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

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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.

The Ideology of Financialization

This is post 1 in my HAMP and principal reduction series. For the introductory post see here.

The analysis in Peter Ganong and Pascal Noel’s Liquidity vs. wealth in household debt obligations: Evidence from housing policy in the Great Recession is an object lesson in the ideological underpinnings of “financialization”. So this first post in my HAMP and principal reduction series dissects the general approach taken by this paper. Note that I have no reason to believe that these authors are intentionally promoting financialization. The fact that the framing may be unintentionally ideological makes it all the more important to expose the ideology latent in the paper.

The paper studies government and private mortgage modification programs and in particular seeks to differentiate the effects of principal reductions from those of payment reductions. The paper concludes “we find that principal reduction that increases housing wealth without affecting liquidity has no significant impact on default or consumption for underwater borrowers [and that] maturity extension, which immediately reduces payments but leaves long-term obligations approximately unchanged, does significantly reduce default rates” (p. 1). The path that the authors follow to arrive at these broad conclusions is truly remarkable.

The second paragraph of this paper frames the analysis of the relative effects of modifying mortgage debt by either reducing payments or forgiving mortgage principal. This first post will discuss only the first three sentences of this paragraph and what they imply. They read:

“The normative policy debate hinges on fundamental economic questions about the relative effect of short- vs long-term debt obligations. For default, the underlying question is whether it is primarily driven by a lack of cash to make payments in the short-term or whether it is a response to the total burden of long-term debt obligations, sometimes known as ‘strategic default.’ For consumption, the underlying question is whether underwater borrowers have a high marginal propensity to consume (MPC) out of either changes in total housing wealth or changes in immediate cash-flow.”

Each of the sentences in the paragraph above is remarkable in its own way. Let’s take them one at time.

First sentence

“The normative policy debate hinges on fundamental economic questions about the relative effect of short- vs long-term debt obligations.”

This is a paper about mortgage debt – that is, long term debt – and how it is restructured. This paper is, thus, not about “the relative effect of short- vs long-term debt obligations,” it is about how choices can be made regarding how long-term debt obligations are structured. This paper has nothing whatsoever to do with short-term debt obligations, which are, by definition, paid off within a year and  do not figure in paper’s analysis at any point.

On the other hand, the authors’ analysis is short-term. It evaluates data only on the first two to three years (on average)  after a mortgage is modified. The whole discussion takes it as given that it is appropriate to evaluate a long-term loan over a horizon that covers only 5 to 10% of its life, and that we can draw firm conclusions about the efficiency of a mortgage modification by only evaluating the first few years of the mortgage’s existence. Remember the authors were willing to state that “principal reduction … has no significant impact on default or consumption for underwater borrowers” even though they have no data on 90 – 95% of the performance of the mortgages they study (that is, on the latter 30-odd years of the mortgages’ existence).

Note that the problem here is not the nature of the data in the paper. It is natural that topical studies of mortgage performance will typically only cover a portion of those mortgages’ lives. But it should be equally natural that every statement in the study acknowledges the inadequacy of the data. For example, the authors could have written: “principal reduction … has no significant impact on immediate horizon default or immediate horizon consumption for underwater borrowers.” Instead, the authors choose to discuss short-term performance as if it is all that matters.

This focus on the short-term, as if it is all that matters, is I would argue the fundamental characteristic of “financialization.” It is also the classic financial conman’s bait and switch. The key when selling a shoddy financial product is to focus on how good it is in the short-term and to fail to discuss the long-term risks. When questions arise regarding the long-term risks, these risks are minimized and are not presented accurately. This bait and switch was practiced on municipal borrowers who issued adjustable rate securities and purchased interest rate swaps, on adjustable rate mortgage borrowers who were advised that they would be able to refinance before the mortgage rate adjusted up, and even on the Trustees of Harvard University, who apparently entered into interest rate swaps without bothering to understand to long-term obligations associated with them.

The authors embrace this deceptive framework of financialization whole-heartedly throughout the paper by discussing the short-term performance of long-term loans as if it is all that matters. While it is true that there are a few nods in footnotes and deep within the paper to what is being left out, they are wholly inadequate to address the fact that the basic framing of the paper is extremely misleading.

Second sentence

“For default, the underlying question is whether it is primarily driven by a lack of cash to make payments in the short-term or whether it is a response to the total burden of long-term debt obligations, sometimes known as ‘strategic default.’”

The second sentence is based on the classic distinction between a temporary liquidity-driven stoppage of payments and a stoppage due to negative net worth – i.e. insolvency. (Note that these are the two long-standing reasons for filing bankruptcy.) But the framing in this sentence is remarkably ideological.

The claim that those defaults that are “a response to the total burden of long-term debt obligations” are “sometimes known as ‘strategic default’” is ideologically loaded language. Because the term “strategic default” has a pejorative connotation, this sentence has the effect of putting a moralistic framing on the problem of default: liquidity-constrained defaults are implicitly unavoidable and therefore non-strategic and proper, whereas all non-liquidity-constrained defaults are strategic and implicitly improper. This framing ignores the fact that a default may be due to balance sheet insolvency, which will necessarily be “a response to the total burden of long-term debt obligations” and yet cannot be classified a “strategic” default. What is commonly referred to as strategic default is the case where the debtor is neither liquidity constrained, nor insolvent, but considers only the fact that for this particular asset the payments are effectively paying rent and do not build any principal in the property.

By linguistically excising the possibility that the weight of long-term debt obligations leads to an insolvency-driven default, the authors are already demonstrating their bias against principal reduction and once again exhibiting the ideology of financialization: all that matters is the short-term, therefore balance sheet insolvency driven by the weight of long-term debt does not need to be taken into account.

In short, the implicit claim is that even if the borrower is insolvent and not only has a right to the “fresh start” offered by bankruptcy, but likely needs it to get onto his or her feet again, this would be “strategic” and improper. Overall, the moralistic framing of the paper’s approach to debt is not consistent with either the long-standing U.S. legal framework governing debt which acknowledges the propriety of defaults due to insolvency, or with social norms regarding debt where business-logic default (which is a more neutral term than strategic default) is common.

Third sentence

“For consumption, the underlying question is whether underwater borrowers have a high marginal propensity to consume (MPC) out of either changes in total housing wealth or changes in immediate cash-flow.”

The underlying assumption in this sentence is that mortgage policy had as one of its goals immediate economic stimulus, and that one of the choices for generating this economic stimulus was to use mortgage modifications to encourage troubled borrowers to increase current consumption at the expense of a future debt burden. In short, this is the classic financialization approach: get the borrower to focus only on current needs and discourage focus on the costs of long-debt. Most remarkably it appears that Tim Geithner actually did view mortgage policy as having as one of its goals immediate economic stimulus and that this basic logic was his justification for preferring payment reduction to principal reduction.[1]

Just think about this for a moment: Policy makers in the midst of a crisis were so blinded by the ideology of financializaton that they used the government mortgage modification program as a form of short-term demand stimulus at the cost of inducing troubled borrowers (i.e. the struggling middle class) to further mortgage their futures. And this paper is a full-throated defense of these decisions.

The ideology of financialization has become powerful indeed.

Financialization Post 2 will answer the question: What’s the problem with the ideology of financialization?

[1] See, e.g., the quote from Geithner’s book in Mian & Sufi, Washington Post, 2014

HAMP and principal reduction: an overview

I spent the summer of 2011 helping mortgage borrowers (i) correct bank documentation regarding their loans and (ii) extract permanent mortgage modifications from banks. One of things I did was check the bank modifications for compliance with the government’s mortgage modification program, HAMP, and with the HAMP waterfall including the HAMP Principal Reduction Alternative. At that time I put together HAMP spreadsheets, and typically when I read articles about HAMP I go back to my spreadsheets to refresh my memory of the details of HAMP.

So when I learned about a paper that finds that HAMP “placed an inefficient emphasis on reducing borrowers’ total mortgage debt” and should have focused more on reducing borrowers payments in the short-run — which goes contrary to everything I know about HAMP, I decided to read the paper.

Now I am an economist, so even though my focus is not quantitative data analysis, when I bother to put the time into reading an econometric study it’s not difficult to see problems with the research design. On the other hand, I usually avoid being too critical, on the principle that econometrics is a little outside the area of my expertise. In this case, however, I know that very few people have enough knowledge of HAMP to actually evaluate the paper — and that many of those who do are interested parties.

The paper Peter Ganong and Pascal Noel’s Liquidity vs. wealth in household debt obligations: Evidence from housing policy in the Great Recession. This paper has been published as a working paper by the Washington Center for Equitable Growth and NBER, both of which provided funding for the research. Both the Wall Street Journal and Forbes have published articles on this paper. So as one of the few people who is capable offering a robust critique of the paper, I am going to do a series of posts explaining why the main conclusion of this paper is fatally flawed and why the paper reads to me as financial industry propaganda.

Note that I am not making any claims about the authors’ motivation in writing this paper. I see some evidence in the paper to support the view that the authors were manipulated by some of the people providing them with the data and explaining it to them. Overall, I think this paper should however serve as a cautionary tale for all those who are dependent on interested parties for their data.

Here is the overview of the blogposts I will post discussing this paper:

HAMP and principal reduction post 1: The ideology of financialization

HAMP and principal reduction post 2: What’s the problem with financialization?

HAMP and principal reduction post 3: A regression discontinuity error
The principal result in the paper is invalid, because the authors did not have a good understanding of HAMP and of HAMP PRA, and therefore did not understand how the variable they use to distinguish treatment from control groups converges to their threshold precisely when principal reduction converges to zero. The structure of this variable invalidates the regression discontinuity test that the authors perform.

Why claims that the 2008 bailout was a “success” should make you angry

In 2008 we needed a bailout – or at least significant government/central bank intervention – but the bailout we got was unfair and almost certainly hampered the recovery. Furthermore, claims that “the bailout made money in the end” need to address the actual structure of the bailout.

So let’s talk about how the 2008-10 bailout of mortgage-related securities and instruments was structured. I focus on the mortgage-related bailout, because even when you’re talking about much more complicated instruments like CDOs, a lot of the trouble came from the outrageous practices that had been going on for the last few years in the US mortgage market. Here I’m not going to get into how the various instruments were related to mortgages, I’m just going to break down how the US used government funds to bail out the issuers and investors in private housing market-related instruments. There were three steps.

STEP 1: The Fed provided temporary assistance by supporting asset prices from March 2008 through February 2010 by accepting just about everything as collateral at the TSLF and PDCF and thus preventing fire sales of assets. The Fed also wrote supervisory letters granting bank holding companies (BHCs) the right to exceed normal limits on aid from the FDIC-insured bank to the investment bank, so that a lot of support of these asset markets took place on the balance sheets of the BHCs.

STEP 2: Many of the mortgages underlying the troubled assets were refinanced with the support of government guarantees against credit risk. The process of refinancing a mortgage requires the existing mortgage to be paid off in full. Thus, these refis had the effect of transferring poorly originated mortgages out of private portfolios and into government insured portfolios. This would not be a problem if the government insured mortgages were carefully originated, but that would not have solved the private sector’s problem, so that’s not what happened. Step 2 required both immense purchases by the government of mortgage backed securities and a simultaneously massive expansion in insurance offered for riskier loans.

1.  Massive purchases of GSE MBS.
The goals were to make sure the GSEs could continue to be active in the mortgage market, to drive down the 30 year mortgage rate to facilitate refinancing as well as purchases, and to raise the price of housing.

a. On Sept 7 2008 when Fannie Mae and Freddie Mac were put into conservatorship, Treasury also announced plan to purchase MBS securities. Apparently this program only ever reached about $200 billion in size (Sigtarp Report July 2010 136). Soon it was superseded by:

b. The Federal Reserve’s QE1: In November 2008 the Federal Reserve announced a massive program of supporting mortgage markets by buying mortgage backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae. This purchase program ended up buying $1.25 trillion in MBS and continued until February 2010.

  • By the end of 2008 the 30 year fixed mortgage rate had fallen by a full percentage point. and would only decline further in later years.

//fred.stlouisfed.org/graph/graph-landing.php?g=ldKE&width=670&height=475

  • Private sector MBS issues had declined to almost nothing by mid 2008 and even GSE MBS issues had dropped over the course of 2008. In 2009 GSE MBS came roaring back so that by mid-2009 monthly MBS issues were almost as high as they had ever been. The fact that in several months Fed purchases in the form of QE1 exceeded GSE MBS issues undoubtedly played a role in this dramatic recovery of the MBS market.

2008 Housing mkt
from “Charting the Financial Crisis” by Brookings & Yale SOM

2.   FHA insurance grew to account for almost 1/3 of the mortgage market.
From mid-2009 to mid-2010 alone FHA and GNMA insured loans increased by $500 billion (Sigtarp Report July 2010 p. 119).

FHA insured loans became a growing and then significant portion of the mortgage market after the major subprime lenders collapsed in early 2007, and FHA became the only choice for borrowers who couldn’t put down much of a down payment. Prior to the crisis FHA loans accounted for as little as 3% of the market. By June 2009 FHA loans accounted for 30% of the market and would continue to do so for several years. (See Golobay 2009 and Berry 2011a.)

By mid-2011 all the major banks held billions in FHA insured loans that were 90 days or more past due: BoA $20 billion, WFC $14 billion, JPM $10 billion, Citi $5 billion. Eventually every major bank would end up settling lawsuits over misrepresentations in FHA insurance applications. In the meanwhile they were using FHA insurance as a cover to avoid taking writedowns on the loans. (See Berry 2011b.)

Here is the FHA’s 2015 report on how the loans it guarantees have been performing. Note that the FHA insured $73 billion single family mortgages in FY 2006, $84 billion in FY 2007, $205 billion in FY 2008 and $365 billion in FY 2009 (see Table 1 here.)

FHA loan performance
(Note that the decision to separate fiscal year 2009 into first half (October 2008 to March 2009) and second half (April 2009 to September 2009) appears to be a genuine effort to show how different the two cohorts are, and as far as I can tell should not be interpreted as questionable data manipulation.)<\small>

3. Expansion of loans eligible for securitization by Fannie Mae and Freddie Mac by increasing the conforming loan limit to $729,750 in high cost states (which lasted until 10-1-2011).

  • The Special Inspector General for the Troubled Asset Relief Program concluded that the government had adopted an explicit policy of supporting housing market prices (SIGTARP report Jan 2010 p. 126). These programs stopped the decline in house prices nationally (the yellow line in the chart below) for the year 2009 and slowed the drop in house prices thereafter. As a result, nationally the bottom in housing prices wasn’t reached until January 2012. This meant that the massive 2009 government guaranteed refinancing of mortgages was deliberately executed at higher than market prices.

CR Case Shiller Index

Before going on to Step 3, let’s pause for a moment to get a good picture of what is going on here. By late 2008, it had become abundantly clear that Private Label Securitization was a shitshow. Tanta, who had 20-odd years of mortgage industry experience and spent the months before her death blogging at Calculated Risk, put it well in a July 2007 blogpost :

“we as an industry have known how to prevent a lot of fraud for a long time; we just didn’t do it. It costs too much, and too many bonuses were at stake to carve out the percent of loan production it would take to get a handle on fraud. The only thing that got anybody’s attention, finally, was a flood of repurchase demands on radioactive EPD [early payment default, i.e. 3 missed payments in first 6 months of loan] loans and other violations of reps and warranties. If [you] want[] to accomplish something, I’d suggest [you] … start slapping some issuers around on their pre-purchase or pre-securitization quality control and due diligence.”

So what was going on in 2007 and 2008 is that the market was recognizing that the “Non-Agency MBS” in the chart below was going to perform very badly, because it was so full of loans that should never have been made.

collapse of PLMBS
In many cases the originators who were theoretically on the hook for the reps and warranties they had made when they sold the loans to Wall Street had been driven into bankruptcy by – you guessed it – claims based on their reps and warranties. The bag they had in theory been holding had most definitely been passed on to someone else, but it wasn’t clear yet to whom. The obvious candidate was the issuers who had packaged these loans – with utterly inadequate due diligence – into securities for investors to buy. The catch was that the issuers were all the big banks: Bank of America, JP Morgan Chase, Citibank, Goldman Sachs, etc.

And we had financial regulators who were like deer in the headlights, transfixed by terror, when they heard that one of the big retail banks might be in danger. These regulators threw themselves headlong into the project of rescuing the big banks from their failure to perform the due diligence necessary to issue mortgage-backed securities according to the terms in their securities documentation. While I suspect that Ben Bernanke never quite wrapped his head around these issues (he had plenty of other things to worry about), it seems fairly clear that Hank Paulson and Timothy Geithner worked consciously to “save the financial system” by hiving loans that should never have been made off onto the Government. Geithner, in particular, would almost certainly claim that this was the right thing to do in the interests of financial stability.[1]

Thus, the mortgage sector bailout was designed so that the mortgages underlying the private label mortgage backed securities (PLMBS), the bulk of which had been made at the peak of the bubble, would be refinanced out of the PLMBS securities as quickly as possible. The private sector had no interest in financing such an endeavor itself, so the only way to do it was through the government sponsored entities.

By engineering a drop in the 30 year mortgage rate (the announcement of QE1 was apparently enough to do this), an incentive was created for mortgagors to refinance their loans. The same Fed program ensured that Fannie Mae, Freddie Mac, and Ginnie Mae would have no problem getting the funds to buy the refinanced mortgages. There was only one catch, a nontrivial segment of the PLMBS mortgages were not of a quality that could be sold to Fannie and Freddie – and the same would be true of any refis of those mortgages. That’s where the FHA comes in: by guaranteeing 30% of all mortgages in the crucial years 2009-2010, the FHA provided a way for some of the more dubious mortgages in the PLMBS to be refinanced and be paid in full. FHA loans are typically securitized by Ginnie Mae and may also be held on a bank’s balance sheet. The PLMBS loans that were paid in full – due solely to the presence of government guarantees in the mortgage market – almost certainly played a huge role in protecting the returns on the PLMBS, in reducing the losses to investors, and in reducing the liability of the issuers for their due diligence failures.

The key point to remember here is that there was nothing “market” about this whole process. The Fed was both providing the funds and driving down the interest rates, while a government backstop for the credit risk on the loans was provided by the GSEs. Multiple experts described the housing finance market as having been “nationalized” or put “on government life support” in this period.

Because of the degree to which the government took over the mortgage market in these crucial years, it becomes a little silly to focus on the fact that no money was lost (in aggregate) due to the government’s support of PLMBS and related assets. (As far as I can tell the costs included in bailout figures never include the losses that the GSEs incurred on the loans guaranteed from 2008Q4 to 2010Q4.) Overall it can hardly be a surprise that the government made money on the officially recognized bailout loans given that the government also took steps in to make sure that many of the underlying assets were paid off in full.

At this point you may be saying: Well okay, but given that the Fed and Treasury were successful in returning the banks to health and the GSEs are all doing okay now too, was there really any harm done by a few years of de facto nationalization of the housing market?

This is where Step 3 comes in. The whole scheme only works because of Step 3, and Step 3 is what has most of those who understand what happened absolutely smoking mad about the bailouts. The key to the PLMBS performing well was that the mortgages in them had to be paid off in full. In order for the existing mortgage to be paid in full, the refi that pays it off will have to be for the same amount as the existing mortgage or a little more.

STEP 3: No principal reduction for mortgage holders. It was essential to make sure that people who hold mortgages don’t have access to a program that allows principal to be reduced. Effectively, since the banks can’t be the bagholders because of the terror of financial instability and the government can’t just be handed the bag because that has very bad visuals, the public had to be made the bagholders. The only way to do this was to make sure the public was not cut any breaks.

1. Prevent cramdown legislation from being passed
Cramdown is how bankruptcy law treats collateral that has fallen in value below the value of the loan. If the debtor declares bankruptcy, the lender only has a security interest up to the value of the collateral and remainder of the loan is not treated as collateralized debt. An exception was written into the 1977 Bankruptcy Code excluding mortgages on primary residences from cramdown. (The claim at the time was that this would be better for borrowers. LOLWT[2].) In short, the bankruptcy code takes the position that finding a good solution to someone’s inability to pay debt requires recognizing the economic reality of the situation in virtually every case except for mortgages on primary residences.

Forcing lenders to come to the table on the basis of economic reality is something that every collateralized borrower can do – except for the little guy whose only collateralized loan is on his/her primary residence. Fixing the cramdown inequity was one of President Obama’s promises before he was elected. But lo and behold Treasury staffers in his administration “stressed the effects of cramdown on the nation’s biggest banks, which were still fragile. The banks’ books could take a beating if too many consumers [were] lured into bankruptcy by cramdown ” (Kiel & Pierce 2011). Treasury’s position on this should be read: we need to bail out the banks, so we can’t allow the economic reality of the situation to affect the cut that the banks get.

2. Failure to establish an effective principal reduction program until 2012
In July 2010 SIGTARP called Treasury out for its failure to establish an effective principal reduction program as part of its mortgage modification program (Sigtarp Report July 2010 174ff.) However, not until May 2011 had the Treasury been sufficiently shamed over the lack of principal reductions to begin reporting on the Principal Reduction Alternative (PRA) data. By May 2011 less than 5000 permanent modifications had been started that included principal reduction. This was less than 1% of the permanent modifications started under the HAMP program (MHA Report May 2011).

This delay was important, because if borrowers had been offered modifications with principal reduction in the crucial years from 2009-10, it undoubtedly would have affected decisions to refinance loans that had been made at the peak of the bubble. By May 2012 permanent modifications with PRA that had been started had jumped to 83,362 which was over 8% of all permanent modifications started (MHA Report May 2012).  More recent reports indicate that ultimately 17% of all permanent modifications started included principal reduction. (MHA Report 2017Q4 p. 4)

3. Failure of FHA short refinance program. In August 2010 the FHA established a short refinance program which imposed strict rules on lenders including 10% 1st lien principal writedowns.  A year later the program had helped only 246 borrowers, in part because Fannie and Freddie refused to participate, and the program was slated to be closed (Prior 2011).

So what’s my conclusion? Everybody who wants to tout the success of the bailout needs to tackle the reality of the bailout’s structure. There was a housing bubble. Somebody was going to have to absorb the losses that are created when lending takes place against overpriced assets.

Because in the name of financial stability the Fed and Treasury decided that banks weren’t going to bear any of the losses on the origination and securitization of bad mortgages, they had to find a way to put the tab to the government and to the public.

It was put to the government by putting the mortgage market on government life support from late 2008 to 2010, so that people would refinance out of the bad mortgages in PLMBS securitizations into FHA loans and into GSE MBS.

It was put to the public by making sure that their mortgages were not written down in value, even though the value of the house being used as collateral had collapsed. This means that the housing price bubble of 2006-07 is still with us today. It is being paid off by homeowners who are still paying these mortgages, who can’t spend that money on consumption, and who are scheduled to keep paying off bubble-level housing prices right up until 2050.

HH svgs
From Deutsche Bank via Tracy Alloway: https://twitter.com/tracyalloway/status/1040391962090590209

So when you see a chart like the one just above, which shows US consumers saving far more than predicted, you should recall that paying down mortgage principal counts as savings and a lightbulb should go off in your head. You should be thinking when you see this chart: “Aha. Look at all the US consumers who are still paying for the housing bubble. The 2008 crisis should have been handled differently.”

P.S. While we’re talking about anger and crisis housing policy let me offer two notes on HAMP modifications.

  1. Look at this chart from “Charting the Financial Crisis” by Brookings & Yale SOM (part of a project advised by Tim Geithner)

HAMP by count

They very carefully report the number of borrowers helped, but not the principal value of the mortgages before the modification and the principal value of the mortgage after the modification. Most HAMP modifications included significant increases in the principal borrowed, as not only interest accrued during trial modifications but also a variety of fees that borrows rarely understood or reviewed, were capitalized into the loans.

  1. In general the HAMP program is performing execrably as might have been expected given its design. (See here for details.) After 60 months the program increases the payments that were carefully set to the maximum the borrower can afford when the loan was made. The program may continue to increase payments each year for 2 to 3 years, that is, at 72 and 84 months. In short, the program was designed to give borrowers as little as possible: borrowers get five years respite in payments without reducing the present value of the modified loan on bank balance sheets. To avoid hitting bank balance sheets payments have to go up for the remaining 35 years of the loan. On pages 7 and 9 of the 2017Q4 MHA Report, the data on performance is very carefully presented only up to 60 months. One has to read the appendices – specifically Appendix 6 – to learn that for each vintage with 84 months of data at least 50% (and up to 65%) of loans have become delinquent.

[1] I have a draft paper in which I draw the analogy between Geithner and a couple of early 19th c. Bank of England directors who had been similarly traumatized by their early experiences dealing with financial crises and also advocated throwing money at them no matter what. The difference is that these two directors were lambasted by their contemporaries including Ricardo, and their claims have gone down in history as “answers that have become almost classical by their nonsense” (Bagehot 1873, p. 86).

[2] LOLWT = Laugh out loud with tears.