Adam J. Levitin and Susan M. Wachter write,
We argue that the bubble was, in fact, primarily a supply-side phenomenon, meaning that it was caused by excessive supply of housing finance. The supply glut was not due to monetary policy or government housing finance. The supply glut was not due to monetary policy or government affordable-housing policy, although the former did play a role in the development of the bubble. Instead, the supply glut was the result of a fundamental shift in the structure of the mortgage-finance market from regulated to unregulated securitization.
Pointer from Reihan Salam.
The implication is that if government regulates securitization, things will be fine. Some problems I have with this analysis:
1. They do not examine how the market for “unregulated” securitization was in fact bolstered by capital market regulations. Take away the regulatory advantage for AAA-rated and AA-rated securities, and I do not think that the securitization market is able to take off. Remember that capital requirements for banks were so perverse that holding a tranche in a pool backed by sub-prime mortgages required more less capital than originating and holding a low-risk mortgage.
2. The “regulated” sector, namely Freddie and Fannie, lowered its standards at exactly the wrong time, in 2005 through 2007. Several private players, including AIG, either exited the market or tightened standards before the bubble burst.
3. The problem with private securities is not that they lack standardization. It is that the whole securitization model is flawed. It introduces more costs than benefits into the mortgage finance system. That fact has been obscured by all of the support that government has given to securitization, including the “too big to fail” status of Freddie and Fannie and the perverse capital requirements noted in (1) above.
Surely you mean “less” instead of “more” at the end of para 1?
IIRC, not only banks were seeking the AAA and AA rated securities with higher return than gov’t debt of similar indicated risk, but many (if not all; I don’t recall exactly) money market funds were federally restricted under to securities of high ratings levels, as bestowed by the “nationally recognized statistical rating organizations” (NRSROs), that is, federally-approved ratings firms. ‘Twas a [federally regulated] house of cards.
Question – Perhaps someone can explain what the nature of the failure was with securitization. A certain percentage of failures would occur. Tranches had been created to separate the risk of a defined range of failures.
So what happened? Were the failure rates so astoundingly high that the top tranches failed anyway? Or, was the problem that securitization worked for the top tranches, but left behind bottom tranches that were toxic, unsaleable, and piled up on balance sheets?
a lot of tranches that were considered unlikely to fail nonetheless failed. What happened was a combination of a worse house price scenario than what was contemplated and a higher proportion of defaults given the house-price scenario because of adverse loan characteristics. For example, a lot of loans that supposedly went to owner-occupants were in fact for speculators.
“For example, a lot of loans that supposedly went to owner-occupants were in fact for speculators.”
And this happened because…..there was too MUCH regulation in the origination??? Just wondering.
Another consideration for investors seeking AAA and AA investments is that there were multiple levels of tranches built off the original MBSs.. See here & scroll down to the large image that’s titled “The Theory of How….”: http://en.wikipedia.org/wiki/Collateralized_debt_obligation
From what I recall from Gretchen Morgenstern’s book Reckless Endangerment and Lewis’s The Big Short, the AAA and AA MBSs were securities built of mortgages with layers based on various types of risk: that we all know. And those MBSs were then subsequently sliced and diced into “offspring” types of securities called CDOs (collateralized debt obligations) that were also sold separately to investors. But, and this is a key point, those CDOs retained the AAA and AA ratings of the “parent” MBSs. They were not re-rated, notwithstanding that their composition may have looked nothing like the original. And there could be even more subsequent “offspring” CDOs sliced and diced on down the line, finer and finer. But they all kept the AAA and AA ratings, regardless of the mortgages that they actually contained.
(I think that’s how it went — but it’s very possible that I’ve gotten some of that wrong.)
As Lewis shows us, those investors who figured out what was going on (Michael Burry for one, Lewis’s main cool character) took a look inside the MBSs and CDOs and didn’t like what was there relative to the developing real estate market environment, and bet on their failure.
Readers, please correct me if/where I went off the rails with my recollections and/or understanding.
I don’t recall whether CDO’s that patched together tranches from different MBS’s automatically kept the same rating as the underlying securities or not. Either way, the ratings agencies were compromised and the ratings assigned to many different stripes of securitized debt couldn’t be trusted. In “All the Devils Are Here,” the authors pointed out several instances where people within Moody’s/S&P were fired or disciplined for questioning whether certain classes of securities really deserved AAA blessings.
Just as important, I think, was that when you start to get into CDO’s of CDO’s of CDO’s, figuring out what you’re actually buying and what you’re likely to collect in principal/interest and then putting a price on it is so convoluted a process that the ratings become virtually meaningless, whatever they happen to be. There are too many moving parts and too many estimates piled on estimates.
Of course, from the issuers’ perspective, that’s a feature, not a bug. The opacity creates an information asymmetry, which translates as ‘profit opportunity.’ You just need to find yourself some ‘dumb money,’ as they say, and that was seemingly no difficult task 6-8 years ago.
What this article fails to mention was the rating agencies were being threatened and those agencies therefore delivered the triple A rating for worthless garbage. Again, because there was too darn much regulation.
Karen,
There wasn’t too much regulation. There was “gamed” regulation or inappropriate regulation. There was neither too much or too little in the way or regulation. What there was is bad regulation.
There is an Econtalk from back in 2009 with Charles Calomiris that I have found very interesting. Calomiris lists all kinds of regulations. Making claims that some was bad and some even good. What I have taken away from that is a list of causes or impediments to good outcomes that I have assigned my own weights to. My weights are much different than I suspect Calomiris would assign.
My last comment was sarcastic.
Interesting that a pair of lawyers single out the U.S. housing finance system as an industry “rife with information asymmetries”, which the “agents” (banks, et.al.) exploited through their fees.
I guess the legal industry/profession isn’t “rife with information asymmetry” and lawyers therefore can’t exploit it.
Isn’t it the delta that caused the problem, i.e. the change from more regulated to less regulated? After the adjustment new regulation is likely to cause some other problem.