Events have really moved on this week with respect to the credit crisis. As Stephen Bartholomeusz in Business Spectator wrote today:
The Reserve Bank’s latest financial stability review confirms the findings of academics Christopher Joye and Joshua Gans in a paper issued earlier this week – the residential mortgage-backed securities (RMBS) market is just about dead and that has unpleasant implications for competition.
This was just as we had spent the vast majority of our report making the case that there was a problem in the RMBS market. And what is more, the RBA is now raising its own, complementary policy to Aussie Mac: to put in place an explicit deposit insurance scheme in Australia. (I’ll note that this too was on Daniel Gross’s list). All this is to the good.
Nonetheless, discussion over the last few days has brought up a few questions that could use a specific answer. So, as I have done before on other issues, over the fold is a FAQ (including also, Christopher Joye’s take).
1. Isn’t it premature to look at responses to the credit crisis? From Bartholomeusz:
It is probably premature to look at institutional responses to the funding issues in the midst of the sub-prime fallout. The markets will eventually settle and, given the quality of Australian owner-occupied conforming mortgages, the RMBS market will almost inevitably re-open in some form.
To which I say, how can it be premature if the crisis is already upon us? The RBA’s call for a policy response also suggests that the time to act is upon us.
I do not think the government can take the bet that the markets will settle and the RMBS market will come back as it did before. The US and Canada have not taken that bet. The time to look at serious policies is now rather than after the fact when it will be already too late to restore this market.
2. Won’t Aussie Mac lead to moral hazard? Again, from Stephen Bartholomeusz:
There is sufficient history within Fannie Mae and Freddie Mac (Roosevelt-era institutions) to suggest that creating a local version of those institutions could have unintended consequences and involve significant moral hazard, as well as representing a potential distortion of the competitive forces within a contestable market.
This is also reflected in concerns that the government might not do a good job of rating mortgage risks. A related issue came up in Slate with questions put to Daniel Gross:
Anonymous: Just a comment, We are ignoring the role that Fannie, Freddie and FHA all played in running up the housing market. Fannie and Freddie were the largest single buyers of subprime MBS, helping to drive that market. FHA continues to lose money, and started the trend toward low or no down-payment lending. It is insane that the House has passed a bill allowing FHA to insure zero down-payment loans—it is the lack of equity and extreme leverage on the part of borrowers and lenders that got us where we are today.
Daniel Gross: There’s no question that Fannie Mae and Freddie Mac played a significant role in contributing to the boom—by essentially guaranteeing that they would purchase mortgages that conformed to their standards. And there’s no question they did end up with a big chunk of subprime debt on their books, much of which was rated AAA (thank you, credit rating agencies.) But as a total percentage of all assets, subprime was a drop in the bucket at Fannie & Freddie. In addition, while it’s easy and popular to bash the two GSEs, it is worth noting that their presence in the marketplace does result in lower interest rates for people who qualify for so-called conforming loans.
Gross argues that the good outweighs the bad. But I would go further and say we can learn from their mistakes and do better. When it comes down to it, there is no greater moral hazard that exists when the government implicitly insures financial institution shareholders that are “too big to fail.” Much better to make guarantees explicit in a way that Aussie Mac and RBA’s deposit insurance push are doing.
Of course, Robert Merkel asks why stop at just a guarantee — why not be active in the market?
But if this is such a good idea, why not have “AussieMac” just directly offer home loans to consumers? And if protecting housing finance is such a good idea, why not small business loans? Heck, plenty of otherwise sound small businesses (and big businesses, for that matter) are copping it in the neck from a global credit crunch that has essentially nothing to do with their actual soundness. In fact, why not go the whole hog and create a government-backed “people’s bank” for the purpose. We could call it, I dunno, the “Common Wealth Bank”, perhaps?
Here is what I said in response there:
I think that when the rationale for intervention is the government’s AAA-rating in a time when credit is being rationed, then we need only consider how to leverage that without going the whole hog. The US is protected by the legacy of FDR on this stuff but where is out protection?
And on confining it to home mortgages, the key to the plan is for it to cost the government nothing. Home mortgages are actually (current times included) the least risky investment. The problem is that when credit gets right, banks can’t simply put up interest rates as that makes those loans more risky. A government guarantee can step into the breach. In all this, I keep asking the question “why not?” and have not heard an acceptable answer. Something worth exploring.
3. Can’t mortgage insurers provide this guarantee without government help? This was asked in a comments section on an earlier post.
And a familiar face responds:
Yes there are: Genworth and PMI Mortgage Insurance are the two dominant providers of LMI in Australia (they currently insure away the default risk associated with over $400 billion worth of Australian home loans). They do not, however, provide any direct liquidity to the primary RMBS securitisation markets, which have historically been the source of funding for nearly 20% of all Australian home loans. All they do is “credit enhance” these assets, which, to be frank, are not in need of a great deal of credit enhancement. Put differently, if we set aside for the moment that “prime” Australian home loans have incredibly low default rates (as at November 2007 only 0.84% of all Australian prime mortgages were in 30 days or more arrears according to S&P), the presence of the “mortgage insurance” supplied by Genworth and PMI has done nothing to prevent the collapse of the $50 billion per annum RMBS securitisation market. As Gans and Joye note in their paper, this market has effectively closed for reasons that are completely unrelated to the health of the Australian economy, our housing finance industry or household balance-sheets. And the ultimate casualties will in all likelihood be competition and the cost, flexibility and availability of housing finance in this country.
But what I want to emphasise is that this is really an expansion in sovereign debt to fill a void and not just an existing service. As was reported in Dow Jones today:
The University of Melbourne/Rismark report follows calls by the Australian Financial Markets Association, in a pre-budget submission, for the government to boost the current pool of sovereign debt from around A$50 billion to remedy an increasingly severe problem of low liquidity.
According to the Allen Consulting Group, which prepared the report for AFMA, the bond market needs additional liquidity of between A$20 billion and A$63 billion to ensure its medium-term viability.
4. Isn’t there enough competition already? Again asked by Stephen Bartholomeusz in Business Spectator.
Pricing – and therefore the ability of the originators to compete with the banks – might be an issue.
It was perverse that small non-banks, albeit with radically lower cost structures, could under-cut the major banks with their pristine credit ratings and high proportion of relatively low-cost deposits. They were able to do so because they could secure such cheap short term funding from the RMBS markets here and offshore during a period, indeed an era, where lenders/investors increasingly under-priced and failed to differentiate risk.
Funding long-term assets almost entirely with 30 to 90-day money isn’t – or at least wouldn’t have been in almost any other era – a sustainable business model, as the RAMS Home Loans group discovered almost the moment the sub-prime crisis emerged.
Whether the originators can again compete profitably with the banks when markets settle and a new framework for pricing RMBS emerges is an open question.
Whether the need to maintain competitive discipline on the major banks is compelling enough to allow non-banks access to subsidise funding provided by an institution that would get a free ride on a sovereign debt rating, as Joye and Gans advocate, is another. There are, of course, some big foreign banks (HBOS, for instance) and non-banks like GE Money, that increasingly compete directly with the major banks and that will provide some sort of discipline on their behaviour. …
If the major banks were to try to exploit the demise of the originators to restore their 4 per cent margins on home loans (if, indeed, the originators can’t compete in a more stable post-sub-prime environment) the banks would invite new competition. In fact, any return to the historical banking oligarchy and pre-RMBS market margins by the big banks might be just the thing to breathe life back into the non-bank sector.
My response (as part of the Business Spectator conversation):
I can see where Stephen Bartholomeusz is coming from when he suggests that, on paper, there should be enough competition between the major banks and a few foreign ones to ensure competitive interest rates for home mortgages. The problem is that history does not bear that out and that the securitisation path increased the lending capacity of the whole system and not just the smaller non-bank lenders. That is the issue here.
The crisis has taken out a major source of the supply of funds for these activities. In our report, we argue that it has hit the major banks as well as the smaller lenders. The issue is that the major banks can retreat to their deposit banks will the smaller lenders cannot. Ultimately that alters the competitive balance. Our Aussie Mac proposal is not a proposal to fund small lending organisations. It is a proposal to bolster the securitised side of the market that everyone and their dog agrees is now a problem. Aussie Mac will be available for all in the market to use and that will lower the cost of lending for everyone.
You say that should the majors not reduce rates, they will face competition. But that competition will not come if the competitors do not have access to funds one similar terms to the major banks. Not only is there sufficient history within Fannie Mae and Freddie Mac to learn from their mistakes and account for them in Aussie Mac. We can also see their beneficial effect on the market, see the paper by Richard Roll that we cite and also a recent article by Daniel Gross in Slate. If these organisations are so awful why do they still exist in the US and Canada? I would suggest because they do more good than harm. Time and again I ask myself why isn’t Australia doing this? I still haven’t heard a good answer.
5. Don’t we want high interest rates to cool off the housing market?
That may be but who do we want controlling that choice: the RBA or the banks? No one will want a cool market forever. Already, the drying up of credit for home mortgages is hampering the Fed’s ability to jump-start the economy by lowering rates. We don’t need this to stand in our way.
And now Christopher Joye adds his thoughts on all of the above:
I think the fundamental policy issue here is–as Joshua has clearly noted–that we have had a critical economic market that is responsible for providing the funding for 20% (or $50.8 billion per annum) of the $250 billion per annum Australian mortgage industry shut down. And not just for a few days or weeks. There has have not been any significant securitisations of AAA-rated Australian home loans since November 2007. Most importantly though, the closure of this market has had nothing to do with the integrity of Australian home loans or the strength of our economy. We are simply a casualty of the extreme risk aversion and illiquidity that has spawned from the US sub-prime crisis and the demise of the SIVs, CDOs and the foreign investment banks that sponsored them. To make this point clear, 30 day default rates on US sub-prime loans are over 16% (these loans account for more than 15% of the entire US market). By way of contrast, 30 day default rates on prime Australian loans are 0.84% (at Nov 07) while sub-prime mortgages make up less than 1% of our market.
The only liquidity available is via the RBA’s new short-term (ie, 90 day) repurchase agreements which it has only made available to ADIs. Under the terms of this “repo facility” the RBA will accept AAA-rated Australian home loans as collateral and lend the institution in question money. The extreme irony here is that these repo facilities are only available to ADIs (ie, banks), which the RBA has claimed are incredibly well capitalised and not bound by significant liquidity constraints. But if the RBA is going to provide anyone with liquidity surely it should be to the segment of the mortgage market that has been most adversely affected by the illiquidity in securitisation markets: ie, the non-bank lenders. I note that the US Fed has recently extended its own repo arrangements, which the RBA has mimicked to non-ADI investment banks and brokers.
The fact is that the RBA is already doing precisely what we propose AussieMac would do: ie, provide liquidity to major financial institutions when markets fail for reasons that are exogenous to the domestic system. The problem is that the RBA is providing that liquidity on a discriminatory basis to the institutions that least need it.
Two final comments:
(1) It would be quite easy to place regulatory constraints on AussieMac’s day-to-day activities to ensure that it did not disintermediate any meaningful private sector activity. For example, except during periods of demonstrable market stress, you could limit AussieMac to supplying no more than, say, 10% of the market liquidity (and note that this would be liquidity only for the purposes of acquiring “prime” RMBS that conformed with AussieMac’ strict credit criteria). This should ameliorate the market distortion and moral hazard issues that have been raised. AussieMac’s chief mandate would be to serve as a liquidity provider of last resort to a key component of the financial system (ie, the securitised RMBS market) when there were these once-every-ten-years external shocks–which appear to be ocurring with increasing regularity given the ever-more integrated nature of financial markets–that massively disrupt the functions of such markets to the irreversible detriment of Australian financial institutions and the households they service.
(2) One interesting point that we did not stress in the paper is that AussieMac’s day-to-day role could be very valuable in the context of providing additional liquidity to the Australian government bond market, which seems to an issue for the capital markets given that it has recently shrunk so much (the existence of a government bond market is critical to institutions for hedging and risk management purposes, amongst other things). Assuming that it remained a public agency (like the CMHC in Canada) AussieMac’s bonds would be super low risk AAA-rated government debt. The Canada Bonds that the CMHC issues serve exactly the same purpose in that market.