An outsider’s perspective
From Griffith REVIEW Edition 25: After the Crisis
© Copyright Griffith University & the author.
Written by Christopher Joye
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I recently parachuted into the crucible of the American policymaking debate when I was invited to present alongside Robert Shiller of Yale at a private summit for Obama administration officials on the future of housing policy. There it struck me that the world I perceived was conspicuously different to the one my American colleagues could see. In analysing why, for instance, Canada's, New Zealand's and Australia's financial systems were in such radically better shape, I began to realise that there was a fundamental frailty in the foundations of America's financial architecture. This has largely been responsible for precipitating the current crisis and propagating it around an increasingly interconnected world.
The problem is ostensibly simple: the vast bulk of American home loans are not funded using the balance sheets of large transnational banks and the regionally diversified retail deposits of their customers, but through the far more complex and sometimes unstable process of ‘securitisation'. This moves the loans off banks' balance sheets by selling them to third-party investors, so the lender can recycle the original capital into new loans. During periods of extreme uncertainty it can become an unreliable source of finance, supplied by a small number of sometimes fickle institutional investors that can withdraw from the market at a whim. In the rest of the developed world, securitisation, if it exists at all, has been a small yet important part of the housing-finance mix. In America it dominates home-loan funding.
This is the consequence of a credit-creation system that evolved from the parochial designs of competing states within the fragmented American federation, distorted further by government responses to the spate of banking failures during the Great Depression. Those failures were a product of the desire of individual states to regulate and control the banks operating within their borders.
The outcome of these decisions and the continued missteps of American policymakers ever since – including the ‘partial' privatisation of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac in 1968 and 1970 – has been the effective disintermediation of deposit-taking organisations as the primary source of housing finance in America, in favour of GSE-based securitisation.
Fannie and Freddie became a synthetic surrogate for the nationally integrated banking systems that are the cornerstones of credit creation in most other OECD countries. The artificial GSE-based securitisation infrastructure relieved pressure on American governments to consolidate a geographically fractured and prone-to-fail banking system – something that should have occurred organically over the twentieth century.
What has not been identified before is that the ineluctable result of the policymakers' decision to favour securitisation was the catastrophic crisis that first emerged in mid-2007 and was quickly transmitted around the world by increasingly integrated international capital markets. Notwithstanding the relative integrity of debt securities in other countries, lenders around the world discovered that liquidity in their local credit markets was eviscerated – with dire consequences for their economies.
When a mortgage is securitised, the lender does not hold it on the balance sheet to maturity. Many economists, including me, have noted that this process makes sense if it is managed properly, enabling lenders to alleviate balance-sheet stresses and spread some of their risks to third-party investors. These investors, such as super funds, get exposure to typically low-volatility ‘mortgage-backed securities' that yield higher-than-cash returns. The low risk and robust long-term performance of securitised home loans in Australia and Canada prior to and throughout the current credit crisis is testament to the merits of this funding medium for consumers, lenders and investors.
The Canadian government's Canada Mortgage and Housing Corporation, which guarantees mortgage-backed securities in return for a commercial-risk premium, has successfully supported continued securitisation of large volumes of Canadian home loans throughout the crisis. It requires mortgage originators to contribute a 2 per cent ‘first-loss' equity position to their securitised portfolios to align the interests of lenders and the ultimate investors.
Australia's and Canada's housing finance markets have been dominated by a small number of successful national banks whose balance sheets are the principal suppliers of mortgage credit. Australia now has four of only eleven AA-rated banks in the world. Canada, which was judged by the 2008 World Economic Forum as having the world's soundest banking system, also has four major banks with this coveted rating. Since mortgage-default rates in both countries remain extremely low – at less than 15 per cent of American levels – and there has been no real credit rationing, bank failures or nationalisations, Australia's and Canada's housing markets have also avoided large house price falls.
While securitisation in Australia and Canada has facilitated new competition and offered lenders valuable portfolio-diversification benefits, it has only ever accounted for around a fifth of all mortgage funding. Trouble arises when artificially strong incentives and subsidies predicate your entire housing-finance system on securitised forms of funding, to the detriment of the traditional deposit-taking market. In addition to stunting the growth of a nationally integrated banking sector, it exposes the financial system to potentially destabilising conflicts.
The most obvious of these is that the organisations that source new home loans, and which are responsible for assessing their credit risk, are removed from the institutions that ultimately own the assets and bear that risk. It is a classic principal-agent problem. Fannie Mae and Freddie Mac had an artificial capital-raising advantage (as investors ascribed to them the US government's AAA credit rating); they could source funds more cheaply than competitors and also enjoyed other crucial advantages such as tax exemptions and lower capital requirements. Fannie and Freddie developed exceedingly high investment-banking-like leverage ratios of 20:1 and 70:1 respectively, which rose further if all the off-balance-sheet mortgage-backed securities they guaranteed were included. Before the credit crisis they funded or guaranteed around half of all American housing finance, with total liabilities of about US$5 trillion. This compares with US$9.5 trillion of government debt at the time of their ‘conservatorship' in 2008.
In the early 2000s, Fannie and Freddie were asked by the Bush administration to increase financing for low– to moderate-income regions with high minority populations. This combined with shareholder calls to improve their returns. As a result the GSEs used their AAA ratings to invest in, or guarantee, higher-risk loans. These loans had little borrower documentation, lower credit scores and/or higher loan-to-value ratios.
By 2008, the GSEs held on balance sheet or guaranteed around $1.6 trillion of these ‘non-prime' mortgages (a third of their total exposures), which unsurprisingly accounted for 90 per cent of their losses. Fannie and Freddie were once again crowding out private lenders and shunting them further down the credit curve. The consequence was an increase in even riskier sub-prime lending, which doubled from a tenth to a fifth of all new American home loans between 2001 and 2005.