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September 22, 2008
Bear Stearns, the CRA, and Freddie Mac
Russell Roberts
I keep hearing that the subprime crisis was caused by people willing to buy stuff they couldn't evaluate. Why would smart people do that? One answer is that they were stupid. In an era of rising home prices, it's hard to remember that prices can go down. And when prices are going up, the risks of default are low. Is there another answer? What was the role of GSE's in reducing the riskiness of these assets? What was the role of GSEs in creating systemic risk rather than one bank or investment house making bad decisions? So here's an interesting press release from October 20, 1997, claiming to be the first securitization of CRA-encouraged loans. What I find interesting is that it was securitized by Bear Stearns and guaranteed by Freddie Mac. I wonder how many more were like that. Here's some of the text:
CHARLOTTE - First Union Capital Markets Corp. and Bear, Stearns & Co. Inc. have priced a $384.6 million offering of securities backed by Community Reinvestment Act (CRA) loans - marking the industry's first public securitization of CRA loans.
The affordable mortgages were originated or acquired by First Union Corporation and subsidiaries. Customers will experience no impact - they will continue to make payments to and be serviced by First Union Mortgage Corp. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods under the Community Reinvestment Act of 1977.
"The securitization of these affordable mortgages allows us to redeploy capital back into our communities and to expand our ability to provide credit to low and moderate income individuals," said Jane Henderson, managing director of First Union's Community Reinvestment and Fair Lending Programs. "First Union is committed to promoting home ownership in traditionally underserved markets through a comprehensive line of competitive and flexible affordable mortgage products. This transaction enables us to continue to aggressively serve those markets."
The $384.6 million in senior certificates are guaranteed by Freddie Mac and have an implied "AAA" rating. First Union Capital Markets Corp. is the investment banking subsidiary of First Union Corporation.
"We are extremely pleased by how well this transaction was received by investors as many of the tranches were significantly oversubscribed," said Owen Williams, managing director of fixed income sales and trading at First Union Capital Markets Corp. "This offering is further proof of investors' b desire for a diverse range of collateral."
Posted by Russell Roberts in Government intervention in housing | Permalink
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"I keep hearing that the subprime crisis was caused by people willing to buy stuff they couldn't evaluate. Why would smart people do that?"
Maybe because they weren't that smart.
Maybe because they felt other smart people had already evaluated it, and it passed muster.
Maybe because the people selling were a bit smarter than the people buying.
In any case, it's an accounting nightmare. I don't see any long term losses from long term investors.
Posted by: SheetWise | Sep 22, 2008 2:11:24 AM
The $384.6 million in senior certificates are guaranteed by Freddie Mac and have an implied "AAA" rating.
Well, my gosh, that wouldn't change anyone's incentives. Being artificially insulated from risk just means greedy and corrupt businessmen wrecked the economy, it couldn't possibly be influenced by a GSE.
Posted by: Will | Sep 22, 2008 5:06:11 AM
Do you have the CUSIP number for that package? If so, you would be able to report whether that particular bundle of "CRA-encouraged loans" had a default rate that was greater than the default rate on other securitized mortgages.
Posted by: T L Holaday | Sep 22, 2008 7:38:21 AM
Here's something else that's interesting:
Abstract: The Community Reinvestment Act (CRA) encourages lenders to make mortgage loans to certain classes of borrowers. However, the law does not apply to all lenders, and lenders do not necessarily receive credit for all loans made to borrowers of a particular class. We use this variation to test whether or not CRA-affected lenders cut interest rates to CRA-eligible borrowers; in other words, we test for the presence of a regulation-driven subsidy. Our theory suggests that loans made by commercial banks and savings associations (``relationship lenders'') and mortgage companies (``transaction lenders'') will differ from one another depending on borrower risk and homeownership benefits. Empirically, we find that CRA-eligible loans at CRA-affected institutions do carry lower mortgage spreads compared with other loans at the same institution. However, once we control for risk and benefit effects suggested by our theory, these differences in mortgage spreads become economically and statistically insignificant.[Emphasis added]
Posted by: T L Holaday | Sep 22, 2008 7:48:00 AM
"I keep hearing that the subprime crisis was caused by people willing to buy stuff they couldn't evaluate. Why would smart people do that?"
Maybe those smart people were actually foreign governments. Due to their desire to sell us more goods than they purchased from us, those governments had billions of Dollars on hand. What should they do with those dollars? They could hold Dollars, but then the Fed was quickly devaluing them. They could buy Treasuries, and they did, but the building inflation was threatening those holdings as well. So many of them looked for higher returns, with a US Government backing. The market responded with securitized mortages: a play on the housing boom and with some implied U.S. Federal backing.
It was all quite rational given the situation.
Posted by: Russ Wood | Sep 22, 2008 8:22:51 AM
This site seems more thoughtful than most, but I'm still struck by the willful need to believe that this long series of Wall Street caused problems is somehow the fault of government. Tremendous effort is being invested in trying to tie this problem on the de facto government backing that Fannie Mae/Freddie Mac enjoyed. So what of all the fraud loans that were written and securitized separate from those? And what of the fact that the 'backing' we are talking about is only being offered up at the point of implosion? Are we therefore saying all these wiseguys on Wall Street had it in their calculations that 'Well Fannie Mae will cover the last nickel of my dollar investment, so I'm OK to buy/insure a fraud loan'? This makes no sense at all.
Seems to me, no one here wants to admit the possibility that markets aren't rational and self-correcting in the way Friedman/Hayek told us they were, so they're looking to put the blame elsewhere.
Posted by: topcat | Sep 22, 2008 10:43:36 AM
topcat,
I don't think we can fully assign blame to any single entity. Of course everyone had their hands in the pot. However you need to look and *why* the incentives were in place to lead people to make such poor decisions and *what* incentivized (i know, i think i made that word up) people to make or take unethical actions to really understand the root of the problem.
In most cases, the boom in the sub-prime sector was sponsored by government policies crafted to create an entitlement to home ownership. Prior to any incentives being in place, you still had a very rigid mortgage structure where real risk was fairly well-known.
Posted by: colson | Sep 22, 2008 11:57:10 AM
Topcat--
They aren't self-correcting when government steps in to intercede.
The assets of these two GSEs have value. Politicians decided they still wanted their market toys. And will pay any price to keep them.
This unwillingness to let go their policy toys means that we will probably never know the real value of Freddie and Fannie's assets. Without that, we'll never be able to know when they are "fixed".
I've listened to all the pundits talk about the situation, and those who agree with the intervention state their view that they hope Congress deals with this.
Expecting Congress to deal with a crisis? They've such a lovely track record.
.
Posted by: OregonGuy | Sep 22, 2008 12:03:28 PM
but I'm still struck by the willful need to believe that this long series of Wall Street caused problems is somehow the fault of government.
Seems you've never heard of regulatory capture.
When government creates bureaucracy to regulate business, the incentive is created for business to influence that bureaucracy, either directly, or via influence on legislators.
It's not as simple as blaming 'the government' as much as discerning the systemic flaws in regulatory systems.
It's similar to drug prohibition creating profit incentives for drug distributors to corrupt enforcement bureaucracy.
Here's a question: Given the fact of drug prohibition, how do you eliminate drug criminality?
You can't
Given the existence of business regulation, how to you eliminate business's influence on the regulatory system?
You can't.
A system of political power creates an oligarchy. Businesspeople quickly learn that it is better to join the oligarchy than to remain outside of it.
What can we the people do about it?
Keeping government out of business will keep business out of government.
That's the only way...as I see it.
Posted by: Sam Grove | Sep 22, 2008 1:59:21 PM
Seems to me, no one here wants to admit the possibility that markets aren't rational and self-correcting in the way Friedman/Hayek told us they were, so they're looking to put the blame elsewhere.
That's not what they claimed. The claim is that markets are self-correcting if they are left alone by political meddling.
The reality is that markets are rarely left alone by political meddling.
Also, see above post.
Posted by: Sam Grove | Sep 22, 2008 2:07:47 PM
I keep hearing that the subprime crisis was caused by people willing to buy stuff they couldn't evaluate. Why would smart people do that?
Because the "smart people" were finance wonks on Wall Street, not real estate investors. They forgot that the payor doesn't matter, it's the collateral that ultimately pays you. They foolishly assumed that "insurance" could substitute for collateral, that there was no counterparty risk in their default swaps.
Posted by: Bob Smith | Sep 22, 2008 3:34:37 PM
Bob Smith, keen observation.
Bob Smith wrote:
“They[Wall Street] foolishly assumed that "insurance" could substitute for collateral, that there was no counterparty risk in their default swaps.”
BUT – as history reveals itself the government IS backing the “Insurance” as collateral.
What now?
Posted by: John Smith | Sep 22, 2008 7:17:29 PM
What now? Hope the government comes to its senses and backs away from bailing anybody out. Barring that, pray it doesn't screw things up too badly.
Posted by: Bob Smith | Sep 22, 2008 10:50:22 PM
How about if the government prints out enough money, sends it out to taxpayers, and they can send it right back to pay their taxes with?
Posted by: Sam Grove | Sep 23, 2008 12:59:13 AM
Article from 1998 on how to convince banks to sell their CRA portfolios.
http://www.allbusiness.com/personal-finance/real-estate-mortgage-loans/677967-1.html
Also, 2000 Fed study on CRA loans that concludes they have a 2x default rate and are not profitable.
http://www.banking.senate.gov/docs/reports/cra-sun/frb-cra.htm
Fascinating to see how this all came together.
Posted by: portia9 | Oct 3, 2008 4:20:36 PM
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