The Subprime Solution

I just picked up Robert Shiller's Subprime Solution. It is a quick read and I highly recommend it. Despite its title, I am not sure the book presents a perfect prescription for policymakers today. Shiller obviously wrote the book before the fatal issues with the GSE's, AIG and I-banks emerged. His main proposal is to re-establish the Home Owner's Loan Corporation to buy up distressed assets...an idea that has been tossed around for at least a year. But there is a lot to like about this book.

First, Shiller provides a nice background on the run up in house prices. In general research has been focused on asset bubbles for quite some time. He wrote Irrational Exuberance on the tech stock bubble (also a recommended read). Subprime Solution echoes many of the ideas of that book - that markets and economists tend to forget that psychology matters. People get caught up in a frenzy and start to believe prices can only go up (or if prices go down, it won't happen all at once or as much as what can and does happen). It is a compelling and easy to read description of the evidence. Too often we read the popular press blame the foreclosure crisis on the Fed keeping interest rates low, or, my personal favorite, Community Reinvestment Act lending (never mind almost all subprime lenders were not covered by CRA). He offers a simple explanation of a speculative bubble that fueled homeowners, bankers, Wall Street, ratings agencies and even policymakers. I think this is mostly right and not well understood.

Second, Shiller offers a wide ranging set of longer-term priorities. While this section reads as a bit of a grab bag, there are some great nuggets here. What I am most struck by is his emphasis on consumers. He discusses improvements to the 'information infrastructure' which will help prevent future problems. Number one is "comprehensive financial advice," especially for lower-income consumers. This might include subsidized fee-only financial planning (an idea EARN is working on in San Francisco, along with a handful of other nonprofits in other areas) or even new technologies. He also talks about using learnings from behavioral finance, such as relying more on default options in mortgage product promotion, and continuously adjustable mortgage contracts which in effect modify themselves as housing or economic conditions change over time. He also provides a critique of too low FDIC and SPIC deposit insurance coverage. All in all a nice collection of ideas.

Shiller concludes by plugging ideas he has worked on for a decade or more, including home equity insurance (he even notes his experiment in Syracuse NY run with Neighborhood Reinvestment Corporation) and options markets consumers can use to hedge drops in real estate prices.

Shiller's general theme in Subprime Solution is the Great Depression spurred the creation of bold social experiments - many of which still exist and play a vital role in the economy - like FHA and FDIC deposit insurance. He thinks today's crisis should result in a similar response. Time will tell if he is correct, but kudos for writing such a timely and accessible summary of policy options today, and for keeping consumer behavior at the center of the debate.

A New Structure for Financial Insitutions, and Regulators?

Today we hear news many old line investment banks are reorganizing as commercial banks or bank holding companies. No long ago (like a year) commercial banks were considered too old school for modern capital markets. Now being regulated as a bank means ready access to the historically little-used Federal Reserve's cash drawer. Given the sense among investors that investment banks lack liquidity or ready access to capital, just having the option to tap the Fed's money may be viewed as a plus.

This just highlights our fractured regulatory system. In 1999 decades old restrictions on blending banking, insurance and investing functions were repealed. Yet the regulatory system remained a mix of mortgage lending compliance, capital ratios for depositories, lighter oversight of some holding companies and then the SEC for Wall Street. It seems the market might actually appreciate one set of rules which serve to reduce overall financial institution risk taking and also make information more transparent across firms. Commonly applied asset ratios means the former investment bank will need to have more cash and liquid assets and will not longer be able to place huge bets by borrowing or swapping liabilities.

During the S&L crisis of the 1980s (which rolled into the 1990s) there were some changes in the structure and functions of the bank regulators --to review this includes: the OTS (part of Treasury focused on thrifts or S&Ls), OCC ('national' banks), FDIC (state chartered but also broader functions related to deposit insurance), the Fed or 'FRB' (holding companies and commercial banks), HUD (a grab bag of institions doing mortgage lending including many former subprime institutions) and NCUA (credit unions).

In the last year the Federal Reserve has been clarified as the super-regulator. In general the regulatory agencies seem to be getting along (except maybe the SEC ). But as policymakers mull their chocies this week it is time to re-examine a more modern system of regulation with one agency outside of the executive branch to work with Treasury as needed.

In the process the community/public/consumer affairs function hopefully can be strenthened. Likewise the commitment to fair lending and community reinvestment can be affirmed. The UK's Financial Services Authority used to be a model to look towards, but the breakdown related to Northern Rock last year might suggest even the FSA model did not go far enough (the FSA lacked the Fed's market mechanism--that stayed with central bank).

In the 1990s financial instututions would shop around altering their charter or aquisitions to find a regulatory agency they felt best met their needs. In hindsight a standardize higher regulatory bar would have been a better approach. One could imagine the FDIC as the insurance agency, as well as expert in taking over failing banks. The FDIC could assess safety and soundness risk and be ready to jump in when firm-level instability looked immenient. The Fed could then take the OCC, OTS and NCUA under its wing, taking on safety and soundness as well as consumer affairs and fair lending.

Most likely there will be resistence to changes and agencies won't willingly give up power. With mega-bank instutitions like Bank of America, Citi, JPMorgan/Chase, and now Goldman and Morgan Stanley under the Fed's purview, the odds are more in favor of the Fed being the achitect of the regulatory structure going forward. Regardless, let's hope the new structure includes a robust consumer perspective in addition to making investors feel more secure about putting money into institutions.

Fannie and Freddie: Implications for Consumer Policy?

The news from Wall Street just keeps coming. I have been drafting thoughts on current events and then constantly revising them as more information comes out. It looks like AIG will have access to an infusion of public capital, but at a cost to shareholders and management, much like Fannie Mae and Freddie Mac. But the issues are very different.

Fannie and Freddie - the government sponsored enterprises (GSEs) - were created as a public-private enterprises. They have historically played a key role in buying whole mortgages from banks, allowing banks to make more mortgage loans. This secondary market function was an innovation and has helped the banking system overall.

The public part of the GSE mission has been widely debated for years. Investors always believed there was an implicit government backing for Fannie and Freddie. Investors behaved like GSE securities were 'almost' like Treasury securities. This gave the GSEs access to lower cost capital and ultimately allowed for lower interest rates on mortgages. How much lower? There have been several studies. The most objective study (arguably) is from the Fed (in the Alan Greenspan era) and suggests about 25 basis points lower interest rates on conforming mortgages. That is one-quarter of 1 percentage point of interest. Not that much for a consumer to notice, really, but it is something from the view of capital markets.

The other function of the GSEs that is less discussed is as a 'backstop' in the capital markets for mortgages available to the middle class. A few years ago many argued banks had direct access to Wall Street and the GSE function was outdated. But as we have just seen, investor capital moves globally in seconds. As confidence in mortgages and financial institutions weakens, investors pull out rapidly. For some lenders there would be no more capital to make another mortgage loan without access to a stablized secondary market. A consumer who is in need of cash to pay for an unexpected expense might not be able to take out a home equity loan. Someone moving might not be able to sell their home because no cash buyers exist. It gets ugly fast.

There has been widespread criticism of how the GSEs have been treated. This summer's announcement that Treasury has the power to take over the GSEs, but no one at Treasury thought they would need to use it had a destabilizing effect. Investors were not comfortable with being in limbo- "maybe the government will take over and maybe that means shareholders are wiped out." In a market with extremely low tolerance for uncertainty, investors ran from Fannie and Freddie. As these firms had losses on the lending side they needed capital, but no investor was willing to go there. In the end Treasury had no choice. Fannie and Freddie shares still exist, but are worth just pennies.

So now what? With all the news about Lehman and AIG, we have not heard much on Fannie and Freddie the last few days. Key staff are heading for the exits, and that is troubling. But the GSE market function is still working. Mortgage rates are somewhat stable. Local lenders can still operate.

How will the GSEs look in the future? We don't know how Treasury will proceed. The clean-up alone will take a while. One view is to spilt them up into 5-6 smaller secondary market firms to buy loans. The Federal Home Loan Banks played a bit of this game a few years back. It is not clear more smaller firms helps overall, and there will always be returns to scale such that consolidation could make economic sense. Firms could specialize by type of loan or region, but that presents problems in terms of concentrated risk.

Regardless of the institutional structure, the public-private GSE structure needs review. The government guarantee needs to be priced and made into legal contracts. The affordable housing function of the GSEs should continue at least as long as the GSEs have some federal support and probably longer. If banks are required to make lending balance deposits under the Community Reinvestment Act, then there must be a vibrant secondary market to support this function. It is hard to imagine a completely private mortgage secondary market. In fact the 3rd GSE - Ginnie Mae - is essentially a department of HUD and facilitates the secondary market for mortgages insured by FHA/VA mortgage insurance. This is going to be complex to sort out.

Unfortunatelty election year politics are caught up in all of this. Most policymakers don't have a full understanding of the issues involved. Career staff at Treasury and HUD, as well as the Fed, will have their hands full for quite some time. Consumer advocates need to be as well informed as possible and make sure lending markets are stable and capital keeps flowing especially for the market segments least well served by the financial market--working families in older urban areas and rural markets--as well as immigrants and minorities with no connections to the financial sector. These consumers are going to continue to be first-time homebuyers, especially as home prices come back down to more affordable levels.

A recent survey I helped run in California and Illinois shows moderate income renters are as interested in buying a home as ever. They see prices coming down and want to own a home. But they also see the risks, and want to be well-educated how to buy a home and find a mortgage loan (in fact they tend to substantially over-estimate the risks of foreclosure--we'll save that for another post). The majority have doubts any lender will offer them a loan. Reading the current press and watching the media, no wonder.