 trillion in outstanding debt,, which, had it been put on the government’s balance sheet, would have increased the public national debt by about 50 percent. Partly to avoid that, the government left 20.1 percent of Fannie’s common stock, as well as other securities known as preferred shares, in the hands of investors.

Fannie and Freddie were originally government agencies. Fannie was privatized not for ideological reasons, but because Lyndon Johnson wanted Fannie’s debt off the government balance sheet. He was trying to fund the Vietnam War, plus the war on poverty, and he did not want Congress bothering him with debt-ceiling issues.

So here we were in 2008, and Fannie and Freddie should have been re-nationalized, but once again, the cosmetics of the government balance sheet took precedence.

The Causes of Mortgage Defaults

The latest paper is by Fernando Ferriera and Joseph Gyourko. This article about the paper says,

Ferreira’s data show that even with strict limits on borrowing—say, requiring every borrower to put 20% down in all circumstances—wouldn’t have prevented the worst of the foreclosure crisis. “It’s really hard for certain regulations to stop the process [of a bubble forming],” Ferreira says. “I really wish my research had showed that it’s all about putting down 20% and all problems are solved, but the reality is more complicated than that.”

This analysis has both good points and bad points. The good point is that it goes against the “predatory lending” narrative. As a home buyer, you were better off with a predatory loan in 2002 (when prices were still headed higher) than with a prime loan in 2006 (when prices were near the peak). The bad point is the implication that there was nothing wrong with loans with low down payments. In fact, it was those loans that allowed speculation to get out of control.

Scott Sumner thinks that the finding that many of the mortgage defaulters were “prime” borrowers is enough to confirm that mortgage defaults were caused by a slowdown in nominal GDP growth. But mortgage defaults do not come from a lack of nominal GDP growth. They come from negative equity among mortgage borrowers.* And that comes from house prices falling, for which the main cause was the rapid rise in the first place. And both the rise in prices and the subsequent wave of defaults were much exacerbated by the fact that so many borrowers, “prime” or otherwise, had so little equity to begin with.

From part of the NBER coverage of the paper that Sumner does not quote:

The authors’ key empirical finding is that negative equity conditions can explain virtually all of the difference in foreclosure and short sale outcomes of prime borrowers compared to all cash owners. Negative equity also accounts for approximately two-thirds of the variation in subprime borrower distress. Both are true on average, over time, and across metropolitan areas.

Let’s assume that we can agree that the big drop in house prices caused the wave of mortgage defaults. Three possibilities:

1. The drop in house prices was a purely exogenous shock.

2. The drop in house prices was due to the slowdown in nominal GDP growth.

3. The drop in house prices was due to the internal dynamics of a housing market that had become saturated with speculative buying with little or no money down.

The stories about the study make it sound like it was (1). Sumner believes (2). I vote for (3).


UPDATE: See Megan McArdle for a similar point of view.

Financial Advice for Bryan Caplan

He says that he maintains as much housing debt as possible, in order to take advantage of the mortgage interest deduction.

My advice to him is to sell his stock portfolio, pay off his housing debt, and take long positions in stock index futures.*

*In practice, the prospect of incurring capital gains taxes might make this a bad move.

Here is my thinking.

1. If you maintain housing debt that you could pay off, you have to put the money to work somehow. The question is whether you can earn more on your money than the after-tax interest rate. If you invest in risk-free securities, the answer is obviously “no.” Borrowing at 3 percent to invest in a money-market fund is a losing proposition, tax deduction or no tax deduction.

2. There might be some bond that you can buy that earns more than the after-tax mortgage interest rate, but that bond is going to have some risk attached to it. And you will have to pay taxes on the interest from that bond.

3. That leaves stocks. If you maintain housing debt in order to own stocks, then you are saying that you are happy to have a leveraged position in stocks, because you think that the expected return on stocks is higher than your borrowing rate. In Pikettyian terms, you believe that g is greater than r.

Fine. But if that is true, then I am pretty sure that the most efficient way to take your position would be by holding a position in stock index futures, rather than by taking out a mortgage loan to invest in stocks.

If you don’t like paying taxes, I understand that. As much as I disparage non-profits, I give large amounts to non-profits because I prefer that to paying taxes. But from a purely financial perspective, I think that maintaining mortgage debt that you could afford to pay off strikes me as a losing proposition. You unnecessarily enrich the mortgage lender at your expense.

Housing Demand and Down Payment Requirements

Andreas Fuster and Basit Zafar write (note: WTP – “willingness to pay”),

we find that on average, WTP increases by about 15 percent when households can make a down payment as low as 5 percent of the purchase price instead of having to put down 20 percent. However, this average masks large differences in sensitivity across households. In fact, almost half the respondents do not change their WTP at all when the required down payment is lowered. On the other hand, many respondents increase their WTP very strongly in the second scenario with the lower down payment requirement. This is particularly true for respondents who are current renters (and often relatively less wealthy): their WTP on average increases by more than 40 percent. They also tend to choose lower down payment fractions than current owners; for instance, 59 percent of renters but only 36 percent of owners choose a down payment fraction of 10 percent or lower.

As Mark Thoma says, this is not a surprise. The question is whether this means that government policies to encourage lower down payments are a good idea. I think not, since it encourages a lot of speculative purchases of houses and makes house prices more volatile.

If you want periods in which people over-pay for housing to alternate with periods of retrenchment, then letting people buy with little or no money down is the way to go. If you want sensible policies to build wealth among households below the top of the income ladder, then you would subsidize saving. But that idea goes nowhere with the real estate lobby, which dictates policy in this area.

Public Availability of Freddie, Fannie Loan Performance Data

Todd W. Schneider has a write-up and some analysis.

I decided to dig in with some geographic analysis, an attempt to identify the loan-level characteristics most predictive of default rates, and more. As part of my efforts, I wrote code to transform the raw data into a more useful PostgreSQL database format, and some R scripts for analysis. The code for processing and analyzing the data is all available on GitHub.

I recommend reading the entire post.

House Prices and Incomes

The data in this story suggest that they are most out of line in San Francisco and Los Angeles. That is, the ratio of the median home price to the median income is highest in those two cities, and it is dramatically higher than in the other cities listed (where it also is high).

The price to income ratio exceed 8 in both cities. A normal ratio of price to rent is about 12. A normal ratio of rent to income is about 25 percent. So a normal ratio of price to income would be 3. To get to 8, you need, say, a ratio of rent to income of 40 percent and a ratio of price to rent of 20.

Some possibilities:

1. This is a sign that some time in the next few years home prices will fall in those two cities.

2. It is the rest of the country that is under-priced. People in other cities should be bidding up house prices where they live.

3. Perhaps there is some statistical fluke. Perhaps the discrepancies across cities go away if you break things down to individual neighborhoods. Note however, that the ratio of two medians is a harder statistic to skew than, say, the mean of income. So I doubt that this is the explanation.

4. Foreign ownership plays a larger role in those two cities than elsewhere, so that the inadequacy of median income is not a factor.

5. Supply is more constrained in California than elsewhere. Note, however, that I have a hard time specifying the demand curve that creates such a dramatic ratio of house prices to incomes.

I think that supply constraints are more likely to lead to volatility in house prices than to house prices that are permanently super-high relative to incomes. And in fact LA and SF have a history of high volatility.

Housing and the Punch Bowl

On Wednesday, I appeared on a panel discussing the state of credit underwriting in the housing market. I raised two questions:

1. Are national credit standards, set by Freddie, Fannie, and FHA, appropriate, or do they throw out too much local information?

I made a Four Forces argument that there are too many divergences in economic performance that make local information valuable. On the other hand, you could argue that simply by tracking search data, Google and Zillow have better information on local trends than would an on-site mortgage underwriter. Interestingly, the session chairman, Bob Van Order, presented information showing that after the crash loans under-performed relative to their known characteristics (including ex post home price performance) and over-performed more recently. This suggests that it is possible for underwriting to be looser or tighter than it appears based on observable characteristics, which in a way suggests that there is local information that is important.

2. Are we in 2004? That is, is the stage set for another housing bubble, and all that is needed is a loosening of credit standards?

One of the speakers, Sam Khater of CoreLogic, re-iterated what he wrote here, that “price-to-income and price-to-rent ratios are high.”

Very few mortgages originated since 2009 have defaulted. There are two reasons for this. One is that credit standards were tightened. The other is that the trend of house prices has been up. Now, there is all sorts of talk about the need to loosen standards. I pointed out that both the private sector and public officials tend to be very procyclical when it comes to mortgage credit–when the market is going up, they want to loosen standards, and after it crashes they want to tighten standards.

I would be ok with loosening standards on credit scores now, provided that the industry holds the line on down payments, meaning that we do not see an increase in the the proportion of loans with down payments below 10 percent. This is not the time for the FHA to make a big expansion in its high-LTV lending (Ed Golding, can you hear me?)

To encourage high-LTV lending now would be adding alcohol to the punch bowl just as the party is getting good.

Housing Finance and Recessions

Oscar Jorda and others write,

The rapid increase in credit-to-GDP ratios since the mid-1980s was just the final phase of a long historical process. The run-up started at the end of World War II and was shaped by a long boom in mortgage lending. One of the startling revelations has been the outsize role that mortgage lending has played in shaping the pace of recoveries, whether in financial crises or not, a factor that has been underappreciated until now.

Pointer from Mark Thoma.

When I read this, I wanted to shout “Underappreciated by who?” Maybe by the macroeconomists who were trained by Stan Fischer, Thomas Sargent, and their progeny. But until Genghis Khan pillaged macro, every macroeconomist knew that housing and mortgage credit rationing were major economic forces in the United States. Until the late 1980s, the process generating recessions consisted of interest rates rising, mortgage lenders losing deposits (because of interest rate ceilings), home buyers losing access to credit, and housing collapsing. And every macro economist knew this.

And even if you are too young to know any old-fashioned macro, you could read Ed Leamer. I would suggest that the authors of this essay try searching for Leamer Housing is the business cycle.

What this essay teaches shows to be underappreciated is Google.

Note that there is more to the essay, which Timothy Taylor found worthwhile.

Housing Policy: A Civilized Approach

Joe Gyourko writes,

They should begin by completely phasing out the FHA over some clearly defined period (for example, three to five years) and replacing it with a new subsidy program that would help the two types of households the agency is meant to serve. The new program would help prospective homebuyers amass a 10% down payment that would then allow them to obtain financing at market rates from private lenders. This could be done through a simple system in which qualified households pay into a special savings vehicle and receive some type of match from the government. These funds would accumulate on a tax-free basis until they were large enough to provide a 10% down payment on a home.

On the civilization vs. barbarism axis, this would encourage saving and responsible behavior. If you read the whole article, you will see reinforcement for this. Of course, along the oppressor-oppressed axis, the only thing holding back people from owning homes is oppression, so there is no need for requiring a down payment.

Of course, what matters here is a different axis entirely. The real estate lobby vs. everybody else. And from that perspective, Gyourko’s sensible proposal does not stand a chance. Another indication of the political impossibility of this approach is that it is one that I have long advocated.