Dismantling the economy’s legal infrastructure V-4: the transformation of mortgage finance in the 1980s

The 1980s saw dramatic reform of the structure of the banking system as the 1970 Hunt Commission’s recommendations for increasing the flow of funds into the mortgage market began to be adopted: first, bank and thrift funding was put on an equal footing; then, existing restrictions on mortgage lending by both commercial banks and thrifts were largely eliminated; at the same time, a policy of regulatory forbearance towards the troubled thrifts was enacted – in the vain hope that they would earn their way to solvency.

Legislation during these years also promoted the growth of mortgage securitization which played an increasingly important role in the mortgage market. The originate-to-distribute model of mortgage finance was born, where non-bank affiliates of commercial banks originated mortgages, and Fannie Mae and Freddie Mac set the standards that “conforming” mortgages had to meet in order to be salable. In short, over the course of the 1980s the mortgage finance system was completely transformed from one in which banks played a peripheral role to one where banks played the most important role. This took place because the predominant theory at the time, portfolio theory, saw no reason to maintain the distinction between banks and thrifts that had been drawn when banking theory was dominant.

It was in this period that the US banking system was effectively divided into two classes. An elite segment of very large banks thrived in the new environment and were able to leverage the new system of “market-based” finance into special treatment: these were the too-big-to-fail banks. The rest of the banking system, however, struggled in this environment where non-banks and the elite banks had special privileges that the typical bank did not. This section addresses the reforms that directly affected the majority of banks, while the next section will focus on the nascent too-big-to-fail banks.

Charts 1 through 4 below, drawn from FDIC data, demonstrate how very different the business model of the 7 largest US commercial banks was from that of the bulk of the banking system. Over the course of the 26 years covered by these charts the 7 largest US banks grew from accounting for only 20% of US bank assets to accounting for about 50% of US commercial bank assets just prior to the 2007-09 crisis. They continue to account for about 50% of assets today.

Chart 1: US commercial bank assets excluding the seven largest banks

Assets CB less 7

Chart 2: Seven largest US commercial bank assets

Assets Big 7

Chart 3: US commercial bank liabilities excluding seven largest banks

Liab CB less 7

Chart 4: Seven largest US commercial banks liabilitiesLiab big 7

The problem of monetary control

By the end of the 1970s many commercial banks were struggling. Their key source of funding was being eroded by competition with financial intermediaries that had been granted preferential regulatory status: the thrifts in the Northeast could pay interest on transaction accounts, MMFs could pay interest while offering limited checkwriting privileges, and for their biggest clients the banks had to compete with the totally unregulated Eurodollar market. In this difficult environment regulators had suddenly authorized the writing of “off balance sheet” guarantees. Unsurprisingly this set off destabilizing competitive dynamics, where the largest banks began to shift their business to fee-earning off-balance-sheet activities, promoting disintermediation at the expense of the banking system as a whole. Thus, in Chart 5 we see significant growth in MMFs and deposit substitutes at the end of the 1970s even as the growth in demand deposits stagnates.

Chart 5: Cash assets

Cash assets

Through the 1970s the Federal Reserve actively managed reserve requirements and their application to different instruments – including Eurodollar funding – in order to control the supply of credit. The Fed found, however, that banks were giving up their Federal Reserve membership in order to escape the regulatory burden of maintaining non-interest-bearing required reserves. Over the course of the 1970s the percent of transaction deposits held by member banks fell from 75% to 65% (and this measure did not include MMFs). The Fed’s ability to implement monetary policy was being eroded. A unilateral Fed proposal to start paying interest on reserves was blocked by Congressional opposition (Feinman 1993: 575-78). The Fed believed that monetary control required extending its authority to impose reserve requirements to cover all depository institutions (Volcker 1979). (Note that Volcker in his testimony on this issue is clearly aware that MMFs also have implications for monetary control, but does not appear to have solutions to offer.)

The Depository Institutions Deregulation and Monetary Control Act of 1980 (“DIDMCA,” Pub. L. 96-221) largely eliminated the distinction between thrifts and commercial banks on the liability side of the balance sheet (as the 1970 Commission had recommended):[1] it authorized thrifts to offer checkable deposits, phased out Regulation Q’s interest rate caps on all depository institution accounts, made thrifts subject to the Federal Reserve’s reserve requirements (with an eight year phase in), opened the Fed’s discount window to the thrifts, and raised the deposit insurance limit for both banks and thrifts to $100,000. On the asset side of the balance sheet, it repealed all usury restrictions on mortgages, including those at the state level (CEA 1981: 111).

Observe that the standard view at the time attributed the stabilization of the banking system in the 1930s to deposit insurance[2] (since the structural reforms of the 1930s were viewed as misguided) and thus there was an expectation that the expansion of deposit insurance mandated by the 1980 Act – together with the elimination of Regulation Q – would give the banks and thrifts a decisive competitive advantage over MMFs and Eurodollar accounts (FDIC 1997: 93). While DIDMCA was effective at stemming the outflow of deposits (see Chart 5), it slowed the growth of MMFs only temporarily.

In fact, there is strong evidence that any government sanction of a financial instrument that, like a bank deposit, is convertible at par into currency will be perceived as official support by the general public: the second wave growth of MMFs (see Chart 5) dates to the 1983 decision by the SEC (48 FR 32555) to formally authorize accounting for money market funds like bank deposits (that is, with a $1 net asset value) instead of using investment fund accounting. It is doubtful that MMFs are consistent with the intent of the Investment Company Act of 1940, which has two sections on “face amount certificate” companies that specify the capital and reserves that these companies are required to hold. As a result, in order for MMFs to operate as they had at the end of the 1970s, the SEC had to grant them exemptions from the Act and Rule 2a-4 (see 47 FR 5428). The 1983 Final Rule formalized this process of granting exemptions to the law in a regulation. In short, the post-Depression regulatory structure was explicitly designed to prevent investment funds from competing with deposits – unless they, like banks had capital and reserves. We have apparently learned the hard way that this structural separation was as important as deposit insurance in stabilizing the banking system post-Depression.

The Garn St Germain Act and its consequences

By 1980 the thrifts had been struggling for years with their legacy portfolios of long-term mortgages that had low fixed interest rates. The dramatic interest rate increases that accompanied Volcker’s policy of taming inflation had a devastating effect on these institutions, leaving many of them insolvent. Instead of recognizing the need to follow Roosevelt’s 1933 model of dealing assertively with a banking crisis by closing some thrifts and recapitalizing others, policymakers chose to eliminate restrictions on the thrifts’ asset portfolios in the hope that the thrifts would be able to earn their way to solvency.

The 1980 DIDMCA had already eliminated all interest rate ceilings on mortgages. In 1982 legislation dramatically broadened not just the types of residential mortgages the thrifts could make, permitting adjustable rate mortgages, balloon payments and negative amortization, but also dramatically increased what had been strict caps on commercial real estate lending (Pub. L. 97-320; McCoy et al. 2009: 499). It also eliminated entirely statutory limits on mortgage lending by commercial banks (§403(a)) such as the requirement that aggregate real estate loans not guaranteed or insured by a government agency could not exceed the greater of bank capital plus surplus or savings plus time deposits.[3]

For the first time in US history the regulation of bank mortgage lending was being left entirely in the hands of regulators. That is, the statutory restrictions on banking that legislators of the 1930s had put in place to protect financial stability and prevent real estate bubbles were first reframed by portfolio theory as “anti-competitive” and “inefficient,” and then eliminated by legislators unfamiliar with the actual history of the legislation. The OCC responded promptly with a regulation that placed no restrictions on national bank real estate lending (FDIC 1997: 95). In addition, within 5 years of this dramatic shift away from statutory restrictions, every single member of the Federal Reserve Board of Governors had been appointed by Reagan and the Fed was throwing its weight behind a deregulatory agenda.

Another part of the same legislation, known as the Garn St. Germain Act, made it easier for the depository institution insurers to provide assistance to troubled banks. Since 1935 the FDIC and FSLIC had been authorized to provide assistance to the merger of a failing bank with a sound one (Isaac 1984: 202). In some cases, the insurers provided “open bank assistance” to these mergers in the form of loans, deposits or purchases of assets, so that deposit-holders and other bank counterparties of the failed institution would experience no inconvenience. Prior to the Garn St. Germain Act the statutory requirements for such assistance were the determinations (i) that the institution was in danger of closing and (ii) that its services were “essential to the community.” Subsequent to the act these criteria were broadened significantly: the insurers could provide open bank assistance for the purpose of preventing the closing of an institution, restoring a closed institution to normal operation, or due to the danger of financial instability (§§ 111, 122; Gorinson & Manishin 1983: 1325).[4] They also could provide this assistance in additional ways including purchasing securities, assuming liabilities, and making contributions. The issue of “net worth certificates” to undercapitalized institutions whose loan portfolios were at least 20% mortgages were authorized (Title II).[5]

Observe that it was not just the thrifts that would be transformed by the Garn St. Germain Act. The law made it possible for the FDIC in 1984 to take Continental Illinois National Bank over on the basis of financial stability concerns. The development of the “too big to fail” doctrine protecting large banks will be explored in the next section. The same legislation also raised the statutory limit on national bank loans to a single borrower from 10% of bank capital to 15% of capital or, if the loan was secured by marketable assets, to 25% of bank capital (FDIC 1997: 94). While small rural banks were the public poster child for this reform, it had obvious benefits for the too-big-to-banks that often dealt with large corporate and government accounts.

As for the thrifts, as might have been expected, the reforms proved disastrous. Insolvent institutions are, after all, not well positioned to go through the learning process of mastering a new business. By 1989 the thrifts’ worsening condition could no longer be ignored and was addressed in the Financial Institutions Reform, Recovery and Enforcement Act (“FIRREA,” Pub. L. No. 101-73) by a complete overhaul of the regulatory structure governing them. The FHLB Board was abolished and replaced by two new agencies, the Office of Thrift Supervision governing the thrifts and the Federal Housing Finance Board governing the Federal Home Loan Banks. Freddie Mac was placed under the supervision of the Department of Housing and Urban Development, just like Fannie Mae (Colton 2002: 14). At long last, a new Resolution Trust Corporation was created to administer the assets of the failed thrifts, and the FSLIC was replaced by a fund administered by the FDIC. FIRREA required those thrifts that were solvent to lower their risks by selling loans and increasing their holdings of liquid assets. The resolution of the insolvent thrifts would end up costing more than $130 billion. As an additional step in the elimination of the structural distinction between the thrifts and the commercial banks, FIRREA opened membership in the FHLB system to commercial banks.

We should also note that in 1987 the Competitive Equality Banking Act was passed (“CEBA”, Pub. L. 100-86).[6] It had the important effect of closing the “non-bank bank” loophole, that had been created in 1970 when the Bank Holding Company Act had been amended to define a bank as an entity that accepted demand deposits and made commercial loans. By either restricting funding to exclude demand deposits or avoiding making commercial loans, a financial institution could preclude Federal Reserve regulation of its holding company. In the early 1980s the OCC did a brisk business in such “non-bank” charters. CEBA redefined a bank to include any entity insured by the FDIC in addition to any entity that accepted transaction accounts and made commercial loans (FDIC 1997: 98).[7]

Mortgage Securitization

One consequence of the efforts to deal with the troubled thrifts was the stimulation of securitization. When a thrift sold a below-market-rate mortgage, instead of taking the loss immediately – which would have reflected the reality of the transaction – thrifts were permitted by an FHLB Board policy adopted in 1981 to spread the loss over the remaining years of the mortgage (Lea 1996: 166). The result of this policy was a boom in mortgage securitization that facilitated a transition in the finance of conventional mortgages from the thrifts to the GSEs. As a result, the GSEs were financing more than half of all mortgages originated in the US from the late 1980s on and most of these mortgages were then securitized (Lea 1996: 166). In short, the collapse of the thrifts was eased dramatically by the rise of agency securitization.

While Freddie Mac’s business model from its founding in 1970 was based on the securitization of conventional mortgages (Howard 2014: 117), through the 1970s Fannie Mae focused on purchasing loans for its own portfolio and addressed the challenges of mortgage finance in the 1970s by shortening the length of its funding. Thus, the high interest rates of 1979 affected Fannie Mae in the same way that it had affected the thrifts: Fannie Mae was losing money on a daily basis and risked exhausting its capital. Fannie Mae, however, unlike the thrifts was not offered capital relief or allowed to change its mission. Indeed, the recommendation of the 1982 President’s Commission on Housing was that the GSEs should be fully privatized. Left to earn its way into solvency, Fannie Mae was successful in doing so by (i) dramatically widening the types of mortgages it purchased to include for example ARMs (On these mortgages Fannie required originator guarantees instead of underwriting the loans itself.) (ii) funding new purchases with debt issues that were maturity matched; (iii) generating fee income by securitizing mortgages (starting in 1981); and (iv) as interest rates fell extending debt maturities (Howard 2014: 27-28).

In 1983 Freddie Mac developed the first mortgage backed securitization that used tranching to address the uncertainty inherent in the timing of mortgage prepayments: some tranches were designed to pay off first. (This product was called a Collateralized Mortgage Obligation or CMO, but to limit the use of jargon I will call it a multi-tranche MBS.) While the multi-tranche MBS had more desirable properties for investors than the single tranche MBS, it was not clear under contemporary tax laws whether pass-through taxation would always apply or whether the structure itself could be subject to taxation (creating an undesirable situation of taxation both at the level of the structure and at the level of the investor) (Howard 2014: 118). This problem was addressed in the 1986 Tax Reform Act (Pub. L. 99-514) which created Real Estate Mortgage Investment Conduits (REMICs). By qualifying as a REMIC an MBS could have pass-through taxation (Howard 2014: 120).

This tax reform had been recommended by the 1982 President’s Commission on Housing, which also advocated that “all mortgage lenders and borrowers should have unrestricted access to the money and capital markets” (Colton 2002: 11). Thus, the Commission recommended the 1984 Secondary Mortgage Market Enhancement Act (SMMEA) which sought to put private label mortgage backed securities (PLMBS) on an even playing field with Agency MBS. Prior to this legislation PLMBS had been subject as securities to significant registration requirements and did not qualify as legal investments for many regulated entities. SMMEA exempted PLMBS from state antifraud and registration laws and made them legal investments for banks, thrifts, insurance companies, and pension funds (Howard 2014: 119-20).

Note that the latter created a significant distinction between Agency MBS and PLMBS. Agency MBS was deemed an appropriate investment for banks because the agencies were closely regulated government-sponsored entities with the goal of benefiting homeowners and the mortgage market. While PLMBS was also issued by regulated entities, that is banks, the goals of bank regulation place emphasis on the safety and soundness of the banking system and allow for bank failure. And there was no expectation that bank regulators should emphasize the interests of the mortgage market – or of MBS investors. Thus, SMMEA introduced the additional criterion that PLMBS had to receive an investment grade rating from a rating agency in order to be deemed an appropriate investment for a bank or other regulated institution. The end result was, however, that SMMEA was one of the early laws granting the credit rating agencies “de facto” supervisory authority over a segment of the financial industry.

As a result of this legislation, the market evolved so that the GSEs set standards for the mortgages they would purchase and securitize, and those loans that fell outside this category were held by banks or thrifts or placed in PLMBS. The loans eligible for purchase by the GSEs were known as “conforming” loans, while the ineligible loans were “non-conforming” and comprised of “jumbo” loans – or loans for an amount in excess of the GSEs’ statutory maximum – and “subprime” loans – which didn’t meet the GSEs’ lending criteria. (Later, and especially when the GSEs broadened their lending criteria, the number of categories increased and the terminology shifted.)

Because the GSEs made their money on volume, they competed to reduce costs to borrowers and to reduce origination costs by, for example, developing automated underwriting programs and encouraging competition between a large population of loan originators (Howard 2014: 90-91). To better match liabilities with assets, the GSEs started issuing callable debt, which by 1990 had become common (Howard 2014: 43). At the same time, because they bore the credit risk of every loan purchased for the life of the loan, they studied the market in order to set sustainable credit standards (Howard 2014: 91). By 1993 Fannie Mae, which had been at risk of failure in the early 1980s had brought its credit losses down to 4 basis points – despite lending on newer products like adjustable rate mortgages (Howard 2014: 46).

As securitization grew to be a more and more important source of mortgage finance, mortgage lending itself transitioned from the originate-to-hold to the originate-to-distribute model. This was accompanied by a shift to the origination of most mortgages by unregulated mortgage companies and brokers instead of by regulated thrifts as had been the case in the past (Immergluck 2009: 465). These unregulated mortgage companies were often subsidiaries of the bank holding companies. On the one hand, the new system was fiercely competitive which tended to keep costs down. On the other hand, many of the originators were thinly capitalized (Lea 1996: 168-69). On balance, however, mortgage securitization functioned well through the 1980s and 1990s.

Through most of the 1990s the GSEs made possible the standardization of mortgage underwriting and kept the cost of the 30 year mortgage consistently low at a spread of less than 1.5% to the 10 year US Treasury Bond (see Chart 6).[8] This was made possible by the entry of mutual funds, pension funds, and foreign entities into US housing investment (Lea 1996: 167).

Chart 6: Mortgage and Baa bond spreads

30Yr mtg 10 yr T spread

[1] On the asset side, it also allowed savings and loans to hold 20 % of their assets as consumer loans.

[2] See Isaac (1984: 198) citing Friedman and Galbraith.

[3] Additional restrictions that were lifted had required 30-year amortization for certain loans, had limited the maximum loan-to-value of mortgages, and had limited the aggregate unpaid balance on second lien real estate loans to 20% of bank capital plus surplus.

[4] It is highly likely that the Federal Reserve pushed for the addition of this latter clause, but I have not yet been able to document this claim.

[5] Mergers were also permitted across regulatory boundaries (e.g. of banks and thrifts or despite geographic restrictions), but only after determining that mergers within regulatory boundaries were not equally advantageous (Gorinson & Manishin 1983: 1326).

[6] The Fed had just lost a lawsuit challenging its effort to close the loophole by adopting regulations that relied on very broad rather than narrow interpretations of the relevant terms. Board of Governors of the Federal Reserve v. Dimension Financial Corporation, 474 U.S. 361 (1986).

[7] CEBA also imposed a six-month moratorium on regulatory agency decisions that expanded the role of banks in securities, insurance, or real estate (FDIC 1997: 97). In theory Congress was to reach a decision on these issues and enact a new statutory framework to replace Glass-Steagall. No such law was passed, however, and as soon as the moratorium was over the regulatory repeal of the statutory framework (that will be discussed in detail in a section on the Greenspan era) continued.

[8] As Lea notes standardization might have worked against the interests of non-traditional borrowers who could no longer successfully appeal their case to the local lender (1996: 167).

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The dismantling of the economy’s legal infrastructure V-2: An aside on the financial economics of the 30 year mortgage

Consider the practical questions of how the risks of financing 30 year fixed rate mortgages can be managed. There are two principal sources of risk: credit risk and interest rate risk; and two possible sources of funding: savings deposits and capital markets financing.

Credit risk is the risk that borrowers fail to make their payments. Even the best managed portfolio will have some regular level of default as borrowers are affected by illness and idiosyncratic hazards. Loan origination practices play a crucial role in credit risk, because if the borrowers are not carefully vetted, their likelihood of default will be higher. In addition, because of the regularity of economic cycles and the resulting fluctuations in employment, credit risk also has both a strong cyclical factor and includes the risk of extreme recessions/depressions. Finally, credit risk is also significantly affected by the loan products being offered: loan products that attract a more risky type of borrower can have dramatic effects on credit risk.

Interest rate risk exists because the funding of mortgage lending is typically shorter term than the mortgage loans themselves. That is, interest rate risk exists because of maturity mismatch between assets and liabilities. At any given moment in time the interest rate being paid on a 30 year fixed rate loan is greater than the interest rate being paid on savings accounts or on the capital market instruments used for funding. Interest rate risk exists because the interest rate on the 30 year fixed rate loan stays fixed for 30 years,[1] whereas the interest rates paid on savings accounts and the instruments used for funding are shifting over time. If the revenue being paid into the bank or funding vehicle from the portfolio of 30 year loans falls below the interest rate expense the bank or funding vehicle must pay to fund that portfolio, then losses will force the bank or funding vehicle into bankruptcy. In short, interest rate risk is the risk that the mortgage lender ends up in a nonviable situation where the lender can no longer afford to pay the interest rate necessary to continue to fund the mortgage portfolio. As a result, when maturity mismatch increases, so does interest rate risk: a portfolio of 12 year loans is safer than a portfolio of 30 year loans with the same funding.

It is important to understand that the greater the maturity mismatch between assets and liabilities, the harder it is to manage not only interest rate risk, but also credit risk. Over a 30 year period the likelihood that an extreme, unexpected recession will occur is much higher than over a 12 year period, and the very slow rate of repayment of 30 year loans means that repositioning the portfolio is much more difficult than it is for 12 year loans. In short, short term financing of a 5 year loan portfolio is easier to manage than short term financing of a 12 year loan portfolio, which in turn is easier to manage than short term financing of a 30 year loan portfolio. This fact explains the structure of mortgage lending prior to the Depression, where the safety of commercial banks was considered a paramount goal, and savings and loan associations were less regulated, but attentive to the risks of mortgage lending.

Once one understands the risks of 30 year fixed rate mortgages, the question becomes how it is possible for the private sector to finance them. Let’s go over the options.

First, consider the case of the very short term funding provided by savings and commercial banks. One solution is for the banks to only lend a fraction of their balance sheets to mortgages, say 10 or 20 percent. In this situation, the banking system as a whole can almost certainly manage its way around the risks. On the other hand, there will be very little availability of these mortgages compared to what we are accustomed to today. In order to reduce demand to this level, one would have to assume that 30 year fixed rate mortgages are actually very expensive – at which point other mortgage options are likely to become popular. Arguably this was more or less the situation before the 1930s: there was a purely private bank-funded solution to the mortgage problem, but mortgages were much less favorable to consumers than the 30 year fixed rate mortgage to which we are all accustomed.

So what are the alternatives for savings and commercial banks to fund 30 year fixed rate mortgages at low rates and with general availability. Without some form of government support, there is little reason to believe that it is possible for the private sector to manage the risks of this extreme maturity mismatch when mortgages account for a significant fraction of bank balance sheets. To address credit risk, there needs to be a government backstop for the lenders in the event of a severe recession. In the 1930s when the 30 year mortgage was first introduced, Federal Housing Administration insurance was created to provide this backstop.[2] In 2009-2011 there was a “backdoor bailout” by a vast broadening of Federal Housing Administration insurance and a program of Federal Reserve-financed refinancing of mortgages.[3] Interest rate risk can be addressed by either financial repression that stymies the market forces raising short term interest rates and forces consumers to incur negative real returns on their savings and thus to bear the costs of funding mortgages, or a government backstop that supports the bank mortgage lenders through the period where they are upsidedown on their net interest rate revenue.

Elements of a policy of financial repression were attempted in the 1960s and 1970s, but there was no genuine commitment to stymying market forces[4] (as there was in Nazi Germany, the classic case of financial repression) and as a result by the early 1980s the realization of interest rate risk had left vast swathes of the savings and loan industry bankrupt. Famously, the government instead of providing the necessary backstop promptly attempted through deregulation to allow the bankrupt savings and loans to earn their way to solvency – and succeeded only in making the problem worse. By the time the savings and loan industry was finally bailed out by the government in 1989, the cost of the bailout had increased dramatically.

An alternate solution to private sector funding of 30 year mortgages is to finance them using capital market instruments. In particular if funding is both longer-term than the mortgage portfolio and callable (that is, the borrower can choose to pay it before maturity), then interest rate risk cannot drive the funding vehicle into bankruptcy. The reason long-term funding must be callable in order to address interest rate risk is that the typical 30 year mortgage permits prepayment and is therefore refinanced when interest rates decline. In order for maturity matching to work, the funding instrument must also be pre-payable. Even if interest rate risk is addressed by maturity matching, credit risk remains and can cause the funding vehicle to go bankrupt, putting losses to the capital markets investors. Thus, because the 30 year lending horizon is inherently risky and because the embedded call option also has a price, capital markets investors are likely to demand relatively high rates for this product, which will in turn mean that for the vehicle to be financially viable 30 year mortgages will have to have relatively high rates. Certainly, in an environment where government subsidization of 30 year mortgages is the norm and is expected, it will be impossible for a purely private funding vehicle that eschews maturity mismatch to compete. (While this type of funding did exist for a short time in the US in the early ‘00s, the market for private label mortgage backed securities (PLMBS) collapsed entirely and had to be bailed out alongside the banks that participated in it.[5] It is no longer a meaningful player in the US mortgage market.)

A standard mechanism for reducing the cost of funding on capital markets is to have a capitalized corporation provide a guarantee to the debt security instead of having it issued by a bankruptcy-remote funding vehicle. A corporate guarantee on the debt ensures that the shareholders of the corporation will bear any losses before the investors do. Under these circumstances the mortgage backed security will bear an interest rate comparable to that of the debt issues of the corporate guarantor. This is a standard means of funding mortgages and is comparable to the system of “covered bond” finance in Europe.

Whether an entirely private corporation will be willing to take on the risks of providing such a guarantee to a securitization of 30 year fixed rate mortgages is I believe unknown. (If you know of an example, please let me know.) The PLMBS that were issued in the US in the early naughties did not have such a guarantee. By contrast, government guarantee of the securitization of 30 year fixed rate mortgages is definitely a viable model, as illustrated by Ginnie Mae, which still issues MBS today.

There is another hybrid model of capital market funding of 30 year mortgages: that of Fannie Mae and Freddie Mac, which were private, but “government-sponsored” corporations (“GSEs”) from 1970 to 2008. These GSEs provided a corporate guarantee of all of their securitizations which put their shareholders at risk, and their longevity is indicative of the fact this model is at least potentially viable. Even though the GSEs had shareholder funds at risk, they were highly regulated and received government support of their debt in the form, for example, of legal preferences for GSE debt over general corporate debt as an asset that may be held by banks and the Federal Reserve (and other regulated entities). Timothy Howard makes the case in The Mortgage Wars for the success of this model.

Under the GSE structure, government support allows the corporations to raise both short and long-term funds cheaply, regulatory requirements set the level of capitalization and monitors that the vehicle is meeting goals for the provision of low-cost mortgage finance, and the private capital at risk creates incentives for careful management of interest rate and credit risk. The corporate guarantee is the key element that makes the GSE structure work: it is in the interests of GSE to carefully supervise the quality of the mortgages it securitizes; in economics jargon incentives are aligned. Thus, the GSEs set the mortgage standards in the US mortgage market for decades – the word “subprime” originally meant that a mortgage was below GSE standards. They reviewed loans carefully and were able to weed out from a plethora of newly introduced loan characteristics those that were consistent with quality mortgages and those that were not. As a result, the securitization market that collapsed in 2007 was the private-label securitization market, not the GSE market.

Howard (2014) makes the case that through the 1990s and into the early naughties Fannie Mae had exceptionally high quality risk management. This is, however, also the pitfall of this GSE model. As Howard’s account itself indicates risk management was such a difficult task that a change in management at the end of 2004 was sufficient to destabilize a very effective mortgage funding mechanism. (On the other hand, one does need to be careful about allowing sceptics of government support to prove their point by sabotaging the GSEs, as Howard argues OFHEO, Fannie Mae’s regulator did. I, unfortunately, have no capacity to weigh these claims on their merits.)

Overall, the conclusion one draws from this discussion is important: there is virtually no reason to believe in the feasibility of the 30 year fixed rate mortgage as a financial product in the absence of some form of government support.

My next post will study what happened when the government, instead of recognizing that if it wanted to support the 30 year loan as a financial product, it would have to underwrite many of its risks, chose to distort financial regulation in order to promote cheap finance for housing.

[1] Because the norm with 30 year fixed rate mortgages is to permit payoff without a prepayment penalty, when 30 year interest rates fall, the interest rate being earned on the portfolio tends to fall quickly as borrowers choose to refinance their loans. There is no counterbalancing effect when 30 year interest rates rise. This makes the interest rate risk problem even more severe, and is known as prepayment risk.

[2] Note that in the 1930s the focus of concern was credit risk, not interest rate risk, because the gold standard had precluded interest rate risk for the preceding generation or two and the immediate problem was deflation and low interest rates.

[3] Owners of shares in Fannie Mae and Freddie Mac make the case that one should add the conversion and use of the GSEs as instrumentalities of the government to this list (Howard 2014: 250-53; http://www.housingwire.com/articles/print/29008-paying-fannie-and-freddie-investors-was-never-part-of-the-plan).

[4] The permissive attitude to the growth of Eurodollar accounts and money market mutual funds precluded a successful policy of financial repression.

[5] Howard (2014: 131) explains the flaws of PLMBS. Because there is no corporate guarantee, there is no incentive for credit standards to be enforced. Thus, when mortgage lenders generate new risky characteristics for loans and rating agencies make risk judgments without adequate or applicable historical data, there is nothing to stop these loans from being securitized and sold on to investors. In this environment relaxed underwriting can bring in new buyers who would not have qualified in the past.

The dismantling of the economy’s legal infrastructure V-1: The evolution of bank balance sheets

Over the last quarter of the 20th century mortgages grew to make up the principal asset in commercial bank portfolios and concomitantly housing now plays an increasingly important role in the economic cycle (Jorda Schularick & Taylor 2014). The shift in commercial bank balance sheets is depicted in Charts 1, 2, 3, and 4 all of which are drawn from the historical data available on the FDIC’s website: https://banks.data.fdic.gov/explore/historical. The vertical lines on the charts divide them into three eras: the war and post-war era up until 1965, the era of inflation from 1965 to 1981, the era of regulatory reform from 1981 to 2008, and the post-crisis era.

Chart 1 provides context, giving an overview of how the asset side of the commercial banks’ balance sheet has evolved over time. During World War II Treasuries (held as investment securities) and cash accounted for more than 80% of bank balance sheets. This declined fairly steadily, so that in 2007 cash and investment securities (which now were dominated by Agency obligations) fell below 20% of assets. This decline was mostly accounted for by an increase in bank lending.

Chart 1: US Commercial Bank Assets

CB Assets

Chart 2 shows that the dramatic increase in commercial bank lending after World War II only represented an increasing flow of bank funding into business activity up until the early 80s (with a decline after the oil price shock of the mid-1970s). (Note that “C&I loans” is short for “commercial and industrial loans.”) From the early 1980s on, commercial bank business lending is mostly on the decline as a percentage of activity, and instead real estate loans begin to dominate commercial bank balance sheets. Furthermore, because most of the Agency securities in which commercial banks invest are also mortgage-backed, by 2004 an unprecedented 40% of commercial banks balance sheets are supporting real estate and that fraction has barely declined up to the present.

Chart 2: Select US Commercial Bank Holdings as a percent of assets

CB Holdings ov Assets

Chart 3 focuses on commercial bank loan portfolios and shows how the fractions of the commercial bank loan portfolio that went to businesses, to real estate and to individuals were remarkably stable up through the early 1980s except for a deviation presumably caused by the oil price shock of 1973. It also shows that during the era of regulatory reform business lending dropped from 40% of bank loans in the post-War era to 20% of bank loans today. At the same time real estate lending rose from 25% of bank lending to almost 60%. We also see that residential real estate lending makes up about 60% of commercial bank real estate lending, and except for a few years in the late 1980s has consistently comprised more than half of commercial bank real estate lending.

Chart 3: Select US Commercial Bank loans as a percent of total loans

CB Loans o Total

In short, the data makes us ask: What happened to commercial banks during the era of regulatory reform? Furthermore, the pattern of the data in Chart 3 indicates that residential mortgage policy might have something to do with it.

1930s monetary theory held that the use of demand deposits to finance long-term assets like real estate would foster asset price bubbles in the long-term assets thus financed due to the feedback loop between bank expansion of demand deposits, loans, and asset prices. As a result, in the 1930s commercial bank real estate loans were funded by savings and time deposits and accounted for only a fraction of them, typically about 40%. And savings deposits made up only a fraction of the deposit base compared to demand deposits. Thus, it is worth looking at what has happened to commercial bank liabilities, too.

Chart 4 shows that commercial bank liabilities were composed mostly of demand deposits in the immediate post-war period, but their share declined steadily from about 1955 to 2008. Unsurprisingly the most dramatic decline took place during the inflationary era when most depositors were looking for a way to avoid holding a non-interest bearing asset. Savings and time deposits make up by far the majority of bank liabilities today. Even so, the growth in real estate loans up until the 2007 crisis was much faster. As a result, the ratio of real estate loans to savings plus time deposits grew steadily from 1983 to 2007 (see Chart 5). Another point to take into consideration is that savings deposits are much easier to use for transactions today than they were 70 years ago, as there are now a variety of means by which savings are transferred automatically in order to cover checks.

Chart 4: US Commercial Bank Liabilities

CB Liabilities

Chart 5: US commercial bank real estate as a fraction of savings + time deposits

RE ov Svgs

Since real estate loans appear to have played a very important role in regulatory reform’s transformation of commercial banking, it’s worth taking a look at what was going on with the institutions that were set up in the 1930s to fund real estate loans, the thrifts. The FDIC has data on the thrifts under the title “Savings Institutions” dating from 1984.

Keep in mind, however, that these balance sheet data mask the fact that the thrift industry stopped growing at the end of the 1980s. Thus, even though thrifts accounted for approximately one-third of depository institution assets from the post-war period through 1988, today they account for only about 5% of depository institution assets. In short, what is going on in the diagrams below matters less and less over time to the economy as a whole.

Charts 6 and 7 demonstrate that for thrifts the era regulatory reform did not affect their activities. They would continue to specialize heavily in real estate loans right up until the 2008 crisis. And only in recent years have the thrifts begun to diversify their activities to a significant degree. Chart 8 presents thrift liabilities and demonstrates that aside from an increase in FHLB loans and in brokered deposits in the years preceding the recent crisis, the liability side of thrift balance sheets didn’t change much either.

Chart 6: Savings institutions holdings as a percent of assets

SI Holdings ov Assets

Chart 7: Select saving institution loans as a percent of total loans

SI Loans o Total

Chart 8: Savings institution liabilities

SI Liabilities

To make very clear how the financial system as a whole evolved over the era of regulatory reform it is useful to combine the balance sheets of the commercial banks and the thrifts. (Together they cover close to 95% of depository assets. Credit Unions are omitted because I do not have that data.) Chart 9 presents holdings of loans and securities as a percent of assets. We see that changes in the aggregate balance sheet from 1984 to 2007 are in general not large with a few exceptions: the percent of combined commercial bank and thrift balance sheet devoted to business lending declined by 31%, while real estate loans increased by 21% and agencies increased by 48%.

On the other hand, Chart 10 presents the same data as Chart 9 with two differences: Both real estate loans and agencies on commercial bank balance sheets are separated from those on savings institution balance sheets. Chart 10 shows the primary transition that took place amongst depository institutions during the era of regulatory reform. Commercial banks started funding the mortgages that the shrinking thrift industry was no longer financing.

Chart 9: Select holdings as percent assets for commercial banks and thrifts combined

CBnSI

Chart 10: Select holdings as percent assets for commercial banks and thrifts combined with separate detail for real estate loans and agencies

CBnSI spec

So what conclusion should we draw from these charts? The era of regulatory reform was one in which commercial banks grew to look more and more like the thrifts on both the deposit and liability sides of the balance sheet. As a result, the effect of the regulatory response to the instability of the thrift institutions in the 1970s and 1980s was to reform the banking system so that it would be more like the unstable institutions. One result of this reform was that when the 2007-09 crisis blew up the U.S. banking system was structurally unsound and had to be saved by a simply grotesque bailout of the commercial banks.

Arguably another result, as I will argue in an upcoming post, was that the new structure of the banking system fostered the growth of a housing price bubble. That post will also attempt to fathom why this rather obviously destabilizing reform of the banking system took place. Before doing so, however, in my next post I discuss the character of 30 year fixed rate mortgages and the challenges of financing them.

 

The dismantling of the economy’s legal infrastructure IV: the 1930s restructuring of the banking system [Updated]

1930s banking reform was predicated on the assumption that because commercial banks issue monetary liabilities, it is essential to control the flow of credit – financed by the expansion of the money supply – from banks. In the absence of such control the economy is prone to destabilizing asset price bubbles, because in Anglo-American financial systems there are robust capital markets, and feedback loops can develop between the expansion of the money supply by the banking system and securities prices or real property prices. Given the demonstrated inability in the 1930s of the recently-created Federal Reserve to impose such control through regulation, Congress took a statutory approach and created a compartmentalized financial system. Legislative history makes it clear that preventing the instability associated with asset price bubbles was a motivating force behind the legislation (Senate Report 1933; Sissoko 2018). [Update 2-6- 2019: The link to the Senate Report has been added at the bottom of the post.]

Thus, in the financial reform of the 1930s investment banking was separated from commercial banking and the existing distinction between mortgage lending institutions and commercial banks was preserved. This compartmentalized structure lasted for less than 40 years, as the inflation of the 1970s led to innovations and policy decisions that created deep fissures in the structure of the segmented system. By the 1980s reform was necessary. Both the policy decisions of the 1970s and the reforms of the 1980s were based on a completely different model of the financial system than that on which the 1930s structure had been built.

The discussion of this history will be separated into two parts: (i) the financial reform of the 1930s and the evolution of the segmented financial system through the 1960s, and (ii) the dissolution of that system. This blogpost addresses the early history.

Mortgage lending in the 1920s

In the years preceding the Depression mortgage lending was provided by a wide range of institutions including savings and loan associations, savings banks, mortgage companies,[1] commercial banks and insurance companies. Only the savings and loan associations offered longer-term amortizing loans of up to 12 years. More typical loans were for five years or less and required only interest payments until maturity when a balloon payment of the whole principal was due.[2]

This market structure reflected basic principles of asset-liability matching as they were applied to financial institutions at the time. In order to limit the likelihood of a liquidity crisis, commercial bank loans that were funded by demand deposits were generally short-term and/or callable. Longer term loans, such as mortgages, were funded by savings deposits which often required that notice be given before withdrawal. Thus, commercial banks were actively engaged in mortgage lending, but only with a small portion of their funding, since most of their funding was demand deposits. Even so, commercial banks were prohibited by statute from lending on mortgages of more than 5 years (Eccles 1937: 164). Thus, it was the savings banks and savings and loan associations that put most of their funds into mortgage lending.

The term savings and loan association reflects the concept underlying this cooperative means of mortgage finance. A member in the association was expected to keep his or her savings with it, earning a good rate of return, and in exchange the member was eligible for a loan. Thus, these cooperatives did not intermediate between a group that saved money and a distinct group that borrowed money. Instead, these mutual associations were created because those who were saving money would also need to borrow money to purchase property. Members had an interest in establishing a savings account in order to meet the eligibility requirements of the savings and loan association for a loan, and would often continue placing their savings with the association even after they had paid their loan since a competitive rate of interest was earned while at the same time they were supporting other members of the community.

The 12-year amortized loan[3] was the means by which the savings and loans made it possible for the middle class to afford a home, while at the same time managing the risks of funding these purchases with savings accounts (Weiss 1989: 109). A $5000 home loan at 6% per annum amortized over 12 years results in a monthly payment just under $50 or about the weekly wage of a skilled urban worker. (At 9% interest the payment would be $57 per month.) At the same time even in the first year of a 12 year loan 6% of the principal is repaid, and on average across an evenly spaced portfolio of loans over 8% of principal is paid every year. In short, this was the type of loan that was both a little hard for a savings bank to manage and little bit of a stretch for a lower-middle class consumer at the time. By contrast, 30 year fixed rate loans strongly favor the consumer, and are very difficult for a depository institution to manage: A $5000 home loan at 6% amortized over 30 years results in a monthly payment of $30, just over 1% of principal is repaid in the first year and on average these loans repay 3% of principal every year.

In short, the reason that 30 year mortgages were not offered in the years preceding the Depression is because the savings banks funding mortgages could not possibly hope to manage the risks of lending over that time horizon. With 12 year loans 58% of their funds were committed for more than 5 years. With a portfolio of 30 year loans 83% of their funds would be committed for more than 5 years. Given that their liabilities were all short-term and a lot can change over the course of just 5 years, the 12 year amortized mortgage was considered to be the limit of risk that it was appropriate for a savings institution to take – for good reason.

On the other hand, this loan structure – and particularly the fact that many mortgages were insurance company, commercial bank, or personal loans that were only for about 5 years and were not amortizing – meant that a severe recession could cause defaults, foreclosures and declining housing prices. As a result, real estate crises in which many lenders failed were regular events: the late 1890s and mid-1920s are examples. Thus, the housing troubles of the 1930s differed mostly in terms of their severity and the nationwide reach of the crisis. During the Depression housing became a national problem, and it was addressed at the Federal level. Indeed, alongside employment and social security, preserving homes was one of the three goals President Roosevelt announced in his 1935 State of the Union speech.

Mortgage lending: the reforms of the 1930s and their consequences

The Federal Home Loan Bank System was established in 1932 under President Hoover (Pub. L. 72-304). It was modelled on the Federal Reserve System with 12 regional banks and a governing board, the Federal Home Loan Bank Board, in Washington, D.C. It was designed as a mutual association of savings institutions (also known as thrifts), all of which jointly guarantee Federal Home Loan Bank debt issues. These debt issues are used to fund purchases of mortgages originated by member institutions. Thus, the system was designed to serve as a source of liquidity for thrifts, which in 1932 financed over 46% of all residential mortgages.[4]

Unfortunately, the Federal Home Loan Bank Act was a matter of too little, too late and did little to mitigate the housing crisis. Furthermore, like banks, many thrifts failed in 1932 and 1933. Unlike banks, thrifts were not covered by FDIC insurance when it was created in the Glass-Steagall Act of 1933, and as a result over the course of subsequent months savings migrated from thrifts to banks. By 1934 the thrifts’ share in the mortgage market had dropped to 37% (Lea 1996), a dramatic 20% decline over the course of two years.

In 1934 the National Housing Act (Pub. L. 73-479) was designed to stimulate the building trades and promote employment in them by creating both the Federal Savings and Loan Insurance Corporation (FSLIC) to support the thrifts, and the Federal Housing Administration (FHA) to support other mortgage lenders (Cong. Rec. 1934: 11189).[5] The FSLIC was designed to stabilize the thrift institutions, just as the creation of the FDIC had stabilized the banking system a year earlier. The thrifts’ share of the mortgage market would slowly recover reaching 40% in 1952 and would peak at about 55% in the mid-1960s (PC on Housing, 1982; Lea 1996).

The FHA facilitated non-thrift mortgage lending by creating a consumer-friendly long-term amortized mortgage product that commercial banks and insurance companies could invest in. The FHA addressed the fact that these mortgages were not viewed as appropriate investments for banks and insurance companies by providing government insurance to long-term fixed-rate amortizing mortgages that met specified underwriting criteria. The insurance premium of one-half a percent on the principal value of the loan was paid by the borrower on top of an interest rate with a statutory maximum of 6%.[6] At the same time the new law permitted national banks to hold FHA-insured loans despite the general statutory prohibition on loans in excess of 5 years or in excess of 50% of the property value. (State legislatures promptly passed similar enabling legislation for state-chartered banks, Eccles 1937.) Thus, the FHA program served the needs of insurance companies and commercial banks, and their share of mortgages outstanding grew from 10% each in 1932 to about 20% each in 1952 (Lea 1996).

Mortgages outstanding by holder

By slowly increasing the participation of commercial banks and insurance companies in the mortgage market and by promoting consumer-friendly mortgages, the FHA almost certainly played a positive role in the recovery from the Depression and from World War II. This, however, came at a cost as the FHA played a dramatic role in shaping not just the structure of US mortgage markets, but also patterns of housing construction and of home-ownership in the US with vast and long-lasting unintended consequences.

America’s urban fabric places great emphasis on suburban living and on cars as means of transportation. Troubled inner-cities surrounded by well-to-do suburbs did not develop by accident, but in no small part because the FHA in its effort to promote the construction industry favored large, new buildings over the existing housing stock and more modest sized homes. Urban construction frequently did not qualify for insurance. The very structure of the typical American subdivision is a product of FHA handbooks, including the preference for strip malls over ubiquitous corner shops (Hanchett 2000; Zuegel 2018).[7]

The FHA also played a huge role in institutionalizing redlining – or racially discriminatory practices – throughout the country and demanded racial and class-based segregation of subdivisions (Hanchett 2000; Brooks & Rose, 2013). And one should remember as one discusses the extraordinary advantages of federal support for housing finance that the groups that were deliberately excluded from these advantages are much less wealthy today than they would have been if the same advantages had been extended fairly to all citizens (Baradaran 2017).

But our focus here is on how the FHA transformed mortgage markets. The FHA played a huge role both in the standardization of mortgages and in the reduction of the costs paid by the homeowner: the 30-year fixed rate mortgage with a maximum 90% loan to value became the norm, as did relatively low interest rates. Prior to the FHA the typical first mortgage was for up to 60% of the home’s value at a rate between 6 and 10% (depending on location) and most borrowers also carried additional mortgages at higher rates (Eccles 1937; FHLB Review 1934: 18). Although the thrifts did much less FHA insured lending, they too extended the terms of their loans and increased the amount they were willing to lend against the value of the home.

The National Housing Act (specifically Title III of the Act) had envisioned that liquidity would be provided to the non-thrift mortgage market through the creation of federally chartered, but privately owned, national mortgage associations that would stand ready to buy FHA insured loans. In fact, not one such association was formed – possibly because the thrifts had successfully lobbied against giving the national mortgage association’s debt the same tax exemption as the Federal Home Loan Banks’ debt (Cong. Rec. 1934: 11181, 11208, 12566). To address this situation in 1938 the government-owned Federal National Mortgage Association (Fannie Mae) was created. In 1948 (Pub. L. 80-864) Fannie Mae was made a federally chartered institution and authorized to purchase in addition to FHA loans the Veteran Administration-insured loans that had been created by the post-War GI Bill (Pub. L. 78-346).

As the economy recovered and Fannie Mae’s role in the mortgage market increased, concerns were raised over an excessive government role in the mortgage market. Transition to private ownership on the model of the Federal Home Loan Banks – that is lenders who sold loans to Fannie Mae had to also hold Fannie Mae stock – was initiated in 1954 (Pub. L. 83-560). In 1964 Fannie Mae was authorized to bundle FHA and VA mortgages together and to sell interests in the bundles. That is, Fannie Mae was authorized to securitize FHA and VA mortgages. At the same time national banks, thrifts, and FHLBs were authorized to invest in these securitizations (Pub. L. 88-560). In 1968, however, Fannie Mae was separated into two entities (Pub. L. 90-448): Ginnie Mae (the Government National Mortgage Association) remained a government-owned entity that packaged together FHA and VA loans and sold the securitizations to private investors; Fannie Mae was transformed into a government-sponsored private corporation that was required to allocate a reasonable portion of its business to mortgages on low- and moderate-income housing and was authorized to securitize mortgages, subject to government supervision.[8]

Observe that, because the thrifts had never relied heavily on Fannie Mae’s facilities, it was a commercial bank and insurance company-owned entity. The thrift industry immediately recognized that if Fannie Mae was authorized to securitize privately-originated mortgages, this could leave the thrifts at a disadvantage, so they lobbied for a similar facility.[9] Thus, in 1970 the Federal Home Loan Mortgage Corporation (Freddie Mac) was created, as an entity owned by the FHL banks and run by the FHLB Board with authority to purchase conventional mortgages (with a limit on the amount and on the loan-to-value of each loan) and securitize them (Pub. L. 91-351). This same law explicitly authorized Fannie Mae to purchase conventional mortgages on the same terms. This had the effect of establishing both a statutory standard targeting low- and moderate-income housing and a statutory prudential limit on the riskiness of the mortgages.

Let’s pause for a moment and consider the structure of US mortgage markets in the post-War years. It was divided into two segments: the non-thrift financial institutions supported by Fannie Mae and the thrifts supported by the FHLB system, FSLIC deposit insurance, and later Freddie Mac. Up to 1968, the non-thrift financial institutions mostly originated FHA and VA insured loans that could be sold to Fannie Mae, and conventional loans (that is, those that were not government insured) were mostly originated by the thrifts. This structure had worked for most of the 1950s and 1960s, because the growth of lending by the thrifts had met the needs of the public and made government-insured loans a decreasing percentage of the mortgage market.

The problematic nature of private institutions funding 30 year loans with short-term deposits was in evidence by 1965 when the Federal Funds rate rose over 4%. Competition between thrifts led them to increase their savings account rates, which raised safety and soundness concerns at the Federal Home Loan Bank Board (Hester 1969). In 1966 Regulation Q, which had long governed the maximum interest rate paid on commercial bank savings deposits, was extended to the savings accounts held at thrifts and authority was given to the FHLB Board to set the maximum rate. The long-term effect of Regulation Q was, however, that as interest rates rose, the thrifts had fewer deposits with which to finance their activities, and through the early 1970s the diminished lending capacity of the Savings and Loans was a growing problem for the mortgage market.

Investment banking: the reforms of the 1930s

As was noted above, 1930s financial sector regulation was constructed on the premise that commercial banks are special because their primary liabilities and thus their primary sources of funding circulate as money. Commercial banks, like the savings and loan associations, had developed because the same businessmen who often had positive cashflow – and thus money to put in the bank – also were very aware that sometimes they had negative cashflow and that short-term loans could be very valuable under these circumstances. These businessmen kept their money with their local bank, not because the were “savers,” but because by doing so they could also rely on the bank to advance them money when they needed a short-term loan. The commercial bank was thus a coordination device that converted the local money supply into a source of short-term funding for local businesses. That a bank-based money supply expands the working capital available to the business community was a fundamental precept of  monetary theory at the time.[10]

In short, in the 1930s money was understood to be a network phenomenon that – to a limited extent – the banks could expand at will without affecting prices. Of course, if the money supply expanded beyond a certain threshold, it could cause either localized inflation, for example when a particular type of long-term asset was being financed by the issue of bank money, or general inflation when an excessive monetary expansion was not so targeted. In short, in the 1930s monetary expansion was understood to be the cheapest way to fund productive activity both for the banks and for the economy as a whole as long as the coordination problem of not issuing too much money and thereby setting off inflation and instability could be addressed (Schumpeter 1939). For 1930s regulators the challenge of financial regulation was to harness the extraordinary power of monetary finance and at the same time control it.

The 1929 stock market crash had been fed by commercial banks offering accounts that invested in stock market margin loans paying as much as 10% per annum – for an overnight, overcollateralized loan – despite the jawboning of the Federal Reserve and influential Congressmen (Senate 1933). In short, the stock market crash had made it clear that the Federal Reserve did not have adequate control over the commercial banking system and the use of funds created by expansion of the money supply (Sissoko 2018). 1930s policymakers decided to turn the monetary system into one that was susceptible of control.

Because of the ease with which the commercial banks can expand the money supply and because of the tendency for bank finance of long-term assets to result in asset price bubbles as had occurred in 1929, the most important aspect of this control was the structural separation of the commercial banks from the investment banks. The Senate Report on the Glass Steagall Act clearly identifies the asset price bubble in the stock market as a consequence of a feedback mechanism generated by bank finance of margin loans (Senate 1933; Sissoko 2018. See also Adrian & Shin 2010). Thus, when the Senate Report summarizes the ills that the Glass-Steagall is designed to address, the first point is “bank loans and their uses” and the Report goes into some detail into how the legislation is designed to control and restrain the use of bank loans. In short, the legislative history is crystal clear: the Glass Steagall Act was passed for the purpose of controlling the flow of bank money. (Note that real estate finance was already for the most part a structurally separate activity and thus was not directly addressed in the bills reforming the commercial banking system.)

While it is generally understood that the Glass Steagall Act separated commercial banks from investment banks (or broker-dealers), the full impact of the Act on the banking system is underestimated. The Glass Steagall Act was designed to protect deposit-taking institutions by (i) preventing them not just from acting as broker-dealers, but also from intermediating security-backed loans to broker-dealers; (ii) empowering the Federal Reserve (a) to regulate the quantity of security-backed loans held by banks as well as interest rates paid by them on deposits, and (b) to replace bank officers and directors who fail to comply with banking laws or to respond to safety and soundness warnings; (iii) prohibiting a bank from lending to its own executive officers, and limiting loans to affiliates and investments in bank premises; (iv) setting capital requirements for all Federal Reserve member banks; (v) creating the FDIC to provide federal deposit insurance to commercial banks; and finally (vi) prohibiting broker-dealers from receiving deposits and requiring state or federal examination and supervision over any deposit-taking institution. For national banks the Act also imposed limits on the interest rate that could be charged on loans; as the limit was the higher of the state usury limit or 1% over the 90-day commercial bill rate, presumably the goal was to limit the risk involved in any national bank loan.

In short, the Senate’s concern with the use of bank loans and their destabilizing flow into securities markets was addressed from every angle. Federal Reserve member banks were forced to spin off any affiliates whose principal activity was broker-dealing (“the issue, underwriting, or distribution of securities”). And broker-dealers were prohibited from taking deposits. And member banks were prohibited from having an officer or director who was also an officer, director, or manager of a broker-dealer. And directors, officers, and employees of any bank organized or operating under the laws of the US were prohibited from being at the same time the director, officer, or employee of a business that makes loans secured by the collateral of stocks or bonds. And every deposit-taking institution was required to be subject to either state or federal examination and regulation. And Federal Reserve member banks were prohibited from intermediating non-bank loans to the broker-dealers if they are backed by securities. And the Federal Reserve was required to set limits on direct bank lending to broker-dealers that is secured by stock or bond collateral.

As a result of this structure the flow of funds from banks that had access to the Federal Reserve discount window into securities-based lending was strictly regulated by the Federal Reserve, and this was an essential part of the structure designed in the 1930s to stabilize the financial system. While federal deposit insurance, statutory capital requirements, constraints on self-dealing, and the additional authority over banks granted to the Federal Reserve surely also played a role in the decades of financial stability, it is a mistake to forget that the first goal of the Act was the firewall it constructed between deposit-taking institutions and securities markets.

Overall, the goal of the segmented structure created by the Glass-Steagall Act was to support a liberal flow of bank money – which monetary theory at the time viewed as playing a crucial supporting role in the circular movement of economic activity – while preventing that liberal flow of money from playing a significant role in the finance of capital market assets or real estate. This structure remained intact through the 1960s, until the inflation of the 1970s coincided with a shift in monetary theory that no longer viewed the flow of commercial bank money as both essential and in need of control. Thus, the 1970s were years of dramatic financial innovation that set the financial system on a very different path from that laid out in the 1930s. The history of this evolution is the topic of the next post.

[1] Mortgage companies were intermediaries that sold whole loans or covered bonds – that is, bonds guaranteed by the mortgage company – to investors including commercial banks and pension funds.

[2] See Michael J. Lea, Innovation and the Cost of Mortgage Credit: A Historical Perspective, 7 Housing Pol’y Debate 147, 154-59 (1996); Marc A. Weiss, Market and Financing Home Ownership: Mortgage Lending and Public Policy in the United States, 1918-1989, 18 Bus. & Econ. Hist. 110, 111-12 (1989); Daniel Immergluck, Private Risk, Public Risk: Public Policy, Market Development, and the Mortgage Crisis, 36 Fordham Urb. L.J., 447, (2009); David Min, Sturdy Foundations: Why Government Guarantees Reduce Taxpayer Risk in Mortgage Finance (Working paper: 2012).

[3] I am simplifying here by describing the situation with respect to the maximum term of a savings and loan mortgage of the 1920s.

[4] Note that another similar predecessor of the FHLB system was the Federal Farm Loan Act of 1916 (Pub. L. 64-158) which established 12 Federal Land Banks which were mutual associations owned by national farm loan associations and supervised by the Federal Farm Loan Board, and was designed to provide fairly priced credit to farmers. It was restructured in 1933 under the Farm Credit Administration which also refinanced mortgages for farmers. The Farm Credit System still operates today. See Quinn 2016.

[5] The crisis was also addressed in 1933 by two additional programs, the Home Owners Loan Corporation and the Reconstruction Finance Corporation, which purchased respectively defaulted mortgages and the stock of bankrupt banks and thrifts. Because these programs did not continue, they are not relevant to our discussion. Note also that the federal charter for savings and loans was created by the 1933 Home Owners Loan Act.

[6] This statutory maximum stayed in place until 1968 (Pub. L. 90-301).

[7] As the spouse of an architect, let me add that the real estate industry’s focus on square footage over quality living spaces has meant that the whole housing stock is of remarkably low quality in terms of the use of space and quality of life. Visitors from Europe sometimes remark on this. The FHA favored the “efficiency” of large operations over small craft builders (Hanchett 2000).

[8] Note that in 1959 Fannie Mae’s statutorily permitted investments had been expanded to include “obligations which were lawful investments for fiduciary, trust, or public funds” (Milgrom 1993: 83).

[9] William Osborn of the National League of Insured Savings Associations testimony March 5, 1970 to the Senate Subcommittee on Housing and Urban Affairs of the Committee on Banking and Currency, Hearing on Secondary Mortgage Market and Mortgage Credit p. 284 (“The National League has no objection to the establishment of a secondary market for conventional mortgages in FNMA as long as a similar facility is made available through the Federal Home Loan Bank System.”)

[10] For example Wicksell (1898: 135) wrote: “But money, which is the one thing for which there is really a demand for lending purposes, is elastic in amount. Its quantity can to some extent be accommodated—and in a completely developed credit system the accommodation is complete—to any position that the demand may assume.” See also Willis, American Banking 3-4 (1916); Dunbar 1909 13-14, 18.

Update 2-6-2019: Link to Senate Report on Glass Steagall Act:  1933 S Rpt on Banking Act

Integrating finance and macro: the problem of modeling debt

So I have finally read Mian and Sufi’s House of Debt. They do an excellent job of setting forth an argument that has met with quite a bit of resistance within the economics profession: the growth of household debt before the crisis and the failure to reduce it after the crisis explains to a large degree the severity of the crisis. (House of Debt was written in 2014, so if you’re thinking: “But wait, that argument is mainstream now” you would be correct.) I actually read the whole book which can be taken as approval of both its structure and the quality of the writing. (On the “life is short” principle I typically don’t get through a book is poorly structured or poorly written.) The book is widely cited and almost universally acknowledged as one of the foremost expressions of the household balance sheet view of the 2007-09 financial crisis. Thus, I am going to take the book’s many excellent qualities as given and focus on the most important flaw that underlies the book, because that flaw also underlies most economic analysis of the way financial factors played a role in the crisis.

While it is wonderful that Mian and Sufi are talking about debt, the way they are talking about debt and in particular their underlying model of debt is very problematic. Furthermore, the errors in their underlying model of debt are so ubiquitous in economic theory that these errors function as a constraint preventing the development of models that can accurately represent the relationship between finance and the real economy. In short, while this post will focus on a critique of Mian and Sufi (2014), this book is really just standing in for all the economic works that make the same assumptions, some of which I will reference below.

Holmstrom (2014) presents the standard economists’ model of debt, which underlies Mian and Sufi’s discussion too, using this diagram:

Holmstrom debt

Debt is modeled as a promise to make a fixed payment that will only be met if the borrower has enough money at the time payment is due. This diagram treats the value of the borrower’s collateral as equal to her entire wealth, assumes that the value of the collateral may take on values ranging linearly from 0 to something well in excess of the amount to be repaid on the debt, and assumes that the lender can take the collateral if the debt is not paid. Thus, the lender’s payoff increases linearly until the value of the collateral exceeds the amount due on the debt at which point the payoff to the lender is fixed.

There is nothing wrong with this model as a first pass at modeling debt. It is widely used for good reason. But the basic model also dates back to the 1980s (I connect it with a paper by Hal Cole that I can’t locate, but am not entirely sure of its origins) and it is remarkable that the model has not in ensuing decades been amended to allow for the much greater complexity of real world debt. Treating this model as if it represents the general category of “debt” and not the specific simple case that is easiest to model is a huge mistake that permeates the economics profession.

So what’s wrong with this model?

1)   It is used to treat “debt” as homogeneous

The model assumes that all debt takes a single specific contractual form modeled on a mortgage. In fact, debt is broad term that encompasses a huge range of different contractual provisions. Debt can be structured to favor the borrower or it can be structured to favor the lender. A debt contract can be designed so that it is hardly distinguishable from equity or so that the lender bears virtually no risk of loss. Economists need to stop talking about “debt” as a homogeneous product and start talking about the specific kinds of debt they mean to address.

For much of the discussion in Mian and Sufi, the standard model is appropriate, because their main focus of inquiry is mortgages, and this is a reasonable model of mortgage debt. On the other hand, this model leads them to make generalizations about debt itself that are simply nonsense, e.g. “This is a fundamental feature of debt: it imposes enormous losses on exactly the households that have the least” (p. 23). If they simply replaced the term “debt” with the phrase “the current US mortgage system” there would be nothing wrong with this sentence. When, however, they generalize from the problems with US mortgages to “debt” itself, they misfire badly. As I note above, this problem is not in any way restricted to Mian and Sufi, this is a general problem that permeates and degrades much of the economic discussion of debt.

It is highly unlikely that the economics can make progress in its efforts to study the relationship between finance and the real economy so long as the profession’s vocabulary for discussing something as fundamental to finance as “debt” is so utterly impoverished.

2)   Failure to model uncollateralized debt

Uncollateralized debt has very different properties from collateralized debt. In economic theory models debt is almost always modeled to be collateralized and is therefore backward looking (see, e.g. Holmstrom 2014 or Gertler and Gilchrist 2018). An agent must already own something pledgeable in order to borrow. This ensures that wealthy agents can borrow more and grow more wealthy, whereas poor agents are likely to be constrained forever. This framing of debt is closely related to the inequality dynamics described by Mian and Sufi.

By contrast, when debt is uncollateralized, it can be forward looking. If I can convince a bank that after investing the proceeds of a loan of $50,000 today, my business will give me revenues of $100,000 in a year, the bank can fund the loan with nothing more than my personal promise to pay it back (and the knowledge that our legal and social system will impose significant costs on me for a failure to pay, e.g. a public judgment against me, and a defective credit report). As long as I am expected to have the funds to pay back the loan when the debt is due, there’s no reason at all for the loan to depend on my ownership of more than $50,000 in assets to be used as collateral. For relatively small amounts and short periods of time this type of unsecured lending is very common in practice and has been very common for centuries.

Effectively the habits of thought that economists adopt when they think about debt are unreasonably constraining their ability to model the relationship between finance and the real economy. And these same habits of thought tend to rule out by assumption the possibility of inequality-reducing debt.

3)   Inaccurate assumptions about the legal framework governing debt

“Debt leads to bubbles in part because it gives lenders a sense of security that they will be unaffected if the bubble bursts” (p. 114).

This is simply not a property of “debt.” In the event of a bubble that bursts there will be a rash of bankruptcies and the basic rule in bankruptcy in this situation is cramdown: the borrowers’ debt is written down to the post-crash value of the collateral. In short, the standard legal procedure governing debt addresses precisely the macroeconomic problem in question here. A lender who lends into a bubble is at risk of loss. As a general statement, Mian and Sufi’s claim is simply incorrect. It is, however, (1) an accurate description of the model of debt that they are working with and more importantly (2) an accurate description of the law governing US mortgages on first homes, because of the explicit exception for these loans in the bankruptcy code. (Interestingly enough, the rules for the treatment of second homes in bankruptcy do allow cramdown.)

Thus, when Mian and Sufi write “Our main argument is that a more even distribution of losses between debtors and creditors is not only fair, but makes more sense from a macroeconomic perspective” (p. 150), what they are missing is an acknowledgement that “debt” as a general category is usually subject to treatment in bankruptcy that addresses their macroeconomic concerns. “The inflexibility of debt contracts” (p. 168) about which Mian and Sufi complain exists in their model and in US mortgage markets, but is not in fact a property of “debt contracts” themselves under the current legal regime in the US.

What should economic models of private debt do?

Economic models that seek to integrate finance and macro need to be very conscious of the different kinds of private debt and make deliberate decisions about why a specific form of debt is being modeled. To assist in this project, I present here a simple hierarchy of different types of debt that are likely to have very different macroeconomic consequences and thus should be modeled differently. (It’s possible and even likely that I have omitted an important type of debt, so this hierarchy is open to revision.)

The types are ranked from those that are most favorable to the lender to those that are most favorable to the borrower. (Note (i) I use “mortgage” as a general term for a collateralized loan, and (ii) the listed term of the loan should be understood as typical and not as claim that these types of debt are restricted to this term.)

  • Repurchase agreement or margin loan: ultra-short-term, overcollateralization, marketable collateral, immediate right to seize the collateral if it falls in value (and isn’t increased).
    Comment 1: A vigilant lender cannot lose money on a repo.
    Comment 2: There has been significant work on repo since the crisis, e.g. Brunnermeier and Pedersen 2008, but as far as know there is no “workhorse” model comparable to the model of debt above. (Please correct me if I’m wrong.) My impression is that much of the work on repo has been empirical (e.g. Adrian and Shin 2010).
  • Mortgage with recourse: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, right to be paid in full if the collateral value at the time of default is deficient.
  • Mortgage without recourse: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, no right to further payment. (This is the type of debt that corresponds to the “standard” model of debt discussed above.)
  • Mortgage with cramdown: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, but subject to cramdown if the borrower declares bankruptcy.
  • Unsecured debt with bank guarantee (e.g. commercial paper): short-term, no collateral, lender relies on bank guarantee.
  • General unsecured debt: short-term or long-term, no collateral. Enforcement must be via long-term incentives (reputation) and/or penalties imposed by the legal system for failure to pay. Corporate bonds fall under this heading.

A regression discontinuity test error

This is post 3 in my HAMP and principal reduction series. For the introductory post see here.

The series is motivated by Peter Ganong and Pascal Noel’s argument that mortgage modifications that include principal reduction have no significant effect on either default or consumption for underwater borrowers. In post 1 I explained how the framing of their paper focuses entirely on the short-run, as if the long run doesn’t matter – and characterize this as the ideology of financialization. In post 2 I explain why financialization is a problem.

In this post I am going to discuss a very technical problem with Ganong and Noel’s regression discontinuity test of the effect of principal reduction on default. The idea behind a regression discontinuity test is to use the fact that there is a variable that is used to classify people into two categories and then exploit the fact that near the boundary where the classification takes place there’s no significant difference between the characteristics of the people divided into the two groups. The test looks specifically at those who lie near the classification boundary and then compare how the groups in the two classifications differ. In this situation, the differences can be interpreted as having been caused by the classification.

Borrowers offered HAMP modifications were offered either standard HAMP or HAMP PRA which is HAMP with principal reduction. In principle those who received HAMP modifications had a net present value (NPV) of the HAMP modification in excess of the NPV of the HAMP PRA modification, and those who received a HAMP PRA modification had an NPV of HAMP PRA greater than NPV of HAMP. The relevant variable for classifying modifications is therefore ΔNPV (which is economists’ notation for the different between the two net present values). Note that in practice, the classification was not strict and there was a bias against principle reduction (see Figure 2a). This situation is addressed with a “fuzzy” regression discontinuity test.

The authors seek to measure how principal reduction affects default. They do this by first estimating the difference in the default rates for the two groups as they converge to the cutoff point ΔNPV = 0, and then estimating the difference in the rate of assignment to HAMP PRA for the two groups as they converge to the cutoff point ΔNPV = 0, and finally taking the ratio of the two (p. 12). The authors find that the difference in default rates is insignificant — and this is a key result that is actually used later in the paper (footnote 30) to assume that the effect of principle reduction can be discounted (apparently driving the results on p. 24).

My objection to this measure is that due to the structure of HAMP PRA, most of the time when ΔNPV is equal to or close to zero, that is because the principal reduction in HAMP PRA is so small that there is virtually no difference between HAMP and HAMP PRA. That is, as the ΔNPV converges to zero it is also converging to the case where there is no difference between the two programs and to the case where principal reduction is zero.

To see this consider the structure of HAMP PRA. If the loan to value (LTV) of the mortgage being modified is less than or equal to 115, then HAMP PRA does not apply and only HAMP is offered. If LTV > 115, then the principal reduction alternative must be considered. Under no circumstances will HAMP PRA reduce the LTV below 115. After the principal reduction amount has been determined for a HAMP PRA mod, the modification terms are set by putting the reduced principal loan through the standard HAMP waterfall. As a result of this process, when the LTV is near 115, a HAMP PRA is evaluated, but principal reduction will be very small and the loan will be virtually indistinguishable from a HAMP loan. In this case, HAMP and HAMP PRA have the same NPV (especially as the data was apparently reported only to one decimal point, see App. A Figure 5), and ΔNPV = 0.

While it may be the case that for a HAMP PRA modification with significant principal reduction the NPV happens to be the same as the NPV for HAMP, this will almost certainly be a rare occurrence. On the other hand, it will be very common that when the LTV is near 115, the ΔNPV = 0, which is just a reflection of the fact that the two modifications are virtually the same when LTV is near 115. Thus, the structure of the program means that there will be many results with ΔNPV = 0, and these loans will generally have LTV near 115 and very little principal modification. In short, as you converge to ΔNPV = 0 from the HAMP PRA side of the classification, you converge to a HAMP modification. Under these circumstances it would be extremely surprising to see a jump in default rates at ΔNPV = 0.

In short, there is no way to interpret the results of the test conducted by the authors as a test of the effect of principal reduction. Perhaps it should be characterized as a test of whether classification into HAMP PRA without principal reduction affects the default rate.

Note that the authors’ charts support this. In Appendix A, Figure 5(a) we see that almost 40% of the authors’ data for this test has ΔNPV = 0. On page 12 the authors indicate that they were told this was probably bad data, because it indicates that the servicer was lazy and only one NPV test was run. Thus this 40% of their data was thrown out as “bad.” Evidence that this 40% was heavily concentrated around LTV = 115 is given by Appendix A, Figure 4(d):

GanongNoel

Here we see that as the LTV drops toward 120, ΔNPV converges to zero from both sides. Presumably the explanation for why it converges to 120 and not to 115 is because almost 40% of the data was thrown out. See also Appendix A Figure 6(d), which despite the exclusion of 40% of the data shows a steep decline in principal reduction as ΔNPV converges to 0 from the HAMP PRA side.

I think this is mostly a lesson that details matter and economics is hard. It is also important, however, to set the record straight: running a regression discontinuity test on HAMP data cannot tell us about the relationship between mortgage principal reductions and default.

What’s the problem with financialization?

This is post 2 in my HAMP and principal reduction series. For the introductory post see here.

The series is motivated by Peter Ganong and Pascal Noel’s argument that mortgage modifications that include principal reduction have no significant effect on either default or consumption for underwater borrowers. In post 1 I explained how the framing of their paper focuses entirely on the short-run, as if the long run doesn’t matter – and even uses language that indicates that people who take their long-run financial condition into account are behaving improperly. I call this exclusive focus on the short-run the ideology of financialization. I note at the end of post 1 that this ideology appears to have influenced both Geithner’s views and the structure of HAMP.

So this raises the question: What’s the problem with the ideology of financialization?

The short answer is that it appears to be designed to trap as many people into a state of debt peonage as possible. Debt peonage, by preventing people who are trapped in debt from realizing their full potential, is harmful to economic performance more generally.

Here’s the long answer.

By focusing attention on short-term payments and how sustainable they are today, while at the same time heaping heavy debt obligations into the future, modern finance has had devastating effects at both the individual and the aggregate levels. Heavy long-term debt burdens are guaranteed to be a problem for a subset of individual borrowers, such as those who are unexpectedly disabled or who see their income decline over time for other reasons. Mortgages with payments that balloon at some date in the future (such as those studied in Ganong and Noel’s paper) are by definition a gamble on future financial circumstances. This makes them entirely appropriate products for the small subset of borrowers who have the financial resources to deal with the worst case scenario, but the financial equivalent of Russian roulette for the majority of borrowers who don’t have financial backup in the worst case scenario. (Remember the probabilities are in your favor in Russian roulette, too.)

Gary Gorton once described the subprime mortgage model as one where the borrower is forced to refinance after a few years and this gives the bank the option every few years of whether or not to foreclose on the home. Because the mortgage borrower is in the position of having sold an option, the borrower’s position is closer to that of a renter than of homeowner. Mortgages that are structured to have payment increases a few years into the loan – which is the case for virtually all of the modifications offered to borrowers during the crisis – similarly tend to put the borrower into a situation more like that of a renter than a homeowner.

The ideology of financialization thus perverts the whole concept of debt. A debt contract is not a zero-sum transaction. Debt contracts exist because they are mutually beneficial and they should be designed to give benefits to both lenders and borrowers. Loans like subprime mortgages are literally designed to set the borrower up so the borrower will be forced into a renegotiation where the borrower can be held to his or her reservation value. That is, they are designed to shift the bargaining power in contracting in favor of the lender. HAMP modifications for underwater borrowers set up a similar situation.

Ganong and Noel treat this distorted bargaining situation as if it is normal in section 6 of their paper, where they purport to characterize “efficient modification design.” The first step in their analysis is to hold the borrowers who need modifications to their reservation values (p. 27).[1] Having done this, they then describe an “efficient frontier” that minimizes costs to lenders and taxpayers. A few decades ago when I studied Pareto efficiency, the characterization of the efficient frontier required shifting the planner’s weights on all members of the economy. What the authors have in fact presented is the constrained efficient frontier where the borrowers are held to their reservation values. Standard economic analysis indicates that starting from any point on this constrained efficient frontier, direct transfers from the lenders to the borrowers up until the point that the lenders are held to their reservation value should also be considered part of the efficient frontier.

In short, Ganong and Noel’s analysis is best viewed as a description of how the financial industry views and treats underwater borrowers, not as a description of policies that are objectively “efficient.” Indeed, when they “rank modification steps by their cost-effectiveness” they come very close to reproducing the HAMP waterfall (p. 31): the only difference is that maturity extension takes place before a temporary interest rate reduction. Perhaps the authors are providing valuable insight into how the HAMP waterfall was developed.

The unbalanced bargaining situation over contract terms that is presented in this paper should be viewed as a problem for the economy as a whole. As everybody realized post-crisis the macroeconomics of debt has not been fully explored by the economics profession and the profession is still in the early stages of addressing this lacuna. Thus, it is not surprising that this paper touches only very briefly on the macroeconomics of mortgage modification.

In my view the ideology of financialization with its short term focus has contributed significantly to growth of a heavily indebted economy. This burden of debt tends to reduce the bargaining power of the debtors and to interfere with their ability to realize their full potential in the economy. Arguably this heavily indebted economy is losing the capacity to grow because it is in a permanent balance sheet recession. At the same time, the ideology underlying financialization appears to be effectively a gamble that it’s okay to shift the debt off into the future, because we will grow out of it so it will not weigh heavily on the future. The risk is that, by taking it as given that g > r over the long run, this ideology may well be creating a situation of permanent balance sheet recession where g is necessarily less than r, even given optimal monetary policy.

[1] The authors justify this because they have “shown” that principal reductions for underwater borrowers do not reduce defaults or increase consumption. Of course, they have shown no such thing because they have only evaluated 5-10% of the life of the mortgage – and even that analysis is flawed.