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A Defense of Asset Securitization from Bedford Falls

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4 Responses

  1. Brett says:

    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?

  2. Bruce Boyden says:

    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.

  3. Nate Oman says:

    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.

  4. AndyK says:

    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.