An outsider’s perspective

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.


A RECENT OECD study on the causes of the global financial crisis argued that these effects were exacerbated by at least two other factors: the Basel II Accord on international bank regulation, which encouraged banks to accelerate their off-balance-sheet mortgage securitisation; and changes in US Securities and Exchange Commission regulations that allowed investment banks to increase their debt to net-equity ratios from 15:1 to as much as 40:1. In the OECD's opinion, the result was that banks started creating their own ‘Fannie and Freddie lookalikes'– so-called ‘structured-investment vehicles'.

Yet in almost all other countries where quasi-government entities do not dominate housing finance, traditional banks account for up to 90 per cent of all mortgage credit, with the vast majority of these assets permanently retained on the lenders' balance sheets. When lenders in these countries do securitise, they usually apply the same credit-assessment standards to these loans that they use with the assets retained on their balance sheets. In most western economies banks control the upfront credit-assessment process, service the underlying assets over decades, and bear the risk if borrowers default. In the US, all three critical functions – origination, servicing and funding – are separated by a ‘fire and forget' approach. Without mitigating regulation this leads to inevitable conflicts of interest.

Britain's problems during the crisis can also be traced back to the vulnerabilities that materialise when securitisation starts to displace the traditional hold-to-maturity banking sector. Northern Rock, which had a 10 per cent share of the British housing-finance market, drew three-quarters of its home loan funding from off-balance-sheet sources. The sudden explosion in global risk aversion in mid-2007 as a consequence of the US sub-prime calamity propagated an indiscriminate rise in illiquidity for all debt securities, especially anything resembling a mortgage. As a result, private mortgage-securitisation markets collapsed in the latter half of 2007, with adverse ramifications for institutions that relied on them.

The emergence in Britain of a bank that predicated three-quarters of its funding on external or ‘wholesale' sources of finance (as opposed to retail deposits) created a channel through which unanticipated international shocks could be transmitted. And so the initially independent American sub-prime virus precipitated the first run on a British bank since 1866; the government was forced to nationalise Northern Rock in February 2008.


HOW DID THE world's largest and purportedly most advanced economy end up with such an inherently risky credit-creation system? America's banking industry is far more fragmented that any other, with only one truly coast-to-coast institution: Bank of America. There are over 8,400 banks and savings entities, half with less than US$100 million in assets, which are highly localised in their lending and deposit-taking activities. This disposes America's banks to an astounding propensity for failure. Between 1984 and 2003, a total of 2,698 US banks and savings institutions failed according to the Federal Deposit and Insurance Corporation.

The American government's panoply of interventions in response to the problem of persistent bank failures and the collapse of its financing system during the Great Depression has, ironically, further hindered the need for consolidation of its dispersed deposit-taking system, which was the underlying cause of these failures in the first place.

The extraordinary degree of direct government involvement in America's housing and financing systems is hard for an outsider to fathom. In addition to the GSEs, the American government created the Federal Housing Administration in 1934, the largest public mortgage insurer in the world to insure the losses of private lenders to non-prime borrowers. Its market share of new mortgages in insures has risen from just 4 per cent in 2006 to nearly a fifth in 2008, with analysts predicting that it will hit a third this year.

When I described the Australian market's characteristics to the policymakers at the housing summit, their jaws hit the floor. Without any government interventions Australia has generated a higher rate of home ownership, no sub-prime lending to speak of, no bank failures, nationalisations or mortgage-credit rationing, and current and long-term mortgage-default rates that are 15 per cent of American levels.

The audience was surprised that 80 per cent of all Australian borrowers are on ‘adjustable rate' home loans (viewed as devil's breath in the US), that those using fixed-rate loans only fix for one to five years, and that mortgage rates are based on the central bank's ‘target cash rate'. In the US, around three-quarters of all borrowers have thirty-year fixed-rate mortgages, over which the Federal Reserve has limited control. While a thirty-year fixed-rate mortgage sounds wonderful from an affordability perspective – as it did to policymakers during the Great Depression – it has undermined the ability of the Fed to manage economic activity and the housing market in particular.

Between August 2007 and December 2008, the Federal Reserve slashed its target rate by 500 basis points. Yet the average interest rate on outstanding US home loans fell by only 15 basis points. It has been no surprise, therefore, to see default rates continue to rise. In comparison, Australia's central bank has been able to deliver a 40 per cent drop in the cost of variable-rate home loans, with 375 of 400 basis points in rate cuts passed on by lenders.

The clear point of difference between Australia and the US is government policy. While both countries are federations, America is disadvantaged by its decentralisation across fifty states. The US also has a longstanding cultural antipathy towards nationally consolidated and regulated banks. Thomas Jefferson declared: ‘Banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake up homeless on the continent their fathers conquered.'

Following a bout of bank failures in 1907, Congress established the Federal Reserve in 1913 to facilitate liquidity between banks and prevent these crises recurring. Yet up until the early 1990s, laws prohibited banks from setting up branches in other states or from merging. According to the economist Charles Calomiris, ‘economic logic often took a back seat to special-interest politics and, occasionally, to populist passions.'

The Federal Reserve was unable to minimise bank failures because of a bizarre patchwork of inadequate and sometimes conflicting regulators. MIT's David A Singer has observed, ‘The US has one of the most institutionally frag-mented...regulatory environments of any industrialised country...Banks face an alphabet soup of regulators, including the Fed, the OCC, OTS, FDIC, the National Credit Union Administration, and separate state regulators, while the SEC, the Commodity Futures Trading Commission and other regulators monitor the capital markets. Most surprisingly, the US does not have a federal insurance regulator; instead, fifty separate state regulators govern insurance firms within their jurisdictions.' In Australia there is one banking and insurance regulator: the Australian Prudential Regulation Authority.

Congress finally agreed to repeal most of the prohibitions on interstate banking in 1994 – yet by then the damage had been done. Despite some subsequent consolidation in the deposit-taking sector, the exceedingly fractured US savings system has been set in stone.


The first-order cause of the global financial crisis was not the advent of sub-prime lending, the Basel II Accord, greedy investment banks, non-recourse lending, community reinvestment acts, or the GSEs per se (although all contributed as catalysts). The underlying driver was over a century of flawed political decision-making that created a deeply dysfunctional and structurally fragile system of housing finance under which bank balance sheets, and a nationally integrated deposit-taking infrastructure, had been displaced.

The government-created yet ostensibly private GSE duopoly, which acted as a surrogate for a national deposit-taking system, stunted the need for the geographically dispersed and intrinsically fragile US banking industry to consolidate and insulate itself from failure. These structural flaws were exacerbated when the highly leveraged GSEs entered the much riskier non-prime segments of the US mortgage market. The traditional private lending sector was pushed further down the credit curve with a consequent explosion in sub-prime loans.

The introduction of the Basel II Accord that encouraged off-balance-sheet securitisation activity only lent additional momentum to these dynamics. As default rates inevitably rose and the system of securitisation instantaneously transmitted these risks to investors around the world, the dark side of capital-market integration and globalisation emerged. Defective mark-to-market accounting standards, premised as they were on the belief that ‘efficient markets' always priced assets accurately (but rarely during times of crisis), entrenched a vicious negative-feedback loop as artificial declines in collateral values forced banks and investors all around the world to pull back on lending, triggering further reductions in asset values, and yet another contraction in lending, and so on.

Many of the so-called ‘toxic' assets were not toxic at all: the market failures triggered by the implosion in America's housing finance system precipitated illiquidity for all forms of credit internationally, which then embedded the deleveraging death-spiral that decimated asset values, parts of the international banking system and, recently, real economic growth.

Today, the private lending market in America has all but disappeared. The GSEs and FHA account for 95 per cent of housing finance. The remnants of private banking are being stealthily nationalised by a questionable process of private risk socialisation; the American government is now the largest individual shareholder in Citigroup and Bank of America.


IT IS WORRYING that American policymakers continue to apply prescriptions that do absolutely nothing to address these dysfunctions. Stakeholders from Paul Krugman to Timothy Geithner appear to be in a state of denial – Krugman had the temerity to blame the crisis on Asia and its ‘excess savings', while Geithner and the Obama administration appear desperate to bail out bankers, without any real reforms. As taxpayers are forced to internalise private risks and the role of the GSEs is repeatedly reaffirmed, the perverse moral-hazard incentives – we'll take the upside of billions of dollars worth of bonuses but only bear limited downside when we're caught short – are being re-infused into the institutional DNA.

If America is to have any hope of cauterising these problems, and preventing similar cataclysms, the administration and key thought-leaders must acknowledge the structural flaws that caused them. Applying bandages myopically in a desperate bid to avoid a cathartic recession without concomitant reforms is not the long-term answer. In fact, the administration's policies increase the likelihood of the same issues reoccurring  – on another president's watch.

America's credit-creation system must be transformed to a hold-to-maturity, balance-sheet-based focus. At some point, the GSEs should be fully nationalised and, alongside other public housing-finance agencies, phased out of the day-to-day housing-finance infrastructure. Governments have a role to play supplying the public goods of liquidity and price discovery when markets fail – but only when markets fail.

In the medium to long term, the administration needs to create something that has been beyond governments since the Founding Fathers: a robust and nationally integrated private banking infrastructure, underwritten principally through retail deposits, to firmly reposition balance sheets as the main repository of credit. To achieve this, the administration must establish singular banking and insurance regulators, rather than a kaleidoscope of agencies, and remove all legal and regulatory obstacles to enable the private banking system to expand and eventually supplant the GSEs and the unnatural activities they spawned.

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