Sunday, February 20, 2011

Supply Side Mortgage Financing

On the recommendation of Mike Konczal, I checked out Adam Levitin’s account of the housing (with Susan Wachter). It’s a pretty long paper with a single core idea: to figure out what happened with the financial crisis, look at prices and quantities. Levitin observes that the yields (ie, interest rates above other interest-bearing assets) on mortgage-backed securities fell dramatically during the subprime boom, while the quantity of such products grew dramatically. The lesson to draw from that is that a rising supply of mortgage finance must be the chief culprit for the crisis, not demand. If the demand for mortgages was rising (say, from federal housing policy), the price of risk in mortgage markets would steadily rise. The fact that they instead fell points to the role of increasing supply in lowering the risk premia on mortgages. Levitin attributes this falling cost to mispriced mortgage securities.

Here’s a graph from a Fed paper by Diana Hancock and Wayne Passmore I'll get to in a bit that illustrates this pretty well:

If you compare the pre-boom era "Normal" with the subprime boom, it’s clear that mortgage yields fell dramatically relative to Treasury rates (ignore the crisis era stuff).

This is a clever idea, but attributing all of that fall in interest rates to mispricing seems a pretty bad assertion. There are many reasons why yields could fall. As I just blogged, large foreign inflows of capital could lead to a lower price of risk, though this scenario isn’t mentioned in the paper. Though Levitin dismisses monetary policy quickly, Rajan has argued that periods of absolutely low interest rates might generate a pattern of increased leverage and yield-seeking that would describe this data equally well.

But what I found most troubling was the use of simple market yields. It’s true that a fall in mortgage yields could imply a lower risk premium, all else equal. But when pricing a mortgage, a lot more goes in than just credit risk. Borrowers of mortgages typically have the ability to pay back the mortgage in full — for instance, by refinancing their mortgage to a lower rate. This is bad from the point of view of an investor, since borrowers are most eager to "prepay" their mortgage once interest rates are low. So, at exactly the point when interest rates fall (and you have fewer good investment options), mortgage borrowers give you all this cash. To deal with this, when you lend money in the mortgage market, you receive a prepayment premium for taking on that risk, and that goes into pricing a mortgage. The factors determining prepayment risk, as well as other risk determinants, changed dramatically during the subprime boom era, so it's not clear whether a falling risk premia explains everything.

Fortunately, the Fed paper from above does break this out. While this can get very complex, one simple check is to compare the MBS yield over Treasury (graphed above) to the option-adjusted spread (OAS) over Treasury (graphed below).

The OAS here is designed to pick up the portion of the mortgage yield attributable to the prepayment risk. You see that the OAS spread went down quite a bit during the subprime boom years as well. Overall, the MBS yield over Treasury (which Levitin interprets only as credit risk) fell by ~.7%. Yet ~.55% of that fall is attributable not to changes in risk preferences, but instead due to changes in the premia for carrying prepayment risk.

And the fault for that goes exactly to the Fed/global investors. The Federal Reserve promoted a climate of low interest rates, while global investors too pushed interest rates down. In response, carrying the prepayment risk of mortgages became lower (as borrowers didn’t have much room to refinance at substantially lower rates), and mortgages became more attractive as an asset class. The net change in mortgage yields due factors other than the prepayment risk should be something like 15 basis points; and some of that may also be attributable to other changes in the financing climate (the authors claim a sizable fall in the roll-over risk in this period associated with having to refinance debt holdings. This, too, can be attributed to interest rates that were persistently low). Though the authors of the Fed paper don’t seem to break this out — it’s very possible that the credit risk for mortgages actually went up during the subprime years.

Not only that, but the stock of borrowers grew quickly in response to these shifts in interest rates, suggesting that homeowners in this period were highly responsive to the price of mortgages. It’s possible that factors like land use regulations, a bubble mentality, lower downpayments, etc. may have been responsible for that, and that responsiveness is as important as the initial shock.

To be sure, the fact that the risk premium seems to have remained roughly constant even as worse borrowers took out mortgages may suggest that the risk premium may not have been high as it should have been. And I don’t understand this field nearly as well as I should, so please check out both papers and tell me where I’m getting things wrong. But I call this as another win for the camp blaming the Fed/foreign investors.

Edit: Adam Levitin has responded in the comments. He makes the good point that the Fed paper only looked at Agency MBS; while the pattern may well be different for private-label MBS, many of which were given out to loans on an adjustable-rate mortgage.


Adam Levitin said...


You're right to argue that we didn't give enough play to the Fed's global supply glut argument. We have a new (and shorter) version of the paper that we will be posting on SSRN in a few days that addresses monetary policy in more detail.

There are two problems with the Bernanke argument as we see it. First, it doesn't explain why the global savings glut went to US real estate rather than other asset classes (or more precisely, why it went to US real estate more heavily than to other asset classes).

Second, the Bernanke global supply glut argument ignores the fundamental economics of structured finance: when you turn a bunch of subprime mortgages into AAA-rated RMBS, there's a by-product of non-investment-grade RMBS that's 5-10% of the deal. Unless a buyer can be found for this non-investment-grade paper, the deal economics just don't work.

Bernanke's most recent paper demonstrates pretty clearly that there was tremendous foreign capital demand for AAA-rated paper (the hams, chops, loins and bacon). But that leaves the question of how banks were moving the BBB-rated pieces of RMBS (the trotters and snouts and ears and tails). ,

The demand for the BBB-rated pieces came from CDOs. The CDOs themselves, however, needed someone buying their BBB-pieces. And that demand came from shorts. First there was the Magnetar move, which basically leveraged perhaps $60B into perhaps trillions or more in subprime mortgage credit: Magentar's purchase of the BBB-pieces made it possible to create and sell the AAA-pieces of the CDOs, which meant that there was demand for the BBB-pieces of RMBS, which meant there was supply of AAA-rated RMBS, which meant cheaper mortgage credit.

Of course, not everyone was doing a Magnetar. John Paulson's Abacus 2007-AC1 move was much simpler: he just went short on RMBS via a synthetic CDO. The use of synthetic CDOs, which are through a dealer market, rather than direct or on an index like the ABX meant that there wasn't transparency to the short demand. It was impossible to know if the short demand was just part of innocuous negative basis trades (short positions as hedges for longs) or actually expressing an opinion on the subprime market. This meant that the spreads on RMBS didn't grow as they should given the short play that was occurring. The result was underpriced mortgage finance.

Adam Levitin

Adam Levitin said...


Also, a major difference between our analysis and that in the Fed piece is that we are only looking at private-label (non-Agency) MBS, while the Fed is looking solely at Agency MBS. The worst excesses of the bubble were in the private-label space, not the Agency space. The Agencies did a lot more business in fixed-rate mortgages than private-label, so one would expect to find a much larger impact of prepayment pricing (OAS) in the Agency space than the private-label space.

Adam Levitin

Arpit Gupta said...


Thanks for stopping by and giving me your thoughts.

I agree that there are many problems with the supply glut idea. To respond briefly,

1) On the real estate point, many durable goods, not just real estate, saw big change. Real Estate may have moved more, but the same could be said of, say, Thailand before its crash.

2) Bernanke's new paper does discuss the structured finance point. His point would be that both forms of demand -- for the good and bad meat -- drove the boom. Without the foreign demand for AAAs, the shorts couldn't have made money.

3) You're right that the Fed paper only looks at Agency, and I've updated that in the post. But the general point is that changes in yields can't always be interpreted as changes in the price of risk.

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