Jaffee Paper

Fisher Center for Real Fisher Center for Real Estate & Urban Economics Estate & Urban Economics

(University of California, (University of California, Berkeley), 2008Berkeley), 2008

Fisher Center Working PapersFisher Center Working Papers““Regulating the Investment Banks and Regulating the Investment Banks and

GSE’s After the Subprime Crisis”, GSE’s After the Subprime Crisis”, Dwight M. JaffeeDwight M. Jaffee

The working paper offers:The working paper offers:

A review of the key factors that led to the A review of the key factors that led to the subprime crisissubprime crisis

The special features of the investment The special features of the investment banks and GSE’s that led to a bailoutbanks and GSE’s that led to a bailout

A solution by the author to avoid future A solution by the author to avoid future Investment bank and GSE bailoutsInvestment bank and GSE bailouts

Has financial regulation been Has financial regulation been successful in the past?successful in the past?

1.1. National Banking Act of 1863 was National Banking Act of 1863 was a federal charter regulating a federal charter regulating commercial banks – wildcat commercial banks – wildcat banking. It also created the banking. It also created the Treasury Department and the Treasury Department and the Office of the Comptroller of the Office of the Comptroller of the Currency. Currency.

2.2. The Federal Reserve System was The Federal Reserve System was created in 1913 in response to created in 1913 in response to continued financial paniccontinued financial panic

3.3. Federal deposit insurance was Federal deposit insurance was created in 1933 to stem bank runs created in 1933 to stem bank runs in the Great Depression in the Great Depression

4.4. The Glass-Steagall Act passed in The Glass-Steagall Act passed in 1933 to address conflicts between 1933 to address conflicts between commercial and investment banks. commercial and investment banks. Glass-Steagall was amended by Glass-Steagall was amended by the Bank Holding Company Act of the Bank Holding Company Act of 1956 and again by the Financial 1956 and again by the Financial Services Modernization Act of Services Modernization Act of 1999.1999.

5.5. The Federal Housing The Federal Housing Administration (FHA) was created Administration (FHA) was created in 1934 – govt’s first residential in 1934 – govt’s first residential mortgage insurance program. mortgage insurance program.

6.6. Fannie Mae was created in 1937 Fannie Mae was created in 1937 to further support the mortgage to further support the mortgage markets. Fannie Mae was later markets. Fannie Mae was later split into two entities; GNMA & split into two entities; GNMA & Fannie Mae.Fannie Mae.

7.7. The Federal Deposit Insurance The Federal Deposit Insurance Corporation Improvement Act of Corporation Improvement Act of 1991 (FDCIA) was created in 1991 (FDCIA) was created in response to the S&L crisis and response to the S&L crisis and required regulators take corrective required regulators take corrective action to any banking firm failing to action to any banking firm failing to meet capital or regulatory meet capital or regulatory requirements.requirements.

Government regulation of past Government regulation of past financial crises have been financial crises have been

successful because:successful because:

Regulations have been focused on the key Regulations have been focused on the key issue of the timeissue of the time

Regulations have been strong, innovative Regulations have been strong, innovative and long standing.and long standing.

So what were the causes of the So what were the causes of the Subprime Crisis?Subprime Crisis?

Subprime mortgage losses and a Boom Subprime mortgage losses and a Boom Bust Real Estate CycleBust Real Estate Cycle

Concentrated & Cash Flow Mismatched Concentrated & Cash Flow Mismatched Investment PortfoliosInvestment Portfolios

Securitization and the Credit Rating Securitization and the Credit Rating AgenciesAgencies

Subprime mortgage losses and a Subprime mortgage losses and a boom bust real estate cycle: boom bust real estate cycle:

Subprime Mortgages failed partly because….Subprime Mortgages failed partly because…. Poor design, underwriting and origination Poor design, underwriting and origination Predatory lending Predatory lending Market institutions were poorly prepared to Market institutions were poorly prepared to

modify loans in lieu of foreclosuremodify loans in lieu of foreclosure

The Federal Reserve is already making changes The Federal Reserve is already making changes to the Truth in Lending laws to address to the Truth in Lending laws to address predatory lending and HUD is also making predatory lending and HUD is also making parallel changes to RESPA rules.parallel changes to RESPA rules.

Subprime mortgage losses and a boom Subprime mortgage losses and a boom bust real estate cycle bust real estate cycle (continued):(continued):

Subprime Mortgages also failed due to a decline in US Subprime Mortgages also failed due to a decline in US housing prices. A typical scenario for real estate housing prices. A typical scenario for real estate cycles:cycles:

Financial innovation expands mortgage lendingFinancial innovation expands mortgage lending Increased lending raises housing demand, which Increased lending raises housing demand, which

increases housing pricesincreases housing prices Increase housing prices fuels expanded lending – Increase housing prices fuels expanded lending –

circular cycle repeats circular cycle repeats Market crash – market prices for housing becomes Market crash – market prices for housing becomes

inconsistent with fundamentals of homeowner inconsistent with fundamentals of homeowner affordability.affordability.

Subprime mortgage losses and a boom Subprime mortgage losses and a boom bust real estate cycle bust real estate cycle (continued):(continued):

Why would investors hold mortgage assets even Why would investors hold mortgage assets even as the real estate market price fundamental as the real estate market price fundamental opposed the affordability fundaments? opposed the affordability fundaments?

Investors have made the bet that with no real Investors have made the bet that with no real aggregate housing decline since WWII, the aggregate housing decline since WWII, the chance of a significant housing price decline chance of a significant housing price decline was slim. was slim.

(Author notes there have been a number of regional house price (Author notes there have been a number of regional house price crashes but these have been idiosyncratic events ignored by large crashes but these have been idiosyncratic events ignored by large

investors with a geographic diverse portfolio)investors with a geographic diverse portfolio)

Subprime mortgage losses and a boom Subprime mortgage losses and a boom bust real estate cycle bust real estate cycle (continued):(continued):

Subprime loans represent less than 4% of Subprime loans represent less than 4% of all US investment securities. The all US investment securities. The aggregate loss rate of subprime loans in aggregate loss rate of subprime loans in the end may not exceed 25%. the end may not exceed 25%.

Assuming this is representative of US Assuming this is representative of US investment portfolio then the one time loss investment portfolio then the one time loss would be 1% (.04 x .25)would be 1% (.04 x .25)

This is not a significant loss to lead to This is not a significant loss to lead to bailouts.bailouts.

Concentrated and Cash Flow Concentrated and Cash Flow Mismatched Investment Portfolios:Mismatched Investment Portfolios:

The flawed investment strategy had two elements:The flawed investment strategy had two elements:

1.1. Portfolios were highly concentrated in subprime Portfolios were highly concentrated in subprime mortgages, achieved by over-weighting the asset class mortgages, achieved by over-weighting the asset class and by taking on the riskier tranches in subprime and by taking on the riskier tranches in subprime securitizations.securitizations.

2.2. Portfolios where funded with short-term debt with the Portfolios where funded with short-term debt with the assets serving as collateral.assets serving as collateral.

This strategy is very profitable assuming mortgages This strategy is very profitable assuming mortgages losses are minor and the funding can be rolled over losses are minor and the funding can be rolled over frequently. frequently.

Concentrated and Cash Flow Concentrated and Cash Flow Mismatched Investment Portfolios:Mismatched Investment Portfolios:

However, as housing prices began to fall However, as housing prices began to fall investment firms were unable to rollover the investment firms were unable to rollover the maturing debt because lenders were not sure maturing debt because lenders were not sure of the value of the collateral. Valuation of of the value of the collateral. Valuation of these securities is complex dependent on the these securities is complex dependent on the future loss ratio. Thus, lenders unable to value future loss ratio. Thus, lenders unable to value the security reasoned not to lend at all is the the security reasoned not to lend at all is the most common sense approach.most common sense approach.

Securitization and the Credit Rating Securitization and the Credit Rating Agencies: Agencies:

The President’s Working Group on Financial Markets The President’s Working Group on Financial Markets (2008 p.1) reports the following as two additional factors (2008 p.1) reports the following as two additional factors that may have contributed to the subprime crisis:that may have contributed to the subprime crisis:

Significant erosion of market discipline by those involved Significant erosion of market discipline by those involved in the securitization process in the securitization process

Flaws in credit rating agencies’ assessments of Flaws in credit rating agencies’ assessments of subprime residential mortgages subprime residential mortgages

The author makes the argument these two issues may The author makes the argument these two issues may have aided in the subprime crisis but re-regulation of have aided in the subprime crisis but re-regulation of securitization and rating agencies is misguided.securitization and rating agencies is misguided.

Securitization and the Credit Rating Securitization and the Credit Rating Agencies:Agencies:

Regulations that allowed investors with systemic Regulations that allowed investors with systemic

responsibility to take risky positions is the true responsibility to take risky positions is the true problem coupled with the fact that rating problem coupled with the fact that rating agencies have traditionally taken a more agencies have traditionally taken a more conservative approach when rating asset class; conservative approach when rating asset class; albeit this huge mistake with subprime albeit this huge mistake with subprime mortgages.mortgages.

So Why Did the Federal So Why Did the Federal Reserve and the Treasury Reserve and the Treasury

Provide Bailouts?Provide Bailouts?

The main reason was because both the The main reason was because both the investment banks and GSEs were market investment banks and GSEs were market

makers and counterparties which created a makers and counterparties which created a systemic risk as an externality.systemic risk as an externality.

Investment BanksInvestment Banks

Market maker and counterparty for derivativesMarket maker and counterparty for derivatives These derivatives included interest rate, foreign These derivatives included interest rate, foreign

exchange swaps and credit default swaps.exchange swaps and credit default swaps. Because of hedging the interconnection of banks is Because of hedging the interconnection of banks is

established: established: Fund A Fund A enters into a swap with enters into a swap with Fund BFund B because it knows B has hedged a particular risk with because it knows B has hedged a particular risk with Investment Bank C Investment Bank C

If one counterparty fails it becomes a domino effect. No If one counterparty fails it becomes a domino effect. No one single counterparty has the incentive to prop up the one single counterparty has the incentive to prop up the entire transaction.entire transaction.

Inability to meet maturing debt obligations = bankruptcy.Inability to meet maturing debt obligations = bankruptcy.

GSEs GSEs

GSEs may be considered the world’s largest GSEs may be considered the world’s largest counterparty in interest rate swaps and counterparty in interest rate swaps and swaptions (options based on swaps). As such swaptions (options based on swaps). As such their failure has a systemic effect their failure has a systemic effect largerlarger than than investment banks.investment banks.

Essentially, the Treasury was concerned that if Essentially, the Treasury was concerned that if GSEs defaulted on their capital market GSEs defaulted on their capital market obligations (5 Trillion - debt and MBS combined) obligations (5 Trillion - debt and MBS combined) GSE’s couldn’t continue to support the US GSE’s couldn’t continue to support the US mortgage market. GSEs were eventually put in mortgage market. GSEs were eventually put in conservatorship under control of the Federal conservatorship under control of the Federal Housing Finance Agency. Housing Finance Agency.

How to Regulate Investment Banks How to Regulate Investment Banks and GSE to Avoid Future Bailoutand GSE to Avoid Future BailoutFirst let’s understand the problem. Investment Banks First let’s understand the problem. Investment Banks

and GSE have two distinct businesses but different and GSE have two distinct businesses but different business activities:business activities:

1.1. Both operate highly leveraged and cash flow Both operate highly leveraged and cash flow mismatched portfolios. These funds aggregate mismatched portfolios. These funds aggregate information creating price discovery and efficient information creating price discovery and efficient resource allocations. resource allocations. “Hedge Fund Division”“Hedge Fund Division”

2.2. Both serve systemic mission serving as key counter Both serve systemic mission serving as key counter parties in the Over The Counter derivatives market. parties in the Over The Counter derivatives market. (GSE additionally stabilize the mortgage market). (GSE additionally stabilize the mortgage market). “Infrastructure Division”“Infrastructure Division”

Problem:Problem: If the hedge fund division is part of the If the hedge fund division is part of the

larger company which includes the larger company which includes the infrastructure division and losses are infrastructure division and losses are sustained by the hedge fund division then sustained by the hedge fund division then total company bankruptcy is possible. total company bankruptcy is possible.

Solution:Solution: Separate the two divisions such that the Separate the two divisions such that the

infrastructure division is “bankruptcy infrastructure division is “bankruptcy remote” from the hedge fund division. remote” from the hedge fund division.

The Monoline Insurer Solution:The Monoline Insurer Solution:

So how do you implement the change?So how do you implement the change?

Follow past precedent from the insurance industry. In 1965 Follow past precedent from the insurance industry. In 1965 Mortgage Guaranty Insurance Company petitioned to offer private Mortgage Guaranty Insurance Company petitioned to offer private mortgage insurance – a high risk insurance policy. The regulatory mortgage insurance – a high risk insurance policy. The regulatory response was to allow the firm to be chartered, but only as a response was to allow the firm to be chartered, but only as a monoline insurer. The net effect insures that standard policies monoline insurer. The net effect insures that standard policies holders with limited risk would not be subject to high risk policies holders with limited risk would not be subject to high risk policies offered through the same company.offered through the same company.

The practice still holds today and with very good results. Even with The practice still holds today and with very good results. Even with the losses arising from the current subprime crisis, there have been the losses arising from the current subprime crisis, there have been no failures among either the private mortgage or the bond insurers.no failures among either the private mortgage or the bond insurers.

The Glass Steagall EvolutionThe Glass Steagall Evolution

The banking industry has essentially implemented a monoline The banking industry has essentially implemented a monoline approach by way of the Glass Steagall Act of 1932.approach by way of the Glass Steagall Act of 1932.

Initial legislation permitted banks Initial legislation permitted banks to carry out “banking business” – to carry out “banking business” – taking deposits and making loans. taking deposits and making loans. This separated banks from This separated banks from investments banks but also from investments banks but also from any other business lines.any other business lines.

In 1956 The Bank Holding Act In 1956 The Bank Holding Act modified Glass Steagall. Bank modified Glass Steagall. Bank holding companies were permitted holding companies were permitted to own one or more banks and to own one or more banks and allowed to carry out activities – at allowed to carry out activities – at the holding company level – the holding company level – “closely related to banking.” The “closely related to banking.” The Fed still has oversight and is Fed still has oversight and is responsible to ensure the responsible to ensure the soundness of the subsidiaries.soundness of the subsidiaries.

In 1999 Glass Steagall was again In 1999 Glass Steagall was again modified by the Financial Services modified by the Financial Services Modernization Act. This Act Modernization Act. This Act created a “financial holding created a “financial holding company” as a special status for a company” as a special status for a bank holding company, with the bank holding company, with the ability to operate both investment ability to operate both investment banking and insurance banking and insurance subsidiaries, along with its subsidiaries, along with its commercial banking subsidiaries. commercial banking subsidiaries. Again, the Fed has regulatory Again, the Fed has regulatory authority. Holding companies authority. Holding companies must meet the Fed’s highest must meet the Fed’s highest capital standards and holding capital standards and holding companies must give the highest companies must give the highest priority to the soundness of the priority to the soundness of the commercial bank subsidiaries.commercial bank subsidiaries.

How to implement Regulation of How to implement Regulation of the Investment Banks the Investment Banks

Given investment banks are currently operating as subsidiaries Given investment banks are currently operating as subsidiaries within the bank holding companies, risk remains that hedge fund within the bank holding companies, risk remains that hedge fund operations may endanger the bank holding company’s viability.operations may endanger the bank holding company’s viability.

The author’s proposal is simple – impose a monoline requirement The author’s proposal is simple – impose a monoline requirement on any investment bank that wishes to carry out both hedge fund on any investment bank that wishes to carry out both hedge fund and infrastructure activities, whether it operates independently or as and infrastructure activities, whether it operates independently or as a part of a bank holding company. EFFECT – potential losses by a part of a bank holding company. EFFECT – potential losses by the hedge fund division will not threaten the infrastructure division.the hedge fund division will not threaten the infrastructure division.

Sample Structure - Infrastructure divisions are structured as a Sample Structure - Infrastructure divisions are structured as a separate subsidiary with dedicated capital. This provides the same separate subsidiary with dedicated capital. This provides the same protection to these subsidiaries currently provided to commercial protection to these subsidiaries currently provided to commercial bank subsidiaries with bank holding companies. Future monoline bank subsidiaries with bank holding companies. Future monoline restrictions can be imposed if the regulator determines an activity restrictions can be imposed if the regulator determines an activity has systemic risk.has systemic risk.

Costs of the ProposalCosts of the Proposal

Administrative costs to isolate Administrative costs to isolate infrastructure division with separate infrastructure division with separate subsidiaries.subsidiaries.

Restriction that the capital of the protected Restriction that the capital of the protected infrastructure subsidiary cannot be applied infrastructure subsidiary cannot be applied to cover losses arising from the activities to cover losses arising from the activities of any other subsidiaries of the bank of any other subsidiaries of the bank holding company.holding company.

Potential Regulatory RefinementPotential Regulatory Refinement

It could be argued that the risk based capital It could be argued that the risk based capital requirements be raised as a means to improve their requirements be raised as a means to improve their future safety. (AIG and Bear Stearns required bailouts future safety. (AIG and Bear Stearns required bailouts even though they met their capital requirements. Their even though they met their capital requirements. Their failures were caused by inability to rollover maturing debt failures were caused by inability to rollover maturing debt – magnified by their solvency concerns.) – magnified by their solvency concerns.)

Regulators must anticipate financial institutions and Regulators must anticipate financial institutions and markets will continue to innovate and create risky markets will continue to innovate and create risky investment vehicles. These risks must be independently investment vehicles. These risks must be independently remote to eliminate the systemic risk.remote to eliminate the systemic risk.

Monoline restrictions have the ability to be quickly Monoline restrictions have the ability to be quickly applied – assuming the risk is identified – to reduce the applied – assuming the risk is identified – to reduce the systemic risk. systemic risk.

How to Implement Regulation of GSEsHow to Implement Regulation of GSEs

GSE operate two distinct activities: GSE operate two distinct activities: Retained Portfolios & SecuritizationRetained Portfolios & Securitization

Retained PortfoliosRetained Portfolios – GSE have “on their own books” approximately – GSE have “on their own books” approximately 1.5 Trillion of MBS which are funded by the issue of approximately 1.5 Trillion of MBS which are funded by the issue of approximately the same amount of corporate debt with three main problems:the same amount of corporate debt with three main problems:

1.1. Major cash flow mismatch – debt issued to fund the portfolio has a Major cash flow mismatch – debt issued to fund the portfolio has a

shorter maturity than the MBSshorter maturity than the MBS2.2. GSEs made significant investment in subprime mortgages GSEs made significant investment in subprime mortgages 3.3. The portfolios are highly leveraged - $40 - $1 The portfolios are highly leveraged - $40 - $1

Retained Portfolios are eerily similar to hedge fund activities by Retained Portfolios are eerily similar to hedge fund activities by investment banks – and resemble the same reasons for a bailout.investment banks – and resemble the same reasons for a bailout.

How to Implement Regulation of GSEsHow to Implement Regulation of GSEs

GSE operate two distinct activities: GSE operate two distinct activities:

Retained Portfolios & SecuritizationRetained Portfolios & Securitization

Securitization Securitization - qualifying mortgages are securitized into MBS. - qualifying mortgages are securitized into MBS.

GSEs currently have 3.5 Trillion in securitized pools. GSEs currently have 3.5 Trillion in securitized pools.

Incidentally, a large portion of the subprime mortgages were Incidentally, a large portion of the subprime mortgages were retained on the GSEs books rather than being placed into the pools retained on the GSEs books rather than being placed into the pools

in order to earn a higher coupon rate as the investor.in order to earn a higher coupon rate as the investor.

How to Implement Regulation of GSEsHow to Implement Regulation of GSEs

The author’s proposal is to once again The author’s proposal is to once again

implement a monoline structure to separate the implement a monoline structure to separate the retained portfolio from the securitization of MBS. retained portfolio from the securitization of MBS.

Once the GSEs are released from Once the GSEs are released from conservatorship, a new entity would be created conservatorship, a new entity would be created to accept the retained portfolios which would to accept the retained portfolios which would function as a private sector investment function as a private sector investment company. The securitization of MBS would company. The securitization of MBS would remain a governmental agency.remain a governmental agency.

New Securitization of MBS Structure New Securitization of MBS Structure –“Middle Income Mortgage Agency” (MIMA)–“Middle Income Mortgage Agency” (MIMA)

The securitization of MBS by GSEs will become a The securitization of MBS by GSEs will become a governmental agency called MIMA that would essentially governmental agency called MIMA that would essentially provide the same service of government insurance and provide the same service of government insurance and securitization to middle-income families that FHA / securitization to middle-income families that FHA / GNMA currently offer to lower income families.GNMA currently offer to lower income families.

Borrowers would be charged insurance premiums and Borrowers would be charged insurance premiums and MIMA would earn a spread to guaranty the loans.MIMA would earn a spread to guaranty the loans.

The private markets would still originate and hold The private markets would still originate and hold mortgages – no governmental crowding.mortgages – no governmental crowding.

Private market securitizers of jumbo mortgages would Private market securitizers of jumbo mortgages would continue to operate business and usual. continue to operate business and usual.

New Retained Portfolio Structure New Retained Portfolio Structure

Retained mortgage portfolios would be spun off Retained mortgage portfolios would be spun off to GSE’s shareholders and would operate to GSE’s shareholders and would operate similar to a publically traded REIT with the ability similar to a publically traded REIT with the ability to originate mortgages directly.to originate mortgages directly.

Shareholders would receive:Shareholders would receive: Mortgage assets Mortgage assets Bond liabilities Bond liabilities Net worth of the portfolio at the time of spinoffNet worth of the portfolio at the time of spinoff Intellectual capital of the GSE (software, techniques Intellectual capital of the GSE (software, techniques

for interest rate risk hedging etc)for interest rate risk hedging etc)

Government Sponsored Enterprises Government Sponsored Enterprises should endshould end

The author concludes the concept of a privately owned, The author concludes the concept of a privately owned, profit maximizing company combined with a public profit maximizing company combined with a public mission and an implicit government guarantee was a mission and an implicit government guarantee was a recipe for disaster. The solutions provided above solve recipe for disaster. The solutions provided above solve this problem.this problem.

Congressional support of GSEs to support lower-income Congressional support of GSEs to support lower-income goals was based in part on the premise that GSEs aid to goals was based in part on the premise that GSEs aid to lower income families was available at no cost – tax the lower income families was available at no cost – tax the GSE in lieu of making appropriations to HUD. In light of GSE in lieu of making appropriations to HUD. In light of the true cost to bailout Fannie and Freddie, Congress the true cost to bailout Fannie and Freddie, Congress should make the appropriations as a more effective should make the appropriations as a more effective means to assist lower-income families.means to assist lower-income families.

Conclusions Conclusions The author offers a framework for the re-regulation of investment The author offers a framework for the re-regulation of investment

banks and GSE with the overriding goal of minimizing the likelihood banks and GSE with the overriding goal of minimizing the likelihood of future losses on risky portfolios posing a systemic risk requiring a of future losses on risky portfolios posing a systemic risk requiring a governmental bailout.governmental bailout.

Key Feature – Risky portfolios (hedge fund divisions or activities) Key Feature – Risky portfolios (hedge fund divisions or activities) are isolated from the activities that create systemic risk are isolated from the activities that create systemic risk (Infrastructure divisions).(Infrastructure divisions).

Investment banks are already operating as a part of bank holding Investment banks are already operating as a part of bank holding companies, therefore the only real change is the isolation of the companies, therefore the only real change is the isolation of the capital of the infrastructure division be bankruptcy remote from any capital of the infrastructure division be bankruptcy remote from any possible failure of the overall holding company. possible failure of the overall holding company.

GSE implication are more severe – MBS securitizations become a GSE implication are more severe – MBS securitizations become a governmental agency while retained portfolios go to the GSE governmental agency while retained portfolios go to the GSE shareholders functioning without government support. shareholders functioning without government support.