Affordable Housing Institute : US

[Continued from yesterday’s Part 1.]

Part 2: The US securitization model emerges

 

Yesterday’s post covered the early part of HUD PD&R’s report on the Evolution of the US Housing Finance System and got us up to the Panic of 1893.

 

Do we look like we’re panicking?

As I’ve written before, catastrophe precedes reform, a point the authors make later:

 

Maybe we should rethink the terminal layout

 

Lesson 1: The evolution entails the sequence of shock-response-innovation. (Page 21)

After the Panic of 1893, the American economy grew steadily, with a particular boost from World War I that led to the Roaring Twenties, which were followed by Black Tuesday’s stock market crash and the ensuing Great Depression:

 

Jobless men marching on Washington

Two outcomes of this economic shock [the Great Depression] were particularly adverse to the housing finance system:

· The ramping up of the unemployment rate that caused liquidity and solvency problems for a large number of borrowers, leading to non-payment of loans, and

· The acute deflation that resulted in an almost 50% drop in the price level of homes.

 

Shanty towns in urban areas were named Hoovervilles

 

This deflation resulted in insufficient collateral values of bank loans, large-scale bank runs, and insolvency for the whole banking system. (Page 5)

 

Starting with John Maynard Keynes, economists generally recognized that when economic value disappears, with it goes liquidity, and the whole thing can very rapidly revolve downward into a financial meltdown.

 

There goes the neighborhood

 

Interestingly, the first sector to be propped up by Roosevelt was residential ownership, via the FHA and the Farmers Home Administration (FmHA, now RHS).

In general, private-sector participants will jump into a new venture only if they see a positive value proposition by doing so. The high uncertainties associated with new products (e.g. the 30-year fixed rate mortgage or mortgage default insurance) usually discourage private-sector initiative of such ventures. As the US history shows, the government played a significant role in introducing and nurturing such products. (Page 20)

 

Thus up pop three more useful lessons:

 

Am I a useful lesson?

1. In affordability, government should lead. Bankers are as much an observant herd as other critters, and if there is a questionable but socially desirable market space to be entered, government should take the lead in its entry.

2. Government should take non-commercial risk. Key for government is to take risks just beyond the commercial threshold, thus those with which the private sector has little experience.

3. As risk becomes commercialized, government should withdraw from insuring against it. Today the 30-year mortgage is so standard it’s taken for granted, and private mortgage insurance can be readily obtained at modest cost. As the private sector embraces a class of risk, the government should always withdraw.

After completing its historical survey in an all-too-short and sketchy Section 2, HUD’s report then turns, in its Section 3, to an extended and quantitative paean to the current system generally and the securitization approach to secondary markets in particular.

In the 1990s, one particular aspect of the US housing finance system (HFS) — mortgage securitization — came into fashion worldwide. (Page 1)

 

I’ll explore what is securitization in future posts; for now, we’ll use a simplified definition: creation of new debt instruments issued by intermediaries (like GSE’s) that change the risk profile. In other words, this definition excludes straight-up revenue bonds backed by a package of whole loans without issuer credit enhancement/ risk mitigation involved.

 

For many reasons — not least the apparent success of Fannie Mae and Freddie Mac — mortgage securitization along the US model became internationally very popular in the 1990s:

Since the early 1990s, 24 countries in 6 continents [What? Not Antarctica? — Ed.] have issued some forms of mortgage-backed securities (MBSs).

 

No securitization here, the market’s illiquid

 

If securitization is the natural, inevitable outcome of upward financial evolution, then it worked everywhere, didn’t it?

Despite the spread of the MBS, only a few countries — mostly those in Western Europe — have experienced success and are expanding their MBS markets. (Page 1)

 

Whose fault is that? The report is in no doubt: it’s the local countries’ problem.

The growth of the US MBS market during the past two decades stemmed at least partially from the critical enabling ingredients that were in place, both within the system (e.g. risk-sharing arrangements, deposit insurance, and confirming loan products) and outside the system (stable macroeconomic conditions, depth in the corporate and government bond markets, and a sound banking system). These infrastructures are not in place in many other countries. (Page 1)

 

Translated: if you ate your vegetables, then you’d be able to have a functioning securitization market and all your problems would be solved.

I don’t buy it. In fact, the simplicity of prescription (and the shallowness of the report’s Chapter 5 diagnosis of its four chosen fusion countries, Korea, Mexico, Poland, and South Africa) for me highlights the report’s weaknesses:

 

[Concludes tomorrow in Part 3.]

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