“…although the private securitization system challenged Fannie and Freddie during these years, the NTMs (nontraditional mortgages) securitized by the private sector were only 24 percent of the NTMs outstanding in 2008, showing that the PMBS (private mortgage-backed securities) and the financial institutions that held them were not the major source of the bubble or the crisis.”, Peter J. Wallison

“With all the new buyers entering the housing market because of the (government’s) affordable housing goals, together with loosened underwriting standards the goals produced, housing prices began to rise….Housing bubbles tend to suppress delinquencies and defaults……in these conditions, potential investors in mortgages and mortgage-backed securities receive a strong affirmative signal; they see high-cost mortgages…..but the expected number of delinquencies and defaults has not occurred. They come to think that “this time it’s different,” that the risks of investing in subprime or other weak mortgages are not as great as they thought…..These factors brought many new investors into the market, looking to invest in securities backed by NTMs (nontraditional mortgages). These were private mortgage-backed securities (PMBS) which were securitized and sold by commercial banks, investment banks, subprime lenders, and others. Although never before a large part of the mortgage market, PMBS, much of them backed by subprime and Alt-A mortgages, became a booming business, especially from 2004 through 2006, as private securitizers discovered ways to compete with securitizations by Fannie and Freddie. Still, although the private securitization system challenged Fannie and Freddie during these years, the NTMs (nontraditional mortgages) securitized by the private sector were only 24 percent of the NTMs (nontraditional mortgages) outstanding in 2008, showing that the PMBS and the financial institutions that held them were not the major source of the bubble or the crisis…..In 2002, the Basel rules were changed so that highly rated PMBS required only 1.6 percent capital, making PMBS even less costly in terms of capital than whole mortgages and high-quality corporate loans. This equalized the treatment of GSE and private mortgage-backed securities that were rated AAA or AA. These regulations encouraged banks to favor the acquisition of PMBS, which made them particularly vulnerable to the decline in housing and mortgage values that occurred in 2007 and 2008. If the Basel rules had not put the regulatory thumb on the scale, pushing banks in the direction of residential mortgages and PMBS, the consequences of the housing value collapse would have been much less significant for the world’s economy than it turned out to be. Score this as another unforced error for the government’s role in the financial crisis.”, Peter J. Wallison, Hidden in Plain Sight

Part Two: Key Excerpts from the Introduction of Peter J. Wallison’s: Hidden in Plain Sight: What Really Caused The World’s Worst Financial Crisis And Why It Could Happen Again:

“With all the new buyers entering the housing market because of the affordable housing goals, together with loosened underwriting standards the goals produced, housing prices began to rise. By 2000, the developing bubble was already larger than any bubble in U.S. history, and it kept rising until 2007, when….at nine times larger than any previous bubble….it finally topped out, and housing prices began to fall.”

“The shock to the market (economist Hyman Minsky’s bubble theory) in the case of the 1997-2007 bubble was the newfound and strong interest by Fannie and Freddie in NTMs (nontraditional mortgages), beginning in 1993. The GSEs’ demand, pressing against the existing supply, created new profits for subprime lenders, as well as Realtors, homebuilders, and banks.”

“Minsky also posited that there must be a continuing injection of new funds in order to maintain the necessary euphoria. The gradual increase in the affordable-housing goals and the growing size of Fannie and Freddie as financing sources appear to satisfy this requirement between 1997 and 2007, accounting for the continued growth of the bubble.”

“Figure 1.3 shows that between 1983 and 1997 the trend in home prices tracked rental values as calculated by the Bureau of Labor Statistics (BLS). Then, beginning somewhere between 1995 and 1998, home prices began a sharp rise.”

“If a potential buyer has a down payment of $20,000, he or she could buy a $200,000 house if the required down payment is 10 percent. But if the required down payment is 5 percent, as it quickly became after the adoption  of affordable-housing goals, the same buyer could buy a $400,000 house. In this way, lower down payments made much more credit available for mortgages and thus enlarged the market for more expensive houses.”

“The principal beneficiaries of these policies were Realtors, and they joined the community activists as cheerleaders for lower underwriting standards. The principal victims, in addition to the taxpayers, were the low-income homebuyers who lost their homes when the inevitable recession arrived.”

“Housing bubbles tend to suppress delinquencies and defaults while the bubble is growing.”

“In these conditions, potential investors in mortgages or in mortgage-backed securities receive a strong affirmative signal; they see high-cost mortgages…..loans that reflect the riskiness of lending to a borrower with a weak credit history…..but the expected number of delinquencies and defaults has not occurred. They come to think that “this time it’s different,” that the risks of investing in subprime or other weak mortgages are not as great as they thought.”

“At the same time, Fannie and Freddie were arguing that the automated underwriting standards they had developed allowed them to find good mortgages among those that would have been considered subprime or Alt-A. For example, in a 2002 study, Freddie Mac officials reported: “We find evidence that AU (automated underwriting) systems more accurately predict default than manual underwriters do. We also find evidence that this increased accuracy results in higher borrower approval rates, especially for underserved applicants.” The superiority of new technology, rather than the existence of a bubble, was thus used to explain the lower rates of default observed in the market.”

“These factors brought many new investors into the market, looking to invest in securities backed by NTMs (nontraditional mortgages). These were private mortgage-backed securities (PMBS), also called private label securities, or PLS, which were securitized and sold by commercial banks, investment banks, subprime lenders, and others.”

“Although never before a large part of the mortgage market, PMBS, much of them backed by subprime and Alt-A mortgages, became a booming business, especially from 2004 through 2006, as private securitizers discovered ways to compete with securitizations by Fannie and Freddie. Still, although the private securitization system challenged Fannie and Freddie during these years, the NTMs (nontraditional mortgages) securitized by the private sector were only 24 percent of the NTMs outstanding in 2008, showing that the PMBS and the financial institutions that held them were not the major source of the bubble or the crisis.”

“Housing bubbles are also by definition procyclical. When they are growing they feed on themselves to encourage higher prices, through higher appraisals and other mechanisms, until the prices get so high that buyers can’t afford them no matter how lenient the terms of a mortgage. But when bubbles begin to deflate, the process reverses. It then becomes impossible to refinance or sell a house that has no equity; financial losses cause creditors to pull back and tighten lending standards; recessions frequently occur; and low appraisals make it difficult for a purchaser to get financing. As in the United States today, many homeowners suddenly find that their mortgage is larger than the value of the home; they are said to be “underwater.””

“This, of course weakens the banking system, with many banks left holding defaulted mortgages and unsalable properties. These banks are then required to reduce their lending in the hope of restoring their capital positions, which diminishes the credit available to consumers and business and impedes a recovery.”

“With the largest housing bubble in history deflating, and more than half of all mortgages made to borrowers who had weak credit, high debt ratios, or little equity in their homes, the number of delinquencies and defaults in 2008 was unprecedented. One immediate effect was the collapse of the market for private mortgage-backed securities. Investors, shocked by the sheer number of defaults that seemed to be under way, fled the market. Mortgage values fell along with housing prices, with dramatic effect on the PMBS market….”

“The abrupt fall in housing and mortgage values during 2007 had a disastrous effect on financial institutions, particularly banks. Since the adoption in the 1980s of the internationally agreed risk-based capital requirements for banks known as Basel I (after the Swiss city in which the bank regulators convened), mortgages had been a favored investment for banks. As outlined in more detail later, the initial capital rules known as Basel I treated mortgages and highly rated MBS as safer investments than commercial loans, requiring banks to hold less capital against a residential mortgage (4 percent) than they held against commercial loans (8 percent).”

“In 2002, the Basel rules were changed so that highly rated PMBS required only 1.6 percent capital, making PMBS even less costly in terms of capital than whole mortgages and high-quality corporate loans. This equalized the treatment of GSE and private mortgage-backed securities that were rated AAA or AA. These regulations encouraged banks to favor the acquisition of PMBS, which made them particularly vulnerable to the decline in housing and mortgage values that occurred in 2007 and 2008. If the Basel rules had not put the regulatory thumb on the scale, pushing banks in the direction of residential mortgages and PMBS, the consequences of the housing value collapse would have been much less significant for the world’s economy than it turned out to be. Score this as another unforced error for the government’s role in the financial crisis.”

“The effect of the decline in housing and mortgage values was also exacerbated for all financial institutions by accounting rules that, since 1994, had required financial firms to use what was called “fair value accounting” in setting the balance sheet value of their assets and liabilities. The most significant element of fair-value accounting was a requirement that financial institutions carry assets and liabilities at current market value instead of using amortized cost or other traditional valuation methods. This system worked effectively as long as there was a market for the assets in question, but it was destructive in the market collapse precipitated by the vast number of delinquent and defaulted mortgages during 2007. In that case, buyers fled the market, and the market value of PMBS plummeted. Although there were alternative ways for assets to be valued in the absence of market prices, auditors…..worried about their potential liability if they permitted clients to overstate assets in the midst of the financial crisis…..were reluctant to allow the use of these alternatives. Accordingly, as described in Chapter 12, financial firms were compelled to write down significant portions of their PMBS assets, taking operating losses that substantially reduced their capital positions.”

“Moreover, because most PMBS held by financial institutions were rated AAA, they were used by many banks and other financial firms for short-term collateralized borrowing through repurchase agreements. Suddenly, no one wanted these securities as collateral, and many firms were left without sufficient liquidity to meet demands for cash by customers and creditors.”

“The asset write-downs and the liquidity constraints created great anxiety among market participants, who did not know whether the affected firms were solvent or insolvent. The Federal Reserve adopted a number of programs to provide liquidity to banks and some investment banks, but while that allowed them to meet some withdrawals, it did nothing to improve their capital positions or compensate for their operating losses.”

“Through the early part of 2007 and into early 2008, the news was uniformly frightening for investors and creditors. Formerly healthy firms that held large portfolios of PMBS were illiquid or insolvent and were declaring bankruptcy. On August 9, 2007, BNP Paribas, a major French bank, suspended redemptions from funds it was managing because it could no longer be sure of the value of the PMBS assets that the funds were holding. This event shook the market and caused a sharp rise in indicators or market unease. Still Ben Bernanke, the chair of the Federal Reserve, and Henry Paulson, the U.S. treasury secretary, continued to assure markets that the problem of subprime mortgages was manageable and the current troubles only temporary. In substantial part their position was the result of the fact that neither they nor anyone else outside of the GSEs knew that Fannie and Freddie had not disclosed their NTM (nontraditional mortgage) holdings in full.”

“In March 2008, however, Bear Stearns, the smallest of the five major Wall Street investment banks, was unable to fund it operations; it had lost the confidence of the market and was bleeding cash. Paulson and Bernanke were forced with a choice between letting Bear Stearns fail or taking extraordinary steps to rescue it. They chose the latter. Bear Stearns was sold to the giant bank JPMorgan Chase with the Federal Reserve providing $29 billion in financial support as an inducement to the acquiring bank. This was a fateful move.”

Posted on February 4, 2015, in Postings. Bookmark the permalink. Leave a comment.

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