Schizophrenia on Leverage
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The Obama Administration believes the surest way to ensure the long-run stability of the financial system is to reduce leverage at financial intermediaries and tightly regulate risky mortgage products. Yet the Administration also believes the best way to address near-term difficulties in the financial system is to increase the availability of leverage for the purchase of speculative assets and to provide hundreds of billions in financing for risky mortgage products. The logical contradictions in this approach are emblematic of the larger challenges this administration and the Federal Reserve face as they strive to rejuvenate the housing market and the financial system.
In March, the Administration released a plan to rescue the financial system premised on the belief that asset prices were depressed because investors could not obtain “private financing on reasonable terms to purchase these assets.” The idea was that certain asset-backed securities (ABS) and their derivatives were trading at such low prices not because of a deterioration in credit quality, but because leverage was no longer available. At the same time, the deflation in housing prices was partly blamed on the newfound prudence in underwriting standards. The response was to use the Federal Housing Administration (FHA), Fannie Mae*, and Freddie Mac to extend the kinds of low-down payment loans the private sector was no longer willing to make.
It’s one thing for the government to step in for the private sector as a lender of last resort to prevent economic collapse. But if prices depend on leverage, as is assumed by these initiatives, then how can leverage ever be removed from the system without resulting in a collapse in prices? For example, when the minimum down payment is 5%, a household can leverage its savings 20 times to buy a home. However, if this household later seeks to sell its house in a “deleveraged” world where capital standards are higher and the minimum down payment is 20%, a prospective buyer would need four times as much savings to make the purchase. The decline in leverage necessary for long-run stability would virtually guarantee that the household could never sell the house for the same price it paid for it.
The same would be true for the holders of financial assets. Most of the leverage used by banks and other financial firms to finance securities comes through repurchase transactions (repos). In a repo, a bank sells an asset today for a price below its market value in exchange for a promise to repurchase it in the future. The difference between the market value of the asset and today’s sale price is called the “haircut.” The “haircut” could be thought of as the “down payment” on the asset; if the haircut is 2%, the investor can leverage each dollar it has 50-times. As with the housing example, the increases in haircuts necessary to de-lever the system would also prove disastrous for the current holders of these securities.
According to the Federal Reserve Bank of New York, from April 2007 to August 2008, the haircut on the ABS at the center of the recent financial market turmoil increased from 5% to 60%. Institutions that had used $250 million to acquire $5 billion in ABS suddenly needed to come up with an additional $2.75 billion to meet the new 60% haircut. Lacking the liquidity to make such a “down payment,” banks and other institutions tried to sell these assets en masse, causing their prices to fall precipitously and forcing the Federal Reserve to begin lending against these assets to prevent a financial collapse.
In both the home mortgage and repo markets, acceptable leverage levels reflect creditors’ views of the riskiness of the assets being financed. As Keynes observed in 1931, the amount creditors are willing to lend against an asset depends on their assessment of what “margin” is sufficient to ensure that the market value of the asset does not fall below the face value of the loan. When creditors believed that house prices would increase by at least 5% per year** low down payment loans seemed reasonable; similarly, low haircuts on repos made perfect sense when the ABS collateral was thought to be AAA. But when house prices began declining by over 10% per year and more than 30% of the loans supporting ABS defaulted, the old leverage ratios made no sense at all.
By stepping in to provide the leverage for mortgages and speculative purchases that a chastened financial system would not, the Obama Administration chose to reflate asset prices rather than recapitalize the institutions holding those assets. As a stopgap measure, this was a reasonable enough policy choice. But the key distinction is that it does not advance the long-term goal of households and financial institutions becoming better capitalized. * See page 109 of the PDF, which is page 99 of the filing. It shows over 1% of Fannie’s loans (about $30 billion) are part of the Obama Administration refinancing program. When coupled with Freddie’s similar programs and FHA’s 1.75 million loans, this totals an amount that is well into the tens of billions.** See page 50. Every 2 year period had rolling price appreciation of 10% or more.