Why the US Mortgage Market Will Remain Heavily Dependent on Government Support (Updated)

In Senate Banking Committee testimony today, Georgetown law professor Adam Levitin explains why the private label (non-government guaranteed) mortgage market is a textbook case of what Nobel prize winning economist George Akerloff called a “market for lemons”. While that conclusion is not news to those who’ve been following the financial crisis and its aftermath, Levitin reaches a second conclusion that many policymakers have been keen to finesse: that the US mortgage market, even if private mortgage securitizations were reformed (which they have not been), is bound to remain heavily dependent on Federal guarantees. Even under generous assumptions, Levitin concludes:

Screen shot 2013-09-28 at 2.52.00 PM

The implication is that the pet dream of Republicans, to kill the GSEs, isn’t realistic unless they want to kill the housing market as it goes through a brutal transition period to more on-balance sheet bank lending. The reason is not simply securitization allowed for mortgages to be issued much more cheaply due to eliminating the cost bank equity and FDIC insurance. A bigger reason is that the 30 year fixed interest rate mortgage with an unrestricted borrower right of prepayment would never exist absent government support.

So it should be no surprise that the various mortgage insurance “reform” programs are simply to have supposedly better GSEs replace Fannie and Freddie but still wield a government guarantee (remember that the perverse structure of having private sector entities run a government guarantee program is to avoid consolidating the debt related to this mortgage insurance activity).

The private label mortgage market has barely made a contribution to housing finance post the crisis. Since 2008, there has been a grand total of 33 private label mortgage securitizations, financing a grand total of under 17,000 mortgages during this entire period versus a total of 8.6 million mortgages in 2012. And these mortgages weren’t just “jumbos,” meaning larger than “conforming” or Fannie/Freddie mortgages. They were also super duper high credit quality (click to enlarge):

Screen shot 2013-09-28 at 3.32.01 PM

“Fully documented” means that, among other things, the lender verified the borrower’s income.

And why did these mortgages need to be of such impeccable quality? Mortgages represent two types of risk: interest rate risk and credit risk. Interest rate risk is more complicated than for normal bonds, since consumer mortgages in the US have an option that works against the investor, namely, an unrestricted right of the borrower to refinance if interest rates fall. So the time when you really like being a bondholder, when interest rates have dropped but you are holding fixed income investments made when interest rates were higher, is exactly when mortgage investors take your nice high-yielding instrument away by prepaying. That produces a related unattractive feature, that you don’t know very well what the maturity of your investment will be. So investors demand, and get a premium over simple coupon bonds (such as corporate bonds) to compensate for these unattractive characteristics.

So investors can be compensated enough to get them to accept the peculiar interest rate features of mortgage-backed securities. By contrast, Levitin explains that there never was much investor willingness to take on the credit risk of consumer mortgages. Remember, private label securities are tranched to create different levels of credit risk. The AAA tranches were supposedly insulated from losses due to overcollateralization and excess spread (finance-speak for different loss cushions built into the deal) and the fact that there were other tranches sitting below them in payment priority who would take losses before them if something really bad happened.

But as we know now, that proved to be a fantasy. The AAA investors typically bought blindly, relying on the rating and the assumption that the lower-tranche investors, particularly the ones in the worst rated tranche, the BBB investors, would do the homework. A deal could not be funded unless the BBB tranche was sold, since the investment banks who were structuring and selling these securitizations didn’t want to wind up holding the bag. And indeed, for some of the life of the private label securitization market, that sort of due diligence took place. Up through 2003 or so, there was a group of “B” investors who would acquire loans tapes and analyze the deals before investing. But the pool of investors both willing to do the work and with the risk appetite constrained the size of the private label market.

But then, enter the Ponzi scheme knows as the CDO. CDOs displaced the traditional “B” investors as the buyers of BBB tranches. But CDOs were not able to sell all of their BBB tranches (even after hawking them to every stuffee around the world they could find, enticed by liberal use of expensive wine, drugs, and hookers*) to investors. So those BBB pieces were rolled into other CDOs (even first generation CDOs could contain a specified percent of low-rated CDO tranches, and some were sold into the more obviously toxic CDOs known as CDO squared and CDO cubed**).Thus Levitin concludes that the maximum size of a sustainable PLS market it is level before the CDO bid overwhelmed the market (and common sense). At its peak, it was $300 billion versus a US mortgage market whose annual financing needs ranged from $2.5 to $4 trillion and thus able to supply at most a quarter, and most likely more like one eight, of America’s housing finance demand.

Even that level of activity assumes either investor amnesia (which typically takes 10 to 20 years as new managers replace the ones that were burned) or reforms. But the sell-side (the large securities firms and the bank servicers) have fought sensible notions, like a short list of improvements put forth by the FDIC in 2010, tooth and nail. Further complicating the situation is that reform would have to address multiple aspects of how private label mortgage securitizations work. For instance: servicers need to be compensated more so that they can service delinquent loans properly (right now, it is more profitable for them to foreclose, so that’s what they do absent crude government cudgels and bribes). Trustees have simply refused to do their job of policing servicers and representing investors; they need to be held to account. And anyone who reads the business press even casually knows that rating agency reform (or approaches that reduce the importance of ratings for certain types of investors) seems much more remote than in 2009. So there is no reason to think the PLS market will return to anything dimly representing even its pre-CDO size any time soon.

The issues discussed above mean that the “let’s kill Fannie and Freddie and let private capital fill the void” is a fantasy. The issue is not whether we continue to have government backstopping of a lot of mortgage credit risk, it’s how we go about doing it (yes, it might have been better not to be in this position, but life is path-dependent, and there is no easy and low-damage way to undo a housing finance system so dependent on Federal guarantees). And as we expect to discuss in future posts, some of the supposed “private sector” replacements for Fannie and Freddie give a central role to the government-sponsored enterprises know as too big to fail banks. Sadly, the debate over an issue this important to consumers and taxpayers is almost certain to remain shrouded in deliberately misleading messaging and arcane but critically important technicalities. But why should we expect GSE reform to be any different than financial reform generally?

Update: Neglected to embed Levitin’s very readable testimony. Apologies.

Levitin Senate Banking Testimony 10-1-13

*If you think I am exaggerating, read former Goldman CDS salesman Tetsuaya Ishikawa’s “How I Caused the Credit Crisis.” Our sources have said similar things about CDO sales tools.
** We’ve come across one CDO to the fourth, sponsored not surprisingly by Magnetar, called Octonian, which is a mathematician’s joke that one might translate roughly into “end of the line”.

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  1. Yancey Ward

    It is funny how some people point to path-dependency in entirely contradictory ways depending on the topic under discussion.

  2. Tim

    So $1.5 trillion per year is buying mortgage backed securities only because they believe they are backed by the full faith and credit of the US? So if that went away where would the $1.5 trillion go? There isn’t some other form of government back securities that has $1.5 trillion net issuance per year. I think a lot more than 500 billion would stick with PLMBS, due to that reason alone.

    So I’m not sure I completely buy the whole argument, but to some lesser extent it is definitely true, the most important part being dramatically higher interest rates would be required regardless of the demand, which would kill the housing market, and severe damage the economy.

    1. Yves Smith Post author

      I’m not sure I comprehend your comment.

      1. Any PLS deal getting done depends on the tranches bearing the most risk getting sold. Those must be placed FIRST because the dealer does not want that risk.

      2. It takes a lot of work, as well as a lot of skill, to evaluate that risk. When the PLS market last had actual end investors (as opposed to the CDO Ponzi), the number of investors willing to play that role was limited in $ terms and numbes, which in turn limited the size of the PLS market

      3. The crisis exposed that a lot of the contractual protection that the savvy buyers we discussed in 2 thought were there to protect them in fact were garbage. So many of those investors will either not come back or will invest in only super-pristine deals absent major reforms that involve all the key players in the market.

      4. The sell side has been very resistant to making the reforms investors need and want.

    2. dw

      well that 1.5 trillion would go some place else. where its possible it could make money, and consider this, prior to the GSE being created, mortgages were 10 notes, that were constantly being folded over into newer notes fallowing the completion of the previous note. no business wants to have a 30 year span of risk. they didnt before the GSE were created. they wont do it if they go away either

  3. raskolnikov

    I assume the banks are smart enough to know that the days of private label are over.

    I also assume that all their bristling over the “wasteful” GSE’s is just empty rhetoric. I think what the banks want as far as “reform” is for the government to insure the lousy mortgages they issue to not-so-creditworthy borrowers. With gov backing, they feel confident that investors will buy their MBS. They’ve already gotten “safe harbor” on the lenient provisions in the Qualified Mortgage from the fumbling CFPB. All they need now, is gov backing and their back in biz!

    Wanna bet they succeed?

    1. dw

      sure. so your betting that ‘investors’ (aka suckes) have dementia, amesia and more? cause they will absolutly have to forget all that has happened since 2008 to ever go back to these ‘investments’

      1. Nathanael

        Many “investors” are demented and can’t think back longer than, say, 3 months. Unfortunately all of world history proves this.

        However, the banks have been quite consistently committing new and dramatic frauds and crimes in the mortgage world every month — and these have been in the newspapers — so investors don’t even need to think back longer than 3 months.

  4. craazyboy

    I think where we’re headed is the USG will merge Fannie, Freddie and Sallie. We’ll have a “Ménage à trois” agency which will bundle new and recycled loans, including naughty bits of “down there” CDO tranches, then securitize and sell student loan and mortgages all mixed together into an attractive and easily digestible hybrid “package”. The Fed needs something to do with Maiden Lane and preserve her marketability, so I would think they would help out here to.

    Then, to get it by fiscal conservatives, you just tell people it has an “implicit” government guarantee, then the fiscal conservatives go “wink wink” at each other, knowing that we really don’t mean that.

    1. Doug Terpstra

      “…heavily dependent on Federal guarantees”? Shouldn’t that read “almost entirely” dependent? Would there be any housing market at all without it and without the “Fed’s” $100-million-an- hour purchases of MBS? No, less than 2% as documented in the post.

      The entire housing market is based on massive Central Committee intervention — manipulation more sophisticated and diabolical than the Soviets, with barely a tattered veneer of free-market camouflage. Wall Street’s congressional puppets wouldn’t dream of reforming Fannie and Freddie; it’s laughable. Any noise to that effect is merely theater for the base, just as the budget crisis disguises the Grand Betrayal. The Criminal Reserve (“Fed”) uses GSEs as public dumpsters while it buys dubious MBS at an ungodly rate of more than 100 million dollars an hour, twenty-four-seven for years on end. It doesn’t have just a thumb on the scale but its fat ass as well and the fat asses of all its crony members. It’s not capitalism; it’s rigged-market cannibalism.

      The private “Fed” cartel has suspended regulation and enforcement, changed all Basel accounting standards, tightly restrained supply, and is inflating yet another housing bubble with free casino money and looser rules — exclusively thru cronies. The housing “recovery” is trickle-down on steroids again, another fraudulent looting operation in plain sight — by PE slumlords. And when this bubble also collapses, these serial looters will once again leave generations of taxpayers holding the bag while they yacht away with the loot to non-extradition jurisdictions. Will we let them again or jumpstart a jobs program making lampposts and ropes?

      People are being gang-raped by an amoral, criminal kleptocracy. How many times do we have to relive ‘Hedgehog’ Day before we finally comprehend this and do something? Let the revolution begin. (What is that droning sound?)

    2. Doug Terpstra

      The above comment was meant as a standalone.

      But to Craazyboy, make that an incestuous “Ménage à trois”.

  5. Rational

    So the “market for lemons” consists of the highest quality mortgages originated? What am I missing?

    1. Yves Smith Post author

      Please reread the post.

      Precisely because PLS is a market for lemons, the only deals that are getting done is a miniscule number of loans of very high quality. That is tantamount to the market being dead, proving Levitin’s point (markets for lemons collapse due to distrust of the sellers). No one wants to invest in PLS absent its many deficiencies being reformed.

  6. Lyle

    Let me put a question, assume you were in a position to invest in mortgages, would you buy a 30 year mortgage under the current terms without the guarantee. I contend you would be a fool to do so, as if interest rates and or inflation go up your going to loose money. I would need some sort of prepayment penalty to invest in them.
    This is the fundamental problem with PLS the current terms absent the government guarantee is a very bad deal for the investor.
    Further since the average mortgage lasts about 7 years, most folks don’t really take advantage of the full term. Why not an adjustable but on a 10 year term, i.e. the mortgage readjusts the rate at 10 and 20 years, with a notification 1 year in advance of the new rate. Further there could be a prepayment penalty unless you move to find a new job, i.e. really a re-fi penalty for the first couple of years after the mortgage is taken out and after the reset.

    1. Yves Smith Post author

      The problem is no one in the mortgage industrial complex (which includes realtors and homebuilders) is going to support shifting the market to mortgages of shorter maturities. There is a lot of talk, I am told, about the future of the 30 year fixed rate mortgage. However, shorter maturity = higher payments = less “affordability” = lower house prices. No one, and I mean no one, will get behind a proposal that goes in that direction.

      You might see efforts to restrict the right to refi and/or have more adjustable rate mortgages to have the investor and the consumer share the interests rate risk. I’m not sure the mortgage industrial complex will support that either. They rip a lot of fees out of refis, and an adjustable rate mortgage takes that opportunity away (as in bank interests are not aligned with investor interests when the bank isn’t planning to keep the loan on its balance sheet).

      I think ARMs are not a bad produce for consumers if you have a celling on the interest rates. To reduce the cost, the structure would likely include a floor.

      Also I don’t think anyone is adequately prepared for what happens when the Fed finally increases rates. Those 30 year fixed rate mortgages issued over the last few years will be 30 year mortgages, not the ‘normally five year duration given moving and refis”. People will be less inclined to move (they won’t be able to get a new mortgage at anything like the old rates) and you won’t see refis.

      1. Wogglebug

        Could this lead to a return of assumable mortages? As an alternative to allowing pre-payment, I mean. People could sell their house and, instead of paying off the old mortgage in full while the new owners take on a new mortgage, the new owners would just make payments on the old mortgage.

      2. Lyle

        I was looking at the issue from the point of view of the investor. If the demand stopped for for RMBS things would change fast. Ignoring the compelex, the question is how do you bamboozle the investors into buying such a product, when its clearly not in their own interest (I guess you just get good salespersons as were around beyond the boom, and assume folks trust them).

  7. JGordon

    I’m pretty upset about the government/Fed’s attempts to prop up prices. Housing must come down anyway to reflect people’s real falling incomes. People are going to have to relearn that housing is not a financial asset to speculate with, but a place to live. Better sooner than later.

    By the way, I have a low income, some savings, and I’m interested in buying a place to live myself. But there is no way in hell I’d buy anything at the insane prices houses are at today–insane despite all the empty “bank owned” properties I see around me. Good riddance to the GSEs. Deflate this bubble.

    1. Ruben Kincaide

      I agree. The problem is that when the bubble deflates the market for existing housing will virtually seize because a majority of homeowners will be under water on their mortgages.

  8. backwardsevolution

    JGordon – “Good riddance to the GSEs. Deflate this bubble.”

    Couldn’t agree more. Charles Hugh Smith said:

    “In effect, The Fed’s ZIRP and easy credit have leveraged up systemic risk and moral hazard. Moral hazard describes the difference between those who risk losing money in a speculation and those with no risk of loss. Those with very limited risk–for example, Too Big to Fail (TBTF) banks backstopped by the Fed or FHA home buyers putting down 3% cash on a home–will act quite differently from those who risk losing their all their capital if the bet goes bad.

    Put another way: if all your losses at the casino are covered by the Fed, while any winnings are yours to keep, you will gamble big and gamble often. After all, why not? The losses are shifted to someone else while you get to keep any gains.”


    Anyone who HAS money/assets, but who is not rich, would never risk like the banks (who are backed by the Fed) or the marginal buyers (who have nothing to lose). The ones who cannot afford to risk, who have worked hard and saved, are the people who are getting screwed.

  9. MyLessThanPrimeBeef

    It’s like two young people in love.

    You first try living together.

    And if it works without too much hassle, you two probably will make it permanent.

    ‘Congratulations! May it last until the next revolution do you part!’

  10. Paul Tioxon

    Federal Housing Administration Said to Take Taxpayer Subsidy

    The Federal Housing Administration will take a taxpayer subsidy for the first time in its 79-year history after efforts to improve its bottom line failed to offset losses on loans backed during the housing bubble, according to three people familiar with the matter.
    The government mortgage insurer will draw the money from the U.S. Treasury to shore up its insurance fund by Sept. 30, the end of the current fiscal year, said the people who asked not to be identified because the action hasn’t been announced.

    Federal budget officials are working to determine the exact size of the cash infusion, the people said. White House officials projected in April that the FHA would need about $1 billion. The agency, which is required to keep enough money on hand to cover all projected future losses, has authority to take the money without prior approval from Congress.
    The FHA’s need for aid could spur lawmakers to move more quickly to shrink the agency’s risk and its footprint in the mortgage market. Representative Jeb Hensarling, the Texas Republican who leads the House Financial Services Committee, urged swift passage of his bill to largely limit FHA coverage to first-time borrowers purchasing moderately priced homes.
    “Over the years, the FHA has strayed far from its original mission,” he said yesterday in an e-mailed statement. “It has become the nation’s largest subprime lender.”


    The FHA’s shortfall stems largely from loans it backed from 2007 to 2009, when it expanded its book of business as private capital evaporated. Those loans alone are projected to cost the agency $70 billion.
    FHA Commissioner Carol Galante said in April that the agency’s need for funds was driven entirely by losses from reverse mortgages. The FHA backs 90 percent of such loans, which enable homeowners age 62 or older to withdraw equity and repay it only when their homes are sold. Declining home prices have left the agency holding properties worth less than the amount borrowed.
    The FHA is mitigating losses in the reverse mortgage program with new requirements for financial assessments of potential borrowers, new limits on the amount of equity that can be withdrawn, and mandatory escrow accounts for payment of insurance and taxes on the properties.
    The agency insures $1.1 trillion worth of mortgages and backs about 15 percent of the U.S. loan originations for home purchases, almost quadruple the 4 percent share it had in 2007.”



    The Reverse Mortgage is heavily advertised as backed by the US Government by former US Senator and well recognized movie actor, the affable Fred Thompson. Taking over from just a plain old actor, the aging well Robert Wagner, you would think that giving away government backed money and not selling your house and you don’t have to make any payments is the deal of the century. Well, I guess it was, or still is or who knows? But the reverse mortgages are now being bailed out by the US Treasury because by some reports, reverse mortgage holders can’t afford taxes and insurance that go with having money mailed to you every month like an annuity. House rich, cash poor and still winding up in foreclosure over back taxes or technical defaults due to insurance lapses. A whole new area of fraud that will no doubt be greatly expanded upon as more baby boomers run out of money but still have a lot of house to offer up as collateral. With a help from the compromised appraisal industry. See Bill Black helpful explanation on corrupted and honest appraisers in he mortgage bubble in the previous post from today.

    And if you look at the date of when this government entity got involved, 2007-2009, well after things fell apart. It looks like the government got involved as private capital bailed out due to risk.

    Speaking of CDO risks, did you see this chart in the spike of CDS from Bloomberg? It looks like the chances of government defaulting on debt is causing an increase in prices of CDS! Wow, who knew?


  11. dearieme

    “the 30 year fixed interest rate mortgage with an unrestricted borrower right of prepayment would never exist absent government support.”

    Whenever I’ve pointed this out on American blogs I’ve received a shower of abuse.

    1. Lyle

      I agree I wonder if any of the folks on this board were investors would they invest in such a mortage without the government guarantee. The product gives all the down side risk to the lender, with no upside risk. (The borrower can re-fi if interest rates turn down, or keep the mortgage if they go up) So there is only downside to the lender, in terms of interest rate risk, add in the credit risk as well and the rates today are far to low to comphensate for it absent a government guarantee.

    2. Nathanael

      You should point out the history. The 30-year mortgage was introduced by FDR as part of the New Deal.

      It basically did not exist before the 1930s. Nobody was crazy enough to lend money for 30 years on a *house*. Mortgages ranged from 5 years to 20 years.

  12. Conscience of a Conservative

    Re the low level of issuance since 2008, I have a few observations.

    1) New issuance needed to compete with the very high yields available from dented 2005-2007 issued loans. No reason to buy new paper when seasoned pays more even on a risk adjusted basis

    2)The pristine Prime deals that were done last year and the year earlier were done to get the market going again and not necessarily representative

    3) With mortgages getting issued at low single digit rates, there’s just not enough spread to compensate for default and prepay risk

    4) Fed engaging in ZIRP pushing down conforming mortgage rates to sub 5% kills the private market. Fed buying TBA’s is in effect a form of price support no different than the U.S. stepping in to buy sugar from producers, keeping mortgage prices high and rates low. But the Fed does not buy mortages inelligible for conformin mortage pools.

    Just an addendum. It’s easy to point to 2005-2007 private market issuance and find problems. But the issuance of Prime mortages done in the early 90’s under such shelfs as Chase, PHMS, RFMSI, GECMS were much more conservative. The market at that time functioned more responsibly.

  13. vlade

    This is interesting. In say Australia RMBS issuance is full speed ahead. So it was in the UK until FLS (which made funding so cheap that the RMBS just didn’t make any more sense for investors). I believe there was quite a bit of Dutch RMBS issuance (which is interesting, as that market is definitely going to tank badly). And I know there’s quiet a bit of appetite between investors (even US based) for all of the above, but we’re not talking 100s of bns of issuance, more like 10s (in total, individual deals in low singe digit bns)

    That said, UK now requires, for example, a full (anonymised) details of mortgages included in the deal (to an extent so much info that I don’t really believe it can be anonymised properly). Of course, the larger question is, will the investors do their own due dilligence (to the extent it’s possible), or will they still rely on raters etc? What I’m seing is that there’s more investor DD, but still not insignificant reliance on raters.

  14. Clayton

    Yves… I have a more sophisticated response in mind, but want to start with a simple question:

    What is the precise nature of the federal guarantees provided by GMEs? Specifically, how do they differ from (and how are they superior to) insuring each mortgage individually?

    It seems to me that mortgage-level insurance would be superior in several ways:

    (1) greater transparency (either more information or a premium to cover the risk generated by less information) and
    (2) a much higher incentive to negotiate a payment plan to reduce the liability arising from foreclosure.

  15. Nathanael

    For historical reference, prior to the New Deal, mortgages were almost always 20 years or shorter, and usually 50% down.

  16. Funonymous

    This popped up in a reddit thread the other day, after reading NC and Bill Black for years at this point, it made me throw up in my mouth a little bit:

    “It wasn’t really a crime on wall street, it was more of bad political policy that had good intentions (giving loans to people with bad credit under the guise of promoting racial equality).

    There were a lot in the banking industry who knew of the impending crash, but it was no secret – even our president at the time (Bush) warned of a coming credit based financial crisis many years before it happened. He even tried to get legislation passed to control Fannie Mae/Freddie Mac (who were the source of the ‘sub-prime loans’).

    Basically, small banks were stronghanded to approve ‘sub-prime’ credit loans to minorities (ie don’t meet the quota, and we won’t approve your merger, your building license, etc). But all was good, because FannieMae/Freddie Mac would buy up the sub-prime loans.

    Then, that’s where you have the big banks buying the sub-prime loans with huge return and little cost (with seemingly zero risk because it was subsidized by the federal government) from FannieMae/Freddie Mac. The ‘crime’ might be to say that these people knew how bad shit was, but if they didn’t do it, someone else would have.

    Blaming Wall Street and the banks, is kind of like blaming the drug users, instead of the drug dealers and producers. Except the drug is legal and encouraged by the government.”

      1. Funonymous

        Oh no, I don’t believe that at all, I’m just shocked that people are still trying to sell that schema to the public, and I figured the readership here would be too. I know the whole collapse is a really complex, interconnected set of fails, scams, and short term nhilistic greed, anyone who reads Yves and Black would have some good background knowledge on that. I too thought that that racist canard was shot down so thouroughly that it was buried. I can’t believe that people still think all of the sham lending was instigated by the GSE’s, when the big 5 investment banks were hungry for any paper they could securitize and sell to pension and muni funds.

        The saddest part, there is a large subset of redditors who wil always believe you if you tell them “problem x is because of poor brown people who aren’t as smart as you fine (white, STEM educated responsible) people, well them and the governemnt.” To which they will nod sagely because they figured that was the case all along.

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