The Unintended Consequences of Regulation and Subsidies
My apologies for the length of this piece, but this is a complex topic and I’ve had a lot of coffee!
In our investment practice, we use tactical asset allocation to vary the mix of assets in a portfolio in response to changing prices, economic and business conditions. We believe this will both reduce the investment rollercoaster ride and provide opportunities for better returns over time. We believe that valuation matters most, so we first determine whether an asset class is currently cheap, expensive or fairly priced. If you pay too much for an investment, all the time in the world won’t fix it, contrary to many popular how-to investment books. We also believe that we cannot forecast the future, but we can make judgments on whether the macro economic conditions are favorable or unfavorable for a particular asset class and adjust our portfolios accordingly.
Any discussion of investments invariable leads to the broader economy. Any discussion about the economy invariably leads to politics, as governments have significant influence over the global and domestic economy. Two of the most impactful tools governments use to impact the economy are regulations and subsidies.
Subsidies distort markets in that they artificially increase demand. This artificial boost in demand raises prices and pushes the market to allocate more resources, (workers, money, equipment, land etc.) into the subsidized industry than it otherwise would have. When the subsidy invariably ends, those mis-allocated resources have to go elsewhere, but the shift can take considerable time and be very painful. In the recent housing crisis, the subsidies discussed later in this piece added a lot of workers to the payrolls of construction firms and induced investments that would have otherwise gone elsewhere. When it all came crashing down, as it always does, those workers had to find jobs in other industries and investments were lost.
Regulations distort incentives. Regulations are typically implemented to keep a nation’s citizens safer than is believed they would be under free markets. This theoretical protection can range from hazardous products to foreign competition or financial irresponsibility. Without regulations, companies will behave according to their individual views on the opportunities and risks in the marketplace. Their views and corresponding actions may be contrary to what a regulator or regulation deems appropriate. However, the unfettered behavior in the free markets, which some may argue is more risky, does tends to create a diversified set of positions, which helps prevent industry-wide failure. All participants don’t put all their eggs in the same basket as companies tend to follow different tactics to gain a competitive edge. Regulations are intended to force companies to all behave in a similar manner with respect to the regulated area, so now everyone has their eggs in the same basket. Thus the industry as a whole may be more vulnerable to systemic changes that are not anticipated by the regulation.
Regulations played a significant, although not widely discussed role in the recent financial crisis. We watch for these distortions in the market place, among others, and adjust our clients’ portfolios accordingly to both protect from and take advantage of the “bubbles” they can cause.
The recent financial crisis was impacted in a large part by a series of well meaning regulations and subsidies designed to make home ownership more widespread and banks stronger. When piled on top of each other, the combination created a whopper of unintended consequences. In order to keep this piece as short as possible, I am only discussing what I believe to be the primary regulations and subsidies involved in the recent financial crisis. Any omission is in the interest of brevity. There are other factors involved in the recent crisis, but the ones discussed here are noteworthy and I believe have been overlooked by many.
By subsidizing housing with low cost loans, low down payments, and increased access for sub-prime borrowers, good intentions pushed housing prices into the stratosphere.
Increasing home ownership for low income earners has long been a mission for the Federal Housing Authority. This sounds like a fantastic goal as what politician would say they don’t want families to own their homes? The problem is that by subsidizing something, you increase the demand for it by effectively lowering the purchase price. Increase demand and prices go up! The Federal Housing Authority (FHA) insured around one million no-down payment mortgages in each fiscal year from 1998 to 2001 (England 2002, 73).
Traditionally non-FHA mortgages required a minimum of 20% down, but in 1994, the Department of Housing and Urban Development (HUD) ordered Fannie Mae and Freddie Mac to supplement and eventually to far surpass the FHA’s efforts, by directing 30% of their mortgages to low-income borrowers, which lead Fannie Mae to introduce 3% down mortgages in 1997. In 2000, HUD increased the Fannie Mae and Freddie Mac low-income target to 50% of all loans! (Schwartz 2009). In 2005, HUD increased the target again to 52%.
In 2000, Fannie launched a “ten-year, $2 trillion ‘American Dream Commitment’ to increase home ownership rates among those who previously had been unable to own homes.” (Bergsman 2004).
In 2002 Freddie Mac joined with the “Catch the Dream” program combining “aggressive consumer outreach, education, and new technologies with innovative mortgage products to meet the growing diversity of home buying needs.” (Schwartz 2009)
All these subsidies increased the supply of mortgages to low income homeowners, but what was the source of the money to fund these loans? Welcome to the Mortgage Backed Security. Banks would pool together mortgages that could then be sold as a mortgage backed security (MBS). By doing this, banks could sell off the loans they’d given to homeowners and get more cash for the next set of loans.
In 1997 Bear Stearns completed the first private securitization of subprime loans that had been pulled together by First Union Capital Markets. Normally a bond, including an MBS, needs to be rated so that investors know how secure the bond is likely to be from default. This issuance was unrated, but since the mortgages in the pool were guaranteed by Freddie Mac, they produced an” implied AAA rating,” according to a news release from First Union. So here we have sub-prime loans, meaning loans with a higher likelihood of default, receiving AAA ratings because they are backed by GSEs (Government Sponsored Enterprise). A collection of subprime loans magically became low-risk because of the GSE backing. Now that is some powerful fairy dust!
So now we have created a way to turn a pool of sub-prime mortgages into AAA rated bonds. But why was there such incredible demand for these bonds? For this we have to look at the Basel Accords and the ratings agencies.
In 1975 the Securities and Exchange Commission effectively conferred the three rating agencies that were then in place, (Moody’s, Fitch and Standard and Poor’s) oligopoly status by ensured that only these three firms were Nationally Recognized Statistical Rating Organizations (NRSROs) and that only an NRSRO’s ratings would fulfill a given regulatory mandate for investment-grade and AAA ratings. Thus the success of these entities was no longer based upon the quality of their ratings, but rather the government’s protection. Without government protection, a rating agency who published inaccurate ratings would suffer financially and potentially go out of business entirely. Thus there was no competition among ratings agencies that could highlight potential weaknesses in their methods of the various agencies. The 1975 ruling effectively prohibits anyone else from competing with the 3 ratings agencies for the institutional investors’ mandatory business.
We now know that these bonds should not have been receiving such high ratings. Why did they? The NRSROs all used models based on historical default data. Clearly this data was relatively useless for the mortgage environment in the recent decade. Never before in our nation’s history had government done so much to subsidize housing and never before had so many loans been given out with low or no down payment. Without skin in the game, a homeowner is much more likely to walk away from a home that is no longer worth the debt on it! A low or no money down mortgage effectively makes the home “owner” a renter from the bank, and can just walk away if the “rent” to home value becomes less attractive, especially in the non-recourse states.
Plenty of employees at the three ratings agencies criticized their firms’ models for risk assessment of the GSE guaranteed MBS. If the government protection of the three NRSROs didn’t exist, these employees could have started competing firms and brought to light the errors they perceived in their former employers’ models. With this protection, no competitor could take advantage of the three agencies’ mistakes and bring differing opinions to the market.
So why was so much of the MBS risk concentrated in the banks? The Basel Accords.
The 1988 Basel Accord required an adequately capitalized commercial bank to maintain at least 8% capital against its assets in reserve. Reserve requirements have been around for quite a while, but Basel changed the required capital to reflect differences in risk among different types of assets owned by the banks. Thus an asset deemed to have zero risk of default, such as a US government bond, required no reserve capital. Commercial loans were given 100% risk weighting, thus required the full 8% capital. Mortgages in general were given 50% risk, thus for a $100 mortgage, the bank was required to keep $100 * 8% * 50% = $4 in reserves.
Then the magic of AAA rated GSE backed bonds emerged and since Basel assigned a risk rating of only 20% to any issuance by a GSE, which includes Fannie Mae, Freddie Mac, for a $100 AAA rated GSE backed bond, a bank would only have to hold in reserves $100 * 8% * 20% = $1.60.
Here’s the insanity. A bank issues a mortgage for $100, which would require it to hold $4 in reserves. If it then sells that mortgage to Fannie or Freddie, then buys it back in the form of a GSE backed MBS, it would only have to hold $1.60. This reduction is required capital reserves, which increases the bank’s leverage – its borrowing and lending power, and thus increases its potential profitability by a whopping 60%, simply by round-tripping mortgages!
These regulations explain why commercial banks found it so profitable to originate sub-prime mortgages, sell them off to Fannie and Freddie for securitization and buy them back as MBS. If Fannie and Freddie weren’t there to buy them OR if the Basel Accords didn’t give a discount for a GSE backed securities, things might have played out very differently, despite the Fed’s artificially low interest rates. It is interesting to note that five days before declaring bankruptcy, Lehman Brothers held a “Tier 1” capital ratio of 11%, almost three times its effective minimum requirement.
Private securitizers such as Bear Sterns, (as opposed to a bank like Wells Fargo) also became heavily involved in subprime securitization in 2002, because 10 years after the 1991 implementation of Basel I, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision adopted the “Recourse Rule,” which added to Basel I’s assignment of 20% for GSE-issued securities the same risk weight for privately issued asset-backed securities, include MBS that had received a AA or AAA rating from an NRSRO.
Starting at the end of 2006, Basel II adopted a similar rule for the entire developed rule, thus banks anywhere in the world could dramatically reduce their reserve requirements by purchasing GSE issued or AA or AAA asset-backed securities.
So much for the financial crisis being a failure to regulate, unless by that we mean a failure FROM the regulations in place.
Lastly, was it bankers’ greed?
It is a popular notion these days to blame the crisis on those evil bankers. Problem with that assessment is if all this was driven by bankers’ insatiable greed, they would have purchased primarily AA ratings. These provided exactly the same reserve benefits, but produced a higher yield: same benefit, bigger profits. But they didn’t do that. Of the $1.323 trillion in MBS held by banks and thrifts in 2008, 93% were either AAA rated or issued by a GSE. (Acharaya and Schnabl 2009) Then to get even more safety, the bankers bought additional insurance against these securities in the form of credit default swaps (CDS), again sacrificing profit for security. There were a good many mistakes made by the banks during the past decade, as in the case of any business, and not all of the banks took the same level of risk, but blaming it all on those greedy bankers is too simplistic.
So what does all this matter to an investor?
As we analyze the markets, we keep in mind the impact regulations and subsidies can have on the economy and are incessantly skeptical when we see bubbles form so that we can both protect and take advantage of the distortions they create.
- Acharya, Viral V., and Philipp Shnabl. 2009. “How Banks Played the Leverage Game.” In Acharya and Richardson 2009b.
- Bergsman, Steve. 2004. “Closing the Gap.” Mortgage Banking (February): 52-29
- England, Robert Stowe. 2002. “Giving it 100 Percent.” Mortgage Banking (February): 68-76.
- Friedman, Jeffrey. 2009. “A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure.” Critical Review Volume 21: 127-183.
- Schwartz, Anna J. 2009. “Origins of the Financial Market Crisis of 2008.” Cato Journal 29(1): 19-23.