A Defense of Asset Securitization from Bedford Falls
posted by Nate Oman
Over the last couple of weeks, the reputation of MBSs and CDOs have taken a drubbing, with folks insisting that they are little more than instruments of irresponsible speculation at best and fraud at worst. To which I say, “Nonsense!” To understand why, consider this clip from “It’s a Wonderful Life!,” which I used in my Article 9 class last week as a starting point for discussing the financial crisis.
Why was the Bedford Falls S&L failing? We learn that the Bank had called their loan and the crazy uncle, in a moment of panic, shut the doors because there simply wasn’t any cash on hand to pay depositors. Depositors, in turn, took the shut doors as a signal of imminent collapse and began clamoring at the gates for their deposits. George Bailey, in turn, puts up his honeymoon nest egg, and doles out dribs and drabs of cash to the good people of Bedford Falls, just enough to keep the doors of the Savings and Loan open through the day and thus put to rest the panic. I love this scene. Jimmy Stewart does a marvelous performance as heroic Everyman, and the vision that the film offers of community solidarity in a moment of crisis is in many ways inspiring. On the other hand, it is not clear that this is such a hot way of financing home ownership.
There are a number of problems with the “It’s a Wonderful Life” system. The Bedford Falls S&L has serious liquidity problems because it’s assets — the rights to payment of long-term home mortgage loans — while valuable would take a very long time to pay out. To deal with the liquidity problem it leveraged itself by borrowing money from the bank, but this leverage made it vulnerable in times of panic. There were other things that made it vulnerable as well, most notably the fact that its assets were geographically concentrated in Bedford Falls. If there is some economic shock to the community, the S&L is not diversified and is likely to go under, taking everyone’s deposits and home values with it. The solution is to move the mortgages out of the S&L. Turn those long-term payment streams into cash now. This solves the liquidity problem and eliminates the need to take on extra debt, and the associated brittleness in the face of crisis. It also means that the risk of a Bedford Falls specific shock can be borne by investors who can diversify that risk away by bundling Bedford Falls mortgages with Palo Alto mortgages and Milwaukee mortgages. This is all made possible by the securitization of the mortgages that George Bailey originates. In other words, MBSs are not a scam fixed up by greedy financial speculators. They are an investment instrument that provides a real solution to a genuine set of problems.
“Okay,” says the CDOs-are-evil skeptic, “but aren’t we witnessing the equivalent of the run on the bank right now? Aren’t MBSs what has made this all happen?”
Yes and no. To be sure the MBS has some systemic problems, the biggest one being the separation of information about risk from the holders of risk. As I told my class last week, notice that when push comes to shove, George put his own, personal money on the line to save the Bedford Falls S&L. This is what you call “skin in the game.” With what amounts to a personal guarantee of the S&L and an intimate knowledge of the community — “You don’t have to sign anything. I know you’ll pay me back when you can.” — his incentives and his information are perfectly aligned. Not so with bundling of mortgage loans into MBSs. In theory, however, we were supposed to have intermediary institutions — most notably the GSEs and the bond rating agencies — that were experts in the management of such moral hazards. After all, moral hazard problems exist virtually any time one has an agency relationship, and it is impossible to run anything other than a subsistence level economy without agency, so the mere presence of the possibility of moral hazard is not enough to damn any particular arrangement. This basic but not insurmountable problem was coupled in the case of the MBSs with a number of government policies designed to increase home ownership by incentivizing debt, as opposed to — for example — subsidizing equity. Finally, we have a large number of investors who thought that the success of their credit scoring models for subprime loans meant that they had overcome the basic risk of lending money — default — when in fact all they were observing were rising home values. This basic mistake, in turn, led the arrogant, the greedy, and the risk tolerant to leverage themselves to the hilt, creating a brittleness in the face of external shocks that would have made even George Bailey wince. It is worth remembering, however, that even George was living dangerously, floating on a sea of debt and the hope that his mortgage loans would perform.
And this gets to the final point in defense of MBSs. Right now these securities are functionally worthless because no one wants to buy them. The absence of a market means there is no price and without a price no one will guess at what they are worth. On the other hand, they can’t be worth nothing. Even in the subprime market the default rate is hovering below 20 percent. That means that even at the bottom of the market, 80 percent of the loans are performing. Those performing loans must ultimately have some value. So even the junk MBSs aren’t utterly junk. (Although the bottom tranch CDOs at this point are worthless.)
I actually don’t think that any of this has much to say one way or another about how best to restore confidence to the markets and prevent immediate financial Armageddon. But regardless of what the Congress does this week on the bailout, a monster of a debate about the best regulatory approach going forward is going to be launched, and it is worth remembering that vilified CDO is not a scam and we lose something important if we destroy the link between the home owners of Bedford Falls and international capital markets.
October 1, 2008 at 10:36 am
Posted in: Bankruptcy
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Responses (4)
Brett - October 1, 2008 at 11:52 am
Great post Nate, but I have one question. You say, “This basic but not insurmountable problem was coupled in the case of the MBSs with a number of government policies designed to increase home ownership by incentivizing debt, as opposed to — for example — subsidizing equity.”
I take it that you are referring to Fannie and Freddie, which were able to finance a lot of bad (but not the worst, due to their “conforming” guidelines) mortgages because investors bought their debt on the belief (now confirmed) that the government would not let their GSE’s fail.
What I don’t understand is how the presence of a big “dumb investor” like Fannie/Freddie in the MBS market contributes to the principal-agent problem you identify. Is the theory that if I see someone else jumping off a cliff I will do so too?
Bruce Boyden - October 1, 2008 at 11:54 am
I should preface all of my comments on this subject with the caveat that this is not my area.
Nate, I agree with you that MBSs are not inherently evil. But the problem you identify with them–”the separation of information about risk from the holders of risk”–is a huge one, and seems to have been pretty prevalent. The opinion seemed to have gotten widespread that securitization performed some sort of voodoo magic that eliminated the risk of a housing downturn causing loan defaults. It’s just like the Internet bubble. Sure, the instruments themselves were not bad, but the market for them was pretty screwed up.
Nate Oman - October 1, 2008 at 1:33 pm
Brett: Fannie and Freddie were supposed to be the experts in moral hazard management and to the extent that they packaged subprime junk investors may have reasonably relied on that expertise. Of course, Fannie and Freddie even in their final let’s-jump-into-the-subprime-market too phase were not, as I understand it, as bad as some of the other bundlers. It seems to me that the big problem with Fannie and Freddie is not that they caused everyone else to behave stupidly, blithely acting as though there was no moral hazard where there in fact was one. Rather it is that they were central insturments of a government policy designed to facilitate home ownership by subsidizing debt. As it happens, I think that there are lots of good externality and nudge paterialism arguments for encouraging home ownership. However, the government could have done this by, for example, subsidizing down payments, which would have reduced the cost to buyers while also reducing systemic risk (larger equity cushions on loans). What they did instead was subsidize home ownership by making ever riskier loans on the basis of their government subsidized credit. This increased homeownership, but it also increased systemic risk.
Bruce: After the tech stock bubble burst no one went around saying that equity stocks were really a vehicle for fraud. The differences is that people have a less intuitive understanding of CDOs, and I think that there is a stronger tendency to discount their virtues. For what it is worth, my understanding is that the voodoo magic was done less via securitization per se than by credit scoring models that failed to accurately forecast risk. In other words, financial analysts thought that they could look at a bundle of loans and predict default rates on the basis of statistical models of the homebuyers’ personal characteristics. These models had been performing pretty well in terms of predicting default rates. Accordingly, folks thought that people were discouting home mortgages more than they should be discounted based on their real risk profile. It now seems, however, that the performance of past loans, which had been apparently predicted by credit scoring, was actually a function of rising real estate prices, so that when those prices fell the models no longer accurately predicted default rates. Note, if this story is true (and I am not sure that it is) then we would have had a huge financial shock any way when the housing market dried up even in the absence of CDOs. It’s just that the shock would have been felt exclusively by lenders and purchasers of loan particpations rather than by holders of MBSs.
Of course, nothing that I’ve said here speaks to the effects of credit default swaps and other forms of credit derivatives. Even here, I am willing to make an argument in favor of the derivatives (realizing that on some definitions, MBS are credit derivatives as well), but I think that the case is weaker than it is for MBSs. In much of the chatter that I have seen and heard however from pundits and politicians, you would think that a CDO and a credit default swap were one and the same thing and equally nefarious.
AndyK - October 1, 2008 at 1:38 pm
Now imagine the Savings-and-Loan were required to value its assets at its current value, creating artificial highs as the market goes up, and artificially deflates loan value as the market goes down. The liquidity problem would be much worse! And that’s where we are today. Thank you Congress.
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