U.S. Mortgage Crisis Rivals S&L Meltdown

Today's Wall Street Journal has a lengthy article about the subprime mortgage crisis.

Northern Rock: the first mass run on an English bank since 1866

Northern Rock is a British bank. It experienced this summer what Chris Giles, Economics Editor of the Financial Times, calls "the first mass run on an English bank since 1866." (FT.com: Oct 25, 2007)


Northern Rock had a peculiar business model: In Mr. Giles' words, the Bank of England characterized Northern Rock "with its dependence on securitisation, the concentration of its asset base in mortgages and the narrowness of its margins - [as] an outlier in British banking."

Where was the lender of last resort? "The Bank [of England] now acknowledges that officials did partly fumble the lender of last resort operation for Northern Rock.

Moral Hazard

Moral hazard is the prospect that a party entering a contract becomes insulated from a risk and that insulation causes him or her to behave differently at the peril of the other party. The contract changes incentives and the changed incentives causes one party to behave differently. A few examples will clarify this.

If you rent a car or your residence to someone, you, as the owner, run the risk that your renter will not treat it the way you would treat your own property. By entering into the rental agreement, you, the lessor, incur moral hazard. If you doubt moral hazard exists in rental contracts, ask yourself why landlord require deposits, and why you as a used car buyer worry more about a rental car than one you buy from the sole owner.

Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore acts less carefully than it otherwise would. This leaves another party bearing some responsibility for the consequences of those actions

Insurance is rife with moral hazard: Why? An insured party's behavior will be riskier than it would have been without the insurance.

In life insurance, moral hazard can arise when the insured can self select. A life insurance company bases its rates on the actuary tables for the average person. If I know everyone in my family has died young, it make sense for me to buy more insurance than normal. This adverse selection will cause the life insurance company to undercharge me.

In banking, deposit insurance creates moral hazard. Consider a hypothetical bank we could call Loan Prone Savings and Loan. The FDIC insures Loan Prone's deposits. The bank gets in trouble. Loan Prone's loans are not sufficient to pay off its depositors. Perhaps its books do not yet show its true condition. They comply with banking regulations, but they do not show the true value of the loans. What can Loan Prone's do?

If it can get more funds (by taking in more deposits), it could make some new loans. So Loan Prone offers an above market interest rate to attract more deposits. There is no risk for the depositors, their deposits are insured. Note: without deposit insurance, depositors would have a strong incentive to investigate a bank's soundness. With deposit insurance, that incentive is gone.

The bank does not care if its losses grow, Lone Prone is already "in the soup." Maybe it can recover enough from new loans that it can get back in the black. Thus Loan Prone hopes that it can find some profitable investments to recoup its loses. It goes for more profitable but riskier loans. It is gambling to get back into the game. The depositors do not care: the FDIC is going to get stuck paying off them off.

Neither the the bank nor the depositors are behaving they way they would in the absence of deposit insurance. That is the essence of moral hazard.

FT: Martin Wolf, "Securitisation: life could follow death"

Securitisation: life could follow death

By Martin Wolf, FT.com site
Published: Oct 02, 2007

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing." Chuck Prince, Financial Times, July 10 2007.

"A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him." John Maynard Keynes, 1931.

The dance has stopped: Mr Prince's Citigroup has just announced $6bn in write-downs and losses for the third quarter of 2007. He is far from alone. More bad news is no doubt to come. As Keynes foretold, the banks joined Mr Prince's dance together and are leaving it together. Until the dance ends, nobody knows what a bank's profits are: bankers report (and pay themselves) on the basis of profits that are normally offset by write-offs when the bad lending comes to light.

What is remarkable about the present crisis is how traditional it is, despite the modern paraphernalia of securitised lending. We are seeing old-fashioned bad lending and old-fashioned mispricing of risk. What is remarkable, in addition, is the severity of the consequences. The US market in asset-backed paper contracted by 21 per cent between August 8 and October 1. The flight from risk also brought about big divergences between interest rates on commercial paper and US Treasury bills and between central bank interest rates and those in interbank three-month markets. This disruption, moreover, has taken place at the core of the world economy: the US housing market and debt markets of advanced countries.

I admit to both surprise and disappointment. No, I am not surprised by the repricing of risk. On the contrary, together with a host of outside observers, I was astonished by the willingness of yield-seeking investors to take on risks for small reward. If anything, the repricing has been remarkably small, at least so far: equity markets are buoyant; spreads over US Treasuries of emerging market bonds in the JPMorgan emerging market composite bond (EMBI Plus) index rose by a mere 39 basis points between July 6 and October 1; on Baa-rated corporate bonds, they rose by 59 basis points; and even on Caa-rated bonds, they rose by no more than 191 basis points.

What I am surprised by is how toxic securitisation of subprime mortgages has turned out to be for the financial markets. I admit that I thought securitisation had attractive features: it should allow banks to remain in the mortgage business as originators and intermediaries without taking too much of the interest-rate, term and liquidity risks on to their own highly leveraged books; it should allow banks to transfer those risks on to investors who want longer-term, higher-yielding assets; and, in the process, riskier borrowers should have access to more credit than before.

In 2005, Alan Greenspan himself, then Federal Reserve chairman, remarked that advances in technology had revolutionised lending: "where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending."* Oops!

So what went wrong? There are two chief answers. The first has nothing to with securitisation itself: it is that a fit of all-too-familiar euphoria overwhelmed both lenders and borrowers at a time of low interest rates and rapid rises in the prices of the underlying collateral (namely, housing). But the second has a great deal to do with securitisation: it is that the process of removing lending from the books of the initiators encouraged sloppy lending ("it is not going to end up on our books") and greater belief that banks were free of the risk ("this special purpose vehicle has nothing to do with us") than turned out to be the case.

Why did this happen? As Robert van Order of the universities of Aberdeen and Michigan points out, securitisation necessarily creates a chain of transactors where bank lending interposes just one institution between the borrower at one end and the depositor at the other. Such chains depend on trust or, as he puts it, "reliance on originators and servicers to originate good loans and service them properly". The trust proved misplaced and has duly vanished: credit means "he (or she) believes". Alas, he no longer does.

In trust's absence, ignorance not only of what securitised assets are worth but also of who holds them has dried up asset-backed paper markets. That has forced banks to lend directly to the conduits, special purpose and special investment vehicles they created. The need to fund these has dried up lending and, above all, the provision of liquidity to interbank markets. One result (among many) was the collapse of Northern Rock's business model in the UK.

An obvious reaction to this debacle is to recommend going back to the old bank-based lending model. But that would be a big mistake. The potential advantages of securitisation, vis a vis "plain vanilla" bank lending, remain, because banks are inherently so fragile. But if these markets are to recover, the errors must be fixed: first, a way must be found to demonstrate integrity of lending; second, transparency of the securities will have to increase; and, third, banks must insure themselves adequately against the need to provide liquidity to their off-balance-sheet vehicles. It is not impossible to sell complex products safely: Boeing and Airbus manage it. But only companies that demonstrably care about their reputations are able to do so. It is up to originators of securitised liabilities to do the same.

A great deal of dust still has to settle in housing markets, financial markets and the world economy. The world that emerges will look different, in many ways. But there is no reason securitisation should not become as normal and reliable an element in financial markets as corporate "junk bonds" and loans to emerging markets have also turned out to be. It is always possible to have too much of a good thing. In this case, the world has had far too much of something that was not as good as it ought to have been. But securitisation is a good thing, all the same. It can re-emerge, provided the lessons of the financial markets' dance are learnt.

*Remarks by Chairman Alan Greenspan, April 8 2005, www.federalreserve.gov/BoardDocs/speeches/2005/20050408/default.htm

**On the Economics of Securitization, http://deepblue.lib.umich.edu/handle/2027.42/55302

martin.wolf@ft.com

Sources for charts: Federal Reserve; Thomson Datastream

FT: Martin Wolf on "Challenge of rescuing world economy"

Challenge of rescuing world economy

By Martin Wolf, FT.com site
Published: Sep 11, 2007

The financial markets have taken the world economy hostage. This has presented the world's central banks with a dilemma. They fear the consequences of paying off those responsible for the mess. But they cannot let hundreds of millions of innocents suffer. Last week's announcement of the first US monthly fall in employment for four years has made a cut in interest rates from the Federal Reserve this month a virtual certainty. So act it will. But making the right decisions is going to be hard.

Martin Feldstein of Harvard university put the case for big cuts in a powerful summing up at this year's Jackson Hole monetary conference.* He argued that the US housing sector was at the heart of three interrelated events. First was "a sharp decline in house prices and the related fall in home-building that could lead to an economy-wide recession ". Second was "a subprime mortgage problem that has triggered a substantial widening of all credit spreads and the freezing of much of the credit markets ". The third was "a decline in home equity loans and mortgage refinancing that could cause greater declines in consumer spending ".

Prof Feldstein pointed, for example, to a 3.4 per cent year-on-year decline in US house prices, with the chance of substantially more to come. Robert Shiller of Yale argued at the same conference that US house prices might ultimately fall by as much as 50 per cent, which would lower US household wealth by more than $10,000bn.

Prof Feldstein also noted the damage done to the financial markets by the crisis in subprime lending. This is partly because credit spreads are correcting, albeit modestly so far. More important, "as credit spreads widened, investors and lenders became concerned that they did not know how to value complex risky assets ". With confidence gone, banks have been forced to advance loans to their off-balance-sheet "special investment vehicles ", which uses up their capital and so starves other borrowers.

Finally, as house prices and borrowing fall, household saving rates will rise towards more normal levels and residential investment fall still further. This combination seems sure to generate a rapid decline in the personal sector's financial deficit (discussed in my column of August 21 2007).

Prof Feldstein concluded by recommending a "risk-based approach ", which treats the risk of a recession as more important than that of an upsurge in inflation. If the latter were indeed to happen, "the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it would succeed in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability. "

If the Fed did what Prof Feldstein recommends, it would risk undermining its credibility. How, then, did it get into this mess? At Jackson Hole, John Taylor of Stanford university - inventor of the "Taylor rule " (which relates monetary policy to movement in output and inflation) - blamed the Fed for excessively loose policy between 2002 and 2006.

Thus, Prof Taylor believes the Fed made a mistake under Alan Greenspan's leadership. Prof Feldstein suggests it should risk repeating it. But these distinguished academics and, indeed, most of the US academic discussion ignore the international dimension to both the origin and resolution of this turmoil.

Prof Taylor dismisses the "savings-glut " explanation for the low US interest rates, with the observation that global savings rates are lower than three decades ago. But the world, without the US, had a rapidly rising excess of savings over investment in the early 2000s, much of it directed to the US. Given the huge capital inflow, the Fed's monetary policy had to generate a level of demand well above potential output.

The international dimension also shapes the resolution of the crisis. The Fed has a delicate judgment to make, not just between saving the hostages and rewarding the hostage-takers, but also between saving the US economy and risking confidence in the dollar.

In essence, the dollar needs to weaken, but not to crash. The Fed cannot risk a big rise in long-term interest rates, in response to loss of confidence in US price stability and an exchange-rate collapse.

Yet when house prices are expected to fall, lower interest rates themselves are unlikely to persuade people to borrow and spend. Thus a large part of the impact of lower interest rates must come via a weaker dollar and large improvements in the external balance.

This is another way of saying that the era in which the world could rely on the engine of US consumption is now at an end. If anything, the engine is more likely to go into reverse.

So the long-awaited and much-discussed "rebalancing " of the world economy is about to accelerate. Should the rest of the world fail to respond appropriately, a significant global slowdown is foreseeable.

Yet the US is not the only country in such a predicament. In an era of low interest rates, house prices soared in a number of developed countries. These also are vulnerable to a house price correction.

Much of the adjustment to lower growth, or even a decline, in US consumption must come elsewhere. Among others, China will be in the eye of this storm. Suppose, for example, that the dollar went down against the floating currencies, notably the euro, accompanied by the renminbi. Suppose, too, that the Chinese authorities took no measures to expand domestic demand. Then the external adjustment would fall elsewhere in the world. This would prove highly disruptive, particularly in continental Europe. Even the commitment to open markets might be endangered.

The combination of house price falls with a financial crisis in the core country of the world economy means big challenges for policymakers everywhere, particularly for the Fed, since it must respond without destroying trust in the dollar, and for policymakers in savings-surplus countries, who must anticipate a world in which the US demand engine slows sharply. Will they manage to keep the world economy expanding stably? A year or so from now we will have a far better idea of the answer.

* 'Housing, Housing Finance and Monetary Policy', September 1 2007, www.kc.frb.org

martin.wolf@ft.com

Richard Green's Three principles for avoiding future subprime messes

Changes in policy should accomplish three things:

(1) It should make sure that all parties in the lending chain have “skin in the game.” While reputational risk mitigates against bad behavior, there is no substitute for financial incentives.

(2) It should make sure that all parties in the lending chain are subject to federal supervision. This will reduce regulatory arbitrage.

(3) It should do what it can to improve disclosures throughout the lending chain. Borrowers must be better informed as to the consequences of their lending choices (although this will be difficult); ratings must be consistent, and securities must be more transparent.

Milton Friedman on Bubbles and Busts.

You can read another version of this on the Hoover Digest 2006 No. 4.