For generations, the strength of the U.S. housing market was due, in part, to securitization of mortgages with guarantees from the government-sponsored companies, Fannie Mae and Freddie Mac. Following the savings and loan debacle of the late 1980s, securitization — which has been defined as “pooling and repackaging of cash-flow producing financial assets into securities that are then sold to investors” — helped bring capital back to battered real estate markets.
Today, securitization of subprime real estate loans is blamed for the global liquidity crisis, but Wharton faculty say securitization itself is not at fault. Poor underwriting and other weaknesses in the market for mortgage-backed securities led to the current problems. Securitization, they say, will remain an important part of the way real estate is funded, although it is likely to undergo significant change.
“Securitization, in the long run, is a good thing,” says Wharton finance professor Franklin Allen. “We didn’t have much experience with falling real estate prices in recent years. The mechanisms weren’t designed for that.” He explains that economists were concerned about the incentives and accounting that shaped the private mortgage securitization market in recent years, but as long as real estate prices kept rising, the weaknesses in the system did not become clear. Now, after credit markets seized up and prices have declined sharply, those problems have been exposed.
Allen believes financial markets will get back into the business of securitizing mortgage debt, but only after making some major changes. One new feature of future securitization deals, he says, could be a requirement that loan originators hold at least part of the loans they write on their books. Before the current crisis, loans were bundled into complex tranches that were passed through the financial system and onto buyers with little ability to assess the real value of the individual assets.
“The way the collateralized debt obligations (CDOs) and other vehicles are structured will change. They are too complicated,” says Allen. “I’m sure the industry will figure out how to do it. There will be a lot of industry-generated reform and the industry will prosper. This is not, in my view, something that should be regulated.”
Privatizing Securitization
According to Wharton finance professor Richard J. Herring, for decades, mortgage securitization was backed by government guarantees through Fannie Mae and Freddie Mac, and it worked well. Of course, these agencies were regulated and bound by less-risky underwriting standards than those that ultimately prevailed in the subprime market which was also, potentially, more profitable. Indeed, default rates were so low in the mortgage-based securities market that banks and other private financial institutions were eager to take a piece of the residential business.
At first, the transition to private securitization worked, because investors were willing to rely on three substitutes for the government guarantees. These included ratings agencies, new business models and monoline insurance designed to guarantee specialized mortgage-backed bonds. “Positive experience with private securitization led to an alphabet soup of innovations that sliced and diced the cash flows from pools of mortgages in increasingly complex ways,” says Herring.
Now, the subprime crisis has undermined confidence in all three pillars of private securitization. Ratings proved unreliable as even highly rated tranches experienced sudden, multiple-notch downgrades that were unknown in corporate bonds. Models developed by the most sophisticated firms selling mortgage-backed securities, including Bear Stearns, Merrill Lynch, Citigroup and UBS, failed. Monoline insurers, it turned out, were not adequately capitalized.
“There has been a highly rational flight to simplicity,” says Herring. Over time, he believes, the real estate securitization market will reemerge as investors regain confidence in the ratings agencies, new models evolve, and monoline insurers are able to increase their capital. “But I think that it will be a long time before the market will be willing to accept the complex, opaque structures that failed,” continues Herring. He adds that recovery will be delayed until investors are confident that the fall in house prices has reached the bottom.
Wharton real estate professor Susan M. Wachter points out that many recent — and historic — international financial problems originated in real estate. The nature of real estate finance and incentive structures is more to blame than securitization this time around. “The most recent crisis is coming through the securitization market, but this isn’t the only real estate crisis,” Wachter notes, adding that the fundamental problem in real estate finance is that there is no way to bet against the industry. Real estate is essentially priced by optimists, and rising prices themselves justify even higher values as assets are marked to market, creating new incentives for investors to overpay.
Wachter points to real estate investment trusts (REITS), publicly traded bundles of real estate assets, as an example of how securitization can help provide liquidity, but also a chance for short-sellers to correct against overly optimistic pricing. Research indicates that REIT prices may not have increased as much as other sectors of real estate finance because the industry has at least 200 analysts looking at the underlying assets in each REIT with the ability to point out faulty pricing to investors. “REITS have performed fluidly relative to the overall market, and that is a good thing,” says Wachter.
Fee-driven Lending
Another problem was that much of the subprime lending was fee-driven, giving banks incentives to write loans to earn the fees because they could then pass the risky assets along to securitized bondholders. And even bank shareholders had no way to limit their real estate exposure because banks invest in various kinds of economic activity and not just in real estate. Biased pricing and bubbles also arise because the supply of real estate is not elastic. By the time the market recognizes supply has outstripped demand, construction has already begun on many more projects that will continue to be built out; this tends to exacerbate oversupply and create downward pressure on prices for years.
In a research paper titled, “Incentives for Mortgage Lending in Asia,” Wachter and her co-authors write: “With [the] forbearance of regulatory authorities and the intervention of governments, banks may be bailed out, mitigating the consequences for shareholders. Nonetheless, the fundamental factor which explains why episodes of bank under-pricing of risk are likely to occur is the inability of banking shareholders to identify these episodes promptly and incentivize correct pricing.”
Wharton real estate professor Joseph Gyourko notes that significant differences exist in the performance of commercial and residential real estate securities. “Securitized commercial property debt will come back once the market calms down,” he says, adding that there has been very little default in commercial real estate finance. “You’ll be able to pool mortgages and securitize them, but almost certainly won’t be able to leverage them as much as you did in the past.”
The residential side, where there is significant default, is more problematic. Gyourko believes the residential market will go back to what it was in the mid-1990s and most borrowers will have to put down at least 10% of the sales price. “We will get rid of the exotic, highly leveraged loans,” he says. “That will lead to lower homeownership, but it should. We put a lot of people into homeownership that we shouldn’t have.”
Wharton emeritus finance professor Jack Guttentag, who runs a web site called mtgprofessor.com, says the short-term future for residential real estate is “bleak.”
“Secured bondholders have been badly burned. They discovered to their dismay that all kinds of problems are connected to mortgage-backed securities, which they hadn’t anticipated.” Guttentag also points to the failure of ratings agencies, which are already being revamped. The methodologies used to determine ratings were flawed, he says. “They used historic performance over a period that simply wasn’t representative.”
“CDOs are Doomed”
In the future, ratings agencies will need to operate on the assumption that a security rated AAA should be able to withstand a shock as great as the current crisis.
“That will mean that under the best of circumstances, it will be harder to get a triple-A rating, which will reduce the profitability of securities,” Guttentag says. Some forms of securities will die. CDOs are doomed, he adds, because the market has seen they are extremely difficult to value. “In the short term, the prospects are dismal. The market will recover, but I don’t think we’ll ever see CDOs again and the standards will be tougher, so the comeback will be gradual.”
Gyourko notes that the crisis is playing out in a presidential election year, complicating the response. “I think this is the worst time to have this happen. It’s never a good time, but in an election year, you’re more likely to get a bad policy response,” he says. According to Guttentag, while Republican presidential candidate John McCain is taking a laissez-faire stance, the Democratic presidential candidates have focused on using the Federal Housing Administration (FHA) to refinance loans that are in default. The idea is similar to what happened during the Great Depression of the 1930s with another agency called the Home Owners’ Loan Corp. which was created specifically for that purpose.
The problem, says Guttentag, is that FHA is not designed as a bailout agency. “The FHA’s core mission is predicated on it being a solvent operation, actuarially sound, charging an insurance premium large enough only to cover losses. How they would reconcile that is not clear.”
Guttentag says attempts may be made to create a separate bailout agency within the FHA with different accountability. “But the devil is in the details,” he warns, “and the details have to do with exactly who is going to be helped, what the requirements are, what the nature of the assistance is going to be, and myriad other factors that have to be worked out.” The Bush administration has taken some steps to ease the crisis, including encouraging lenders to modify contracts to avoid foreclosure. A strong case can be made for these measures, Guttentag adds. “The cost of foreclosure is often greater than the cost of modifying the contract and keeping the borrower in the house.” One downside is that once some loans are modified for those truly on the brink of foreclosure, other borrowers who could somehow manage to avoid foreclosure may demand the same modifications, shortchanging investors.
In testimony before the U.S. House of Representatives’ Committee on Oversight and Government Reform, Wachter laid out a proposal developed with the Center for American Progress to resolve the current crisis. Under the so-called SAFE loan plan, the U.S. treasury and the Federal Reserve would run auctions, in which FHA originators, as well as Fannie Mae and Freddie Mac and their servicers, would purchase mortgages from current investors at a discount determined at the auction.
Investors would take a reduction in asset value and yield in exchange for liquidity and certainty and the auction process would price pools and bring transparency back to the market. The FHA, Fannie Mae, and Freddie Mac could then arrange for restructuring of loans.
Meanwhile, Allen notes the Federal Reserve has taken some dramatic steps with interest rate policy to resolve the current economic crisis, but that could lead to tension with Europe and Japan over currency valuations. As the dollar continues to fall, U.S. companies are increasingly more competitive overseas. “The Fed cut the rate at the beginning, and that was fine, but now things are getting way out of line,” he says.
Furthermore, it is not clear that cutting rates is going to solve the basic problem. As rates continues to drop, foreigners may begin withdrawing their money from dollar-denominated investments, driving rates up. “What the Fed is doing is unprecedented,” says Allen. “It is laudable that it is trying to stop a recession, but how many risks should you take to do that? We’re now moving into an area where the Fed is probably taking too many risks. If inflation picks up and long-term rates go up, we’ll be in a situation where we have to raise short-term rates as we go into recession, which is not a happy thing to.”
Vulture Capital
The private sector has begun to show signs of willingness to get back into the fray. A number of vulture funds have begun to form to take advantage of distressed real estate prices. BlackRock and Highfields Capital Management have announced they will raise $2 billion to buy delinquent residential mortgages. The companies have hired Sanford Kurland, the former president of Countrywide Financial, to run the new venture called Private National Mortgage Acceptance, or PennyMac. “Many distressed funds will come in to discover prices,” says Gyourko.
Wharton real estate professor Peter Linneman offers an intriguing prescription to bring prices down to the point where the industry can start to rebuild. He suggests that the government tell banks that if they want to maintain their federal insurance, they should fire their CEO by the end of the day, and the government will pay the CEO $10 million in severance. Ousting the former CEOs gives the new bank CEOs an incentive to write down all the bad assets immediately, so that any improvement will make them look good going forward. That would speed the painful process of gradual price declines.
“There’s plenty of money out there waiting for these assets to be written down to bargain prices,” says Linneman. In another quarter or two, the lenders would have new cash and be ready to lend again. Meanwhile, he says, the government should tell bankers it will keep interest rates down but raise them after the end of the year. “That says, ‘Get your house in order in the next nine months because the subsidy ends at the end of the year.'” Linneman figures that 1,000 CEOs are accountable for about 80% of the current lending mess. If the government were to spend $10 billion to restore liquidity to the market in nine months with only 1,000 people losing their jobs, it would be the best investment it could make to restore the economy. “I’m only half-kidding,” he quips.
Linneman also argues that concerns about moral hazard — or the tendency to take greater risks because of the presence of a safety net — because of a bailout are not valid. Those concerns, he says, already exist and have been in place since the U.S. government agreed to insure bank deposits. “The minute you say to somebody, ‘No matter what you do I’ll give your people their money back,’ you’ve created moral hazard,” he says. “Now it’s only a matter of how often and how much they will have to spend to settle up. If you go through our history, every eight years to 15 years we have had an episode.”
Indeed, Wachter cautions that while the plan she outlined for the Congressional committee might halt the current meltdown, it would not prevent a replication of the crisis in the future. “The ultimate question before us is do we want a system that produces risks such as those that we have seen in the current market. It is clear that Wall Street will underwrite any risk,” she testified. Wachter told the committee that adding financial risk to the home-loan market not only poses potential problems for borrowers and investors, but it also exposes all homeowners and the overall economy to increased house price volatility and risk. “We, as a society, will have to decide whether we wish to encourage such financially vulnerable funding as backing to the asset we also call home.”
