Understanding the US housing boom

At the centre of the global financial crisis was a housing boom and bust in the U.S. A New York University team has looked at the flaws in the design of U.S. housing finance that opened the door for the mayhem that followed. A column at VoxEU.org describes the race to the bottom that occurred among Fannie Mae, Freddie Mac, and the too-big-to-fail private financial institutions.

In their article, A race to the bottom: Understanding the US housing boom, Viral Acharya, Matthew Richardson, Stijn Van Nieuwerburgh and Lawrence J. White argue that

There was, during 2003-7, a race to the bottom between the huge government-sponsored enterprises (GSEs) – Fannie Mae and Freddie Mac – and the private financial sector, consisting of too-big-to-fail large complex financial institutions. Both the GSEs and the too-big-to-fail institutions were making highly leveraged bets on the mortgage market at below-market funding rates in credit markets that were implicitly backed by the government.

The U.S. mortgage market changed dramatically starting 2003:

The mortgage market in the US increased dramatically in size, especially starting late 2003 with the sharp growth of the riskier subprime and Alt-A mortgage lending [ ... ]. Since the too-big-to-fail institutions couldn’t compete directly with Fannie and Freddie because of the GSEs’ access to government guaranteed capital and their roughly 40 basis points lower cost of borrowing, they instead moved along the credit curve, dealing in increasingly shaky mortgage loans that the GSEs had difficulty competing with given the walls, even if somewhat porous, around their underwriting standards. Also, the too-big-to-fail institutions greatly increased their leverage, through use of asset-backed commercial paper and sale-and-repurchase (“rep”) financing, allowing them to expand by issuing cheap debt.

The too-big-to-fail firms were not only creating more toxic mortgage-backed securities but also investing in those same securities. Over 50% of AAA-rated non-GSE mortgage-backed securities were held within the financial sector!

The Acharya, Richardson, Van Nieuwerburgh and White column continues,

This growth in private label mortgage-backed securities was the culmination of the dream of the 1982 “Commission on Housing”. It did, however, have an important and unintended consequence that what would have caused great consternation to that Commission: it encouraged the GSEs to take on riskier portfolios too in order to prevent their market share from being eroded by the private sector too-big-to-fail institutions.

It is instructive to note that the Fannie and Freddie share of the mortgage market rose shapely beginning 2005. This was in contrast to the sharp fall in the preceding years when they lost market share to private label mortgage-backed securities.

Before 2003, as a fraction of their total mortgage-backed securities portfolio, each year the GSEs purchased approximately 10% in lower-quality loans. For the period from 2004 to 2007 this fraction saw a shape increase, averaging 50%.

While there is little doubt that, starting in the mid 1990s, government-mandated affordable housing goals played an important role in shifting Fannie and Freddie’s profile to riskier mortgage loans, it is an interesting question as to how much of the GSEs’ steeper dive into lower-quality mortgages was driven by those mandates and how much by their desire to maintain and expand their market shares.

Acharya, Richardson, Van Nieuwerburgh and White's conclusion:

The bottom line is that it is not possible to fix the US housing finance without dismantling the GSEs in a phased manner and removing their impact on housing markets, lest another race to the bottom emerge in due course once benign conditions return and capital and credit more readily available. However, it is pie in the sky to believe that systemic risk will not exist in the mortgage finance market once the GSEs leave this world. Too-big-to-fail institutions will gradually build up this risk on their balance sheets. It is unavoidable. As a result, it is crucial that the external costs of systemic risk are internalised by each of these firms, or we will end up with an alternative group of private GSE-financial firms in the mortgage finance area. The Dodd-Frank Act in the US, even if imperfect, serves as a useful step in the direction of focusing regulatory attention on systemic risk contributions of the private financial firms.

and

[ ... ] when governments run their own banks badly in good times, they crowd out private banks and thereby encourage them to take greater risks. A secular credit boom and bust must follow. The seeds of such a new cycle are currently being sown.