Wall Street investment banks and mortgage bankers seem poised to get what they want in housing finance reform – at the expense of taxpayers.
When firms compete for government subsidies and regulatory advantages, economists call it “rent seeking.” As Washington considers how to replace Freddie Mac and Fannie Mae in the mortgage market, we can expect the policy process to be dominated by rent-seekers. That is how it has been for generations.
Who will win the battle to get the most favorable subsidies and regulations? At this point, all signs point to victory by two of the biggest culprits in the mortgage crisis — the mortgage bankers (firms that originate loans to distribute, not to hold) and the Wall Street investment banks. Both depend on securitization if they are to participate in the mortgage lending process.
However, securitization has only been able to compete with traditional bank lending when securities are backed by guarantees from the taxpayers and when bank capital requirements punish banks that hold their own loans.
Lessons from the S&L Experience
From the end of World War II until the late 1980s, mortgage lending in the United States was dominated by the savings and loan industry. The S&Ls, particularly the large California thrifts, were formidable players in the rent-seeking game. Interest rates on consumer deposits were regulated and the California thrifts rigged the system by making sure that in competing for those deposits, they were permitted to pay slightly higher interest rates than banks.
Another feature of the regulatory landscape in those days was the prohibition against interstate banking. As a result, states such as California, where housing needs were growing faster than available savings, were short of mortgage funds, while other states, such as New York, had more savings than they needed to meet the demand for mortgages. To get around this, Congress chartered Freddie Mac in 1970, which created a “secondary market” in mortgages, allowing California thrifts to sell packages of mortgages as securities to investors outside of the state. The California S&Ls could then use these outside funds to expand their in-state mortgage lending.
However, the regulatory advantages of the thrifts would soon be taken away. The bond trading firms on Wall Street saw an opportunity to wrest the vast mortgage market away from the S&Ls, and their lobbyists and financial wizards went to work.
No Ceilings for Wall Street
One of their first innovations, the money market fund, was invented in 1971. Once regulators permitted this novelty, Wall Street had an advantage in attracting consumer savings because banks and S&Ls remained subject to interest-rate ceilings while Wall Street did not.
As the inflationary decade of the 1970s unfolded, S&Ls began to suffer large market losses on their fixed-rate mortgage assets. They could not fund their portfolios with deposits because of disintermediation. (Disintermediation means that savers put their funds in money market funds rather than banks and thrifts. Disintermediation was particularly dramatic in the 1970s, because the money-market funds had the advantage of having no interest-rate ceilings.) Nor could the S&Ls sell their loans to raise cash because doing so would have forced them to recognize losses, which in turn would have forced their regulators to shut them down.
In the early 1980s, the regulators wanted to keep the S&Ls in business, so they agreed to a solution that brought Wall Street further into the game. Freddie Mac and Fannie Mae agreed to do “swaps,” in which an S&L exchanged a pool of mortgages to, say, Freddie Mac, in return for a security backed by those same mortgages. The S&L then used the security as collateral to borrow via Wall Street in order to stay in business.
The key to the whole “swap” transaction was a regulatory ruling that the S&Ls did not have to mark their securities to market. So if a thrift had originated $100 million in mortgages that were now worth only $50 million, it was allowed to “swap” the mortgages for a security that it could value at $100 million, even though the market price for that security would be only $50 million. The Federal Home Loan Bank Board made this generous ruling because it did not want to close all of the bankrupt S&Ls. While the ruling was obviously a big win for the S&L’s, the “swaps” also generated nice fee income for Freddie Mac, Fannie Mae, and the investment banks. The ultimate losers were the taxpayers, as eventually the S&Ls became so insolvent that at the end of the 1980s a massive bailout was required.
Enter Fannie and Freddie
The 1990s saw Freddie and Fannie come to dominate the mortgage market. They also became dominant figures in Washington by expertly playing the rent-seeking game. They and their friends on Wall Street obtained favorable tax treatment for esoteric mortgage security instruments, known as real estate mortgage investment conduits (REMICs), separate trading of registered interest and principal of securities (STRIPs), and collateralized mortgage obligations (CMOs).
Wall Street wanted to get as much of the mortgage market as it could. From their point of view, the problem with Freddie and Fannie was that those enterprises held too many securities permanently in their own portfolios, depriving Wall Street of the profits that could be obtained by having the securities trade frequently in the money market. However, it was very difficult for Wall Street firms to sell any mortgage securities that lacked the Freddie or Fannie label, which investors treated as tantamount to a government guarantee.
During the subprime mortgage boom, Wall Street came up with the collateralized debt obligation, or CDO, which allowed them to market mortgage securities without a government guarantee. The trick was to create “tranches” that were so well protected against default that they could earn AA and AAA ratings from credit rating agencies. It was these tranches, backed by extremely low-quality subprime loans, that were at the heart of the financial crisis. Ironically, by 2006 and 2007, Freddie and Fannie had decided to buy their way into this market, and so they suffered some of the worst losses from low-quality mortgages.
Wall Street Wants, Gets
As usual, Wall Street needed favorable regulatory rulings in order to get its subprime machine rolling. What was most important was that bank regulators tilted capital regulations in favor of highly-rated securities. As a result, the capital requirements for a bank holding a very safe mortgage where the borrower had made a down payment of 30 percent were more onerous than those for a bank holding a CDO tranche backed by the most dodgy subprime loans with low down payments, as long as the issuer of the security could find a rating agency willing to confer its AAA blessing on that tranche. The tilt away from originate-to-hold and toward originate-to-distribute was a matter of what even public officials termed “regulatory capital arbitrage.”
For Wall Street, the ideal situation is one in which taxpayers provide a guarantee that makes mortgage securities viable, banks remain hamstrung by capital requirements that penalize them for holding loans that they originate, and the government enterprise that supplies the guarantee is not permitted to have a portfolio of securities, the way Freddie Mac and Fannie Mae have operated.
Today, the housing finance reforms that have the most bipartisan support appear to do exactly what Wall Street wants. They create a new government agency to guarantee mortgage securities. They do nothing about the perverse capital requirements that penalize banks that originate safe loans while rewarding banks that hold securities backed by dodgy loans. They ensure that mortgage securitization, which has never demonstrated an ability to compete on a level playing field in the market, will continue to dominate the American mortgage market.
Whenever this system suffers its next crisis, taxpayers will be delivering the bailout. The mortgage bankers and Wall Street firms win. You lose.
Arnold Kling ([email protected]) is a member of the Mercatus Center’s Financial Markets Working Group at George Mason University. This article reprinted from The American magazine, a publication of the American Enterprise Institute at www.american.com.