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How US Politicians Brought Down the Global Financial System. Patric H. Hendershott and Kevin Villani PBFEAM, July 9, 2011 Taipei, Taiwan. What Brought Down Global System?.
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How US Politicians Brought Down the Global Financial System Patric H. Hendershott and Kevin Villani PBFEAM, July 9, 2011 Taipei, Taiwan
What Brought Down Global System? • Large global holdings of Fannie and Freddie MBSs and private label securities (PLBs) held by governments, banks and retirement systems • Both the MBSs and PLSs were highly-rated securities backed by sub-prime mortgages (and sub-prime was REALLY sub-prime) • The avalanche of sub-prime loans came on top of a normal boom, funding an abnormal rise in US house prices from mid2004 through 2006
The Crash • Some of the mortgage loans were so bad that they would fail (default) even if house prices didn’t fall – a fifth were delinquent in six months • House prices were due to fall because they has been artificially run up • Defaulting loans and falling house prices reinforced each other, leading to a total collapse of the US housing market and many financial institutions • And thus the expression sub-prime debacle
Brief Overview on US Mortgage System US has developed a housing finance system that differs from most developed economies • Most mortgages are securitized and most securities are tranched • The leading securitizers are federally-sponsored agencies, Fannie Mae and Freddie Mac (F&F) System was developed in part to get around branching restrictions – regional capital shortages would develop providing an impetus for securitization
So What Caused the Sub-Prime Debacle? Two competing narratives: • The politically correct narrative pushed by the Financial Crisis Inquiry Commission established by the US Congress (2009) and embodied in the Dodd-Frank Act of 2011 • An alternative factually correct narrative pushed by conservative US think tanks
Politically Correct Narrative Causes that made sub-prime debacle systemic • Deregulation and inadequate regulation • Wall Street greed led to massive PLSs that, when defaulted, dragged down Fannie Mae and Freddie Mac (F&F) • Home buyers, lenders, etc behaved irrationally Solution is more comprehensive regulation (Dodd-Frank Act)
Some Truth (Regulation Was Awful) But Three Myths First myth: deregulation was a cause of debacle • Removal of deposit rate ceilings (1980) • Elimination of branching restrictions (1994) • repeal of Glass-Steagall (1999), which had required separation of commercial and investment banking All of these steps strengthened the financial system; they were not a cause of debacle
Myth 2: Private Sector Dragged Down Fannie Mae and Freddie Mac • F&F were mandated to make percentage of loans to those with below median income (30, 42, 56) – also below 60% of median – were mandated to make bad loans • F&F required to fund half of sub-prime loans in 2005 • F&F bought 40% of subprime private label securities (PLS) during the boom
Myth 3: Behavior Was Irrational • Borrowers didn’t need to expect house price appreciation to make owning a wise economic decision (nothing to lose – no money down, live rent free) • F&F executives made hundreds of millions • Loan originators – securitizers of PLSs - made billions making/selling crap loans • NRSROs (Nationally Registered Statistical Rating Organizations) made billions ratings MBSs
How Did Everyone Make Money? Leverage • Homeowners borrowed up to 100% • F&F borrowed 99% at just above the government rate – federally sponsored • PLS leverage was only 95% (sometimes 98%) Even if things eventually went bad, what was made before that more than compensated
Factually Correct Narrative • Regulation was near complete by 2001 (and enforcement was almost totally inept) • F&F had largely replaced the private market in the conforming loan segment • Prudential regulation controlled PLSs Moral hazard created by politicians/regulators was the sole cause of the debacle
Error 1: Fannie Mae and Freddie Mac • Privatization created public risk for private profit model: incredible moral hazard problem • Regulator put in HUD where attempts to regulate were overruled: conflict of prudential and mission regulation • Extreme leverage • 30/42/56 and 50% of sub-prime market in 2005
Error 2: Recognized Security Raters • Establishment of NRSRO by the SEC: removed potential competition of other raters • Raters determined how much of the issue could be put into investment grade tranch and thus pay a low coupon • Risk assessors then relied on ratings rather than evaluating the risk of the investment • With little competition, ratings (especially of second mortgages) were far too generous
Error 3: Basil I Capital Requirements(response to previous S&L debacle) • Risk weightings: commercial loans and mortgages 100%, MBSs 50%, AAA/AA rated securities 20%, governments 0% • Huge impetus to securitize – to originate mortgages to sell, producing major moral hazard in loan originations • Relied on NRSRO ratings; gave them (undeserved) credibility • Generally eroded market discipline
Error 4: Commercial Banks • TBTF banks were allowed to develop as banking system consolidated • Off-balance sheet funding was allowed (SIVs) • Banks were permitted to issue preferred stock (AAA rated, of course) and count it as equity capital • Erroneous Basil I requirements; in 2001 20% weighting given to PLS AAA/AA segments
Error 5: SEC and Investment Banks • Bail out of LTCM (1998) illustrated that investment banks, too, could be TBTF (Geitner) • Still, capital requirements were far less than those of commercial banks • SEC declared five largest to be “consolidated supervised entities” and lowered capital requirements in 2004, but provided little supervision
Why Was Regulation So Bad? Politicians • They believed that their judgment (or that of their appointees) could substitute for market discipline • They believed that off budget subsidies through finance could be given (Housing Lending Goals) • They received millions in political contributions and payoffs • They created crony capitalism and called it a new hybrid public/private partnership
Some Errors of Politicians • Put F&F regulator in HUD and prevented him from stopping bad loan purchases • Voted against raising far too low F&F capital requirements • They didn’t oversee behavior of SEC, FDIC, etc.
Repeal Dodd-Frank • Doesn’t fix money market regulation – invest in government securities (not Greek debt) • Retains F&F, contending that government sponsorship can be limited with moral hazard • Extends investment market regulation to derivatives/hedge funds Creates a committee of politicians, bureaucrats and professors to prevent the next crisis – and housed in the Treasury Department!
Restoring Investment Market Discipline • Eliminate F&F – no government sponsorship • Repeal NRSRO designations • Alter risk-based rules for mortgages to reduce the incentive to originate to sell • Encourage a market determined allocation of risks (covered bonds, ABSs)