To a Conference on the Liquidity Crunch At the UCLA - Anderson School of Management Los Angeles, CaliforniaNovember 13, 2007
Thank you, Stuart [Gabriel]. It's good to be here – and only in part because my daughter is a Ph.D. candidate in the Cal system. I particularly want to thank Richard [Roll] for organizing this timely forum and inviting me. As soon as my assistant told me who the invitation was from, I asked just one question: "Which flight can you get me on?"
That’s all the Irish blarney you’ll hear from me today. I will be as candid as I can, given the constraints facing a highly-regulated entity that’s always under the political microscope.
These have been tough times in the mortgage industry and volatile times in the broader financial markets. Markets are better than anything else but they are not perfectly efficient. We face a situation where the market mispriced risk for a considerable period, and allowed a lot more risk to end up in a lot more places than it should.
While some aspects of the credit crunch have eased, a lot of damage has been done and many markets are still fragile. The spread between jumbo and conforming mortgages blew out to four times its typical quarter point; now it’s fallen to about three or two times the norm. But that’s still unacceptable – especially in high cost states like California, New York and where my accent is from, Massachusetts. Beyond that, the subprime issue ended up being the straw that broke the camel’s back on credit spreads that had been too tight. Investors remain leery of asset-backed securities because they don’t know if subprime dangers might be lurking there. The asset-backed commercial paper market became dysfunctional. The only part of the mortgage space working relatively normally is the conventional conforming market. That’s primarily the space in which Freddie Mac and Fannie Mae – both government-sponsored enterprises, or GSEs – pursue our mission of providing liquidity and stability to the markets. The spillover from all of this has been considerable, of course. Within the mortgage industry itself, roughly a quarter of the former top 25 lenders have been forced out of business, were acquired by other lenders, or have shut down their subprime operations.
In the broader economy, employment and consumer confidence have both been affected. GDP statistics show that the downturn in residential investment accelerated in the third quarter, subtracting a full percentage point from national GDP growth. I fear that drag may increase. Declines in home values in the coming year will reduce housing wealth and will likely impede consumer spending. Of course, the regional impacts are uneven, with high-cost areas like California – and Los Angeles in particular – being particularly exposed. According to the California Association of Realtors, sales of single-family homes are down 50 percent from a year ago. Various measures of house prices in the Los Angeles market show values significantly down from a year ago – and the decline is likely to continue. So those are among the many symptoms of a serious liquidity crunch. What were its causes?
One root cause has been widely noted: tight credit spreads due to a global glut of savings. But a major contributing factor has been much less remarked upon – the role of China. For the first time in modern history, the world’s largest emerging economy was a net exporter of both capital and, in effect, of labor.
A second cause was advances in technology and financial engineering that de-institutionalized the mortgage market. On the whole, these new tools and techniques have been a good thing. But here they also separated the origination decision from the investment decision. So in this instance, combined with other factors, they were part of some very bad outcomes – and also have complicated resolving the situation.
A third cause involved the age-old balance between fear and greed. After periods of relative stability, greed often prevails. It got to the point where some mortgage product could be originated for almost any applicant. Many of these mortgages had risky features, including large payment shocks upon reset. Essentially, if you made a mortgage, somebody would buy it.
All right, those were some of the key causes. What are some useful solutions?
It's important to acknowledge there is no silver bullet. Even if the entire system works perfectly going forward – including the political and regulatory components – the fact is we have a substantial housing inventory overhang, and it will need considerable time to be absorbed.
Still, there are useful things we can do. I’ll talk mostly from the perspective of the GSEs. Not because we are a panacea or a white knight or any such thing here. We've had our own problems but we must be part of the solution. I doubt there’s much disagreement about this.
Here’s some of what Freddie Mac has done to be part of the solution.
First, we raised standards – early. In February, we were the first investor to announce tightened lending standards to limit payment shock for subprime borrowers, and help ensure these borrowers can afford and keep their homes. The only subprime securities we buy today that are backed by short-term adjustable-rate mortgages have been underwritten to a fully-indexed, fully-amortizing level. This is consistent with a number of our other efforts to combat predatory lending and help families not only to buy homes, but to keep them.
Next, in April, we committed to purchase an incremental $20 billion in more consumer-friendly mortgages that will provide better choices for subprime borrowers. We began delivering on that commitment this summer. I’ll return to this in a few minutes.
We are also working hard to ensure there is no disruption in the supply of mortgage funds. For example, in August we offered needed support to the Alt-A market by providing a 90-day forward purchase commitment to certain lenders, which allows borrowers to "lock in" their rate.
Finally, we have consistently been at the forefront of efforts to help borrowers avoid foreclosure. This year, through September, we helped more than 33,000 families find alternatives to foreclosure that keep them in their homes. That brings our total of such workouts since the beginning of 2004 to almost 200,000.3
In the course of our efforts on the subprime problem, we've developed a greater understanding of this former backwater of the mortgage market. It can be roughly divided into three parts. The top group of subprime loans might have been eligible for prime credit but ended up in subprime. It may well be possible to "upstream" or refinance these into many of the prime or FHA loans available today. We're also finding a bigger role for the GSEs buying whole loans of this kind.
A second group of loans probably are legitimately in subprime, but could benefit from better subprime products – for example, loans with reasonable reset terms and better underwriting standards.
Finally, there’s the bottom group of subprime loans that may not have been repayable in any reasonable scenario unless house prices continued to escalate. Price inflation can bail out a lot of bad underwriting. For people in this bottom group, it may be better to be renters rather than homeowners at this point in the cycle. That used to be the norm. Meanwhile, issues of moral hazard aside, it’s in all of our interests to see this transition occur with as little harm to neighborhoods as possible.
Part of the problem is that subprime loans were doing a lot of work for which they were never intended. We must remember, subprime traditionally has been a niche market. In the mid-1990s, according to a Bear Stearns study, only 2 percent of subprime loans were for home purchase; and even by 2001, subprime comprised only about 5 percent of the overall market.4 Subprime historically was kind of an emergency bridge loan, equity product, primarily for refinance purposes. Only recently did it become a product for ordinary homebuyers and even investors to buy homes, such that from 2004 through 2006, almost half of subprime loans were for home purchase – and they accounted for about a fifth of mortgage originations overall.5
That kind of mission creep and outsized growth should tell us something.
The harsh reality is that as a society, we must stop looking almost exclusively to housing finance to solve the problem of housing affordability. When you consider the panoply of issues affecting the cost of housing – from supply side factors such as zoning and permitting to transportation to income inequality – it's very hard to conclude that the cost of money in the world’s most developed mortgage market is the root cause why we lack enough affordable housing. To the contrary, as Daniel Patrick Moynihan said, the basic problem with poor people is, they don’t have enough money.
I hope Americans will one day look back on the current downturn and remember that when housing is unaffordable, the answer can not lie solely in mortgage finance – adding ever more exotic mortgage products, eliminating tried and true underwriting standards, raising the risk of payment shocks.
Now, all of Freddie Mac's special efforts I mentioned a minute ago are a good thing and they are helping to cushion the negative effects on borrowers and communities. But I would argue that over time, it is the GSEs' everyday activities to carry out our mission that are making the greatest difference. And I would further argue that this is no accident – because this is the very kind of situation for which we were designed.
One reason Freddie Mac and Fannie Mae were created was to mitigate the impacts on the housing finance system of a liquidity crunch like this one. Clearly, the market is experiencing a flight to quality. At times like these, the GSEs provide stability to the housing sector by providing funds counter-cyclically to lenders.
That means that at the point in the business cycle when economic activity is contracting, Freddie Mac and Fannie Mae should increase their relative provision of funds to the mortgage market, and vice versa. In contrast, other mortgage investors make credit available pro-cyclically, such that fewer funds are available when they are most needed – as during a housing downturn. By acting counter to the business cycle, Freddie Mac and Fannie Mae should help reduce the depth of a housing recession and support credit flows during an expansion on an "as needed" basis.6
The various parts of our business work together to do this. Critics of our retained portfolio ignore the fact that it allows us to manage overall mortgage risk, not just mortgage credit risk. This lets us bring our skills at prepayment and interest rate risk management to bear, as well as our low funding costs. The retained portfolio lowers our cost of capital and allows us to keep mortgage rates relatively low, as suggested in some of Stuart Gabriel's research.7 It also significantly broadens our investor base and enables us to insource U.S housing finance from abroad – because GSE debt is more broadly appealing to foreign investors than mortgage backed securities or whole loans, both of which entail prepayment risk.
Equally important, the retained portfolio lets us diversify our risk exposure, especially in periods of great stress – like now.
A key benefit of the retained portfolio is that it helps us complete markets, as Professor Roll detailed in the Journal of Financial Services Research.8 And it is fundamentally a market instrument, allowing us to respond nimbly to market developments.
There seems to be a misperception that the GSEs' operations and our retained portfolios are infinitely elastic to political and policy demands. But the fact is, we are also shareholder-owned corporations, and there are points beyond which our business model simply cannot work on a sustainable basis. The retained portfolio is a market instrument that must continue to answer to market dictates, not solely political dictates, if we are to continue performing our mission.
And how is that mission going, in terms of the subprime crisis? In fulfillment of the $20 billion commitment I mentioned earlier, by the end of this year we will have purchased over $30 billion of loans from credit-challenged borrowers, many of whom likely were in the subprime market in the past. This $30 billion figure includes not only purchases into our SafeStep subprime product, but also refinancing into our standard offerings, such as our targeted affordable offering, Home Possible.
This doesn't solve the whole subprime problem – not by a long stretch – and our efforts will continue. But it does represent meaningful progress. And the 33,000 workouts instead of foreclosures this year that I mentioned are helping the overall housing situation as well.
I want to mention one other helpful aspect of Freddie Mac's routine functioning these days – namely, our securitization activities.
By providing a corporate guarantee, Freddie Mac's mortgage backed security provides an active, useful guarantee very different than a private label, asset-backed security. The private label instrument in today’s market seems like a structured security having almost the characteristics of a story bond. Today, people aren't buying the story – or if there's a story involved they don’t even want to hear it.
So in this time of uncertainty, by providing a solid corporate guarantee, our securitization activities are in themselves a very useful thing. We've had to bear some added credit risk to be as active as we’ve been during this period. But it has helped the conforming market remain orderly, and it’s been the right thing to do for our mission.
At a time of elevated risk like this, a liquidity premium is to be expected. And of course, we don't want to suppress the market price for risk. One healthy aspect of this liquidity crunch is that it's been part of a widespread reassessment of the pricing of risk. Where to draw the line is a judgment call. But again, no one wants the GSEs to play any role in artificially reversing or suppressing the price of risk.
I want to mention loan limits, because this is a topic especially germane for this forum. There’s been a great deal of discussion back in Washington of letting the GSEs buy loans larger than the current limit of $417,000.
Again, there's obviously no move that will solve everything. But the basic principle is unassailable. At ordinary times, the spread between conventional and jumbo loans is about a quarter point. As Professor Roll has written, that’s one sign of the efficiency of the GSE part of the market. At the worst of the recent crisis, the spread quadrupled to a record of about 100 basis points; now it’s closer to double, at 50 to 60 basis points.
It makes no sense to assume that housing costs are the same throughout the contiguous United States. For example, in a high-cost state like California, the median home price in August was more than $150,000 above the conforming loan limit.9
What this means is simple. The housing crunch here will be worse than it needs to be, because low-cost GSE financing will be less available here.
I’ll end with a brief word on the mortgage market's direction.
The market is coming back today to the long-term, fixed rate, prepayable mortgage – what I call "the American Mortgage." And I must say, I think that's a good thing, and not only because it’s what the GSEs finance best. This kind of lending has a host of advantages for families and our nation. For example, recent research for the UK Treasury and the IMF shows that such fixed-rate lending makes a nation’s economy less prone to boom and bust.10
The GSEs are a key reason why the U.S. is the only major economy where this type of mortgage is prevalent. And it remains the revealed preference of a high proportion of American families. Together with access to second mortgages, it provides much of what consumers need to make their life cycle optimization decisions. So I find the fact that borrowers and lenders have moved back in this direction to be a heartening development.
In closing, I'll repeat once more that Freddie Mac is not the whole solution. We've been far from perfect and we have a lot left to do. But given the serious liquidity and credit concerns still disturbing the markets today, we need to put the past behind us and all focus on what each of us, including the GSEs, can do to stabilize the markets and give Americans the future they deserve.
