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):


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.


  • 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.

When can banks create their own capital?

A commenter directed me to an excellent article by Richard Werner comparing three different approaches to banking. The first two are commonly found in the economics literature, and the third is the credit creation theory of banking. Werner’s article provides a very good analysis of the three approaches, and weighs in heavily in favor of the credit creation theory.

Werner points out that when regulators use the wrong model, they inadvertently allow banks to do things that they should not be allowed to do. More precisely, Werner finds that when regulators try to impose capital constraints on banks without understanding how banks function, they leave open the possibility that the banks find a way to create capital “out of thin air,” which clearly is not the regulator’s intent.

In this post I want to point out that Werner does not give the best example of how banks can sometimes create their own capital. I offer two more examples of how banks created their own capital in the years leading up to the crisis.

1. The SIVs that blew up in 2007

You may remember Hank Paulson running around Europe in the early fall of 2007 trying to drum up support for something called the Master Liquidity Enhancement Conduit (MLEC) or more simply the Super-SIV. He was trying to address the problem that structured vehicles called SIVs were blowing up left, right, and center at the time.

These vehicles were essentially ways for banks to create capital.  Here’s how:

According to a Bear Stearns report at the time, 43% of the assets in the SIVs were bank debt, and commentators a the time make it clear that the kind of bank debt in the SIVs was a special kind of debt that was acceptable as capital for the purposes of bank capital requirements because of the strong rights given to the issuer to forgo making interest payments on the debt.

The liability side of a SIV was comprised of 4-6% equity and the rest senior liabilities, Medium Term Notes (MTNs) of a few years maturity and Commercial Paper (CP) that had to be refinanced every few months. Obviously SIVs had roll-over (or liquidity) risk, since their assets were much longer than their liabilities. The rating agencies addressed this roll-over risk by requiring the SIVs to have access to a liquidity facility provided by  a bank. More precisely the reason a SIV shadow bank was allowed to exist was because there was a highly rated traditional bank that had a contractual commitment to provide funds to the SIV on a same-day basis in the event that the liquidity risk was realized. Furthermore, triggers in the structured vehicle’s paperwork required it to go into wind down mode if, for example, the value of its assets fell below a certain threshold. All the SIVs breached their triggers in Fall 2007.

Those with an understanding of the credit creation theory of banking would recognize immediately that the “liquidity facility” provided by the traditional bank was a classic way for a bank to transform the SIV’s liabilities into monetary assets. That’s why money market funds and others seeking very liquid assets were willing to hold SIV CP and MTNs. In short, a basic understanding of an SIV asset and liability structure and of the banks’ relationship to it would have been a red flag to a regulator conversant with the credit creation theory that banks were literally creating their own capital.

2. The pre-2007 US Federal Home Loan Bank (FHLB) System

In the early naughties all of the FHLBs revised their capital plans. For someone with an understanding of the credit creation theory, these capital plans were clearly consistent with virtually unlimited finance of mortgages.

The FHLBs form a system with a single regulator and together offer a joint guarantee of all FHLB liabilities. The FHLB system is one of the “agencies” that can easily raise money at low cost on public debt markets. Each FHLB covers a specific region of the country and is cooperatively owned by its member banks. In 2007 every major bank in the US was a member of the FHLB system. As a result, FHLB debt was effectively guaranteed by the whole of the US banking system. Once again using the credit creation theory, we find that the bank guarantee converted FHLB liabilities into monetary assets.

The basic structure of the FHLBs support of the mortgage market was this (note that I will frequently use the past tense, because I haven’t looked up what the current capital structure is and believe that it has changed):

The FHLBs faced a 4% capital requirement on their loans. Using the Atlanta FHLB’s capital plan as an example, we find that whenever a member bank borrowed from the Atlanta FHL bank, it was required to increase its capital contribution by 4.5% of the loan. This guaranteed that the Atlanta FHL bank could never fall foul of its 4% capital requirement — and that there was a virtually unlimited supply of funds available to finance mortgages in the US.

The only constraint exercised by FHLBs on this system was that they would not lend for the full value of any mortgage. Agency MBS faced a 5% haircut, private label MBS faced a minimum 10% haircut, and individual mortgages faced higher haircuts.

In short, the FHLB system was designed to make it possible for the FHLBs to be lenders of last resort to mortgage lenders. As long as a member bank’s assets were mortgages that qualified for FHL bank loans, credit was available for a bank that was in trouble.

The system was designed in the 1930s — by people who understood the credit creation theory of banking — to deliberately exclude commercial banks which financed commercial activity and whose last-resort lender was the Federal Reserve. Only when the FIRRE Act in 1989 was passed subsequent to the Savings and Loan crisis were commercial banks permitted to become FHLB members.

From a credit creation theory perspective this major shift in US bank regulation ensured that the full credit creation capacity of the commercial banking system was united with the US mortgage lending system making it possible for the FHLBs to create their own capital and use it to provide virtually unlimited funds to finance mortgage lending in the US.


Missing the point on the “wages of sin”

Ryan Avent seeks to rebut Matt Klein on the issue of whether a popped real estate bubble must have adverse consequences on the economy as a whole. Afterall, as Avent points out the houses are built and in the worst case we can just let them rot and turn our efforts to gainful production. He “dreams of a day when the only people who suffer from money-losing investments are the money-losing investors.”

The problem with our reaction to the real estate bubble is that the “money-losing investors” haven’t lost their money (yet). The houses were built on debt and there are vast losses on that debt that have not yet been realized.  There’s no issue of morality here.  Someone has to take the losses.  It should have been the banks (who had vast exposure on second liens) and the mortgage investors. Instead, we’ve been protecting the financial sector by convincing people to continue making payments at bubble prices on their houses.  That’s the point of HAMP, the government modification program.

The “wages of sin” language is unfortunate, but the point that nothing good can come of prolonging the financial sector’s realization of its losses over a decade or more remains. The nature of debt means that losses must be realized — and this truth remains with or without moralistic framing.

Vast numbers of mortgagees still owe twice as much as their homes are worth are are continuing to make payments (in December 2012 30% of mortgagees in the crisis states were underwater, 4.7% of all mortgagees owed twice as much as their homes were worth) — in part because the payments have been temporarily reduced through HAMP and HAMP-like mods. These payments are going to support the banks and mortgage investors, who are currently accounting for these loans as though there are no losses (i.e. because payments are current). Instead of these individuals’ income being freed to circulate in the economy productively, this income is spent on preventing the realization of losses in the financial sector.

People who know economics generally assume that what is happening can’t happen, because it doesn’t make sense.  Any rational homeowner would walk away from a mortgage that’s the double the value of the home — and indeed sometime over the course of the 40 to 50 years that this debt is to be paid most likely the homeowners will choose to walk away. However, currently large chunks of U.S. income are being spent on preventing the realization of financial sector losses. I would say that it’s no coincidence that the overall economy is simultaneously remarkably weak.

Given how poorly our financial system is functioning when it comes to simply recognizing losses and moving on, Matt Klein may be right to ask: “Wouldn’t it be ironic if our unwillingness to punish reckless lenders for their sins crippled our economy for a generation?”