Lawrence Summers: This Is Where Fannie and Freddie Step In

Larry Summers looks at three questions arising from the current financial crises, and in response to the third says it's time for Fannie Mae and Freddie Mac to step in and help solve the problems we are having in mortgage markets:

This is where Fannie and Freddie step in, by Lawrence Summers, Commentary, Financial Times (free): ...Financial crises differ in detail but, ... they follow a common arc.

First there is a period of overconfidence... Second, there is a surprise that leads investors to seek greater safety. In the current case it was the discovery of huge problems in the subprime sector and the resulting loss of confidence in the ratings agencies. Third, as investors rush for the exits, ... risk analysis shifts from fundamentals to investor behaviour. As some investors liquidate their assets, prices fall; others are in turn forced to liquidate, further driving prices down. The anticipation of cascading liquidations leads to more liquidations creating price movements that seemed inconceivable only a few weeks before. The reduced availability of credit then has a negative effect on the real economy. Eventually ... there is enough price adjustment that extraordinary fear gives way to ordinary greed and the process of repair begins.

Only time will tell where we are in this cycle. There have been some signs of returning normalcy over the past week, but we cannot judge whether they represent a false spring or the end of a crisis phase. ... The impact on consumer confidence and spending ... remains unknown.

While it is too soon to draw policy lessons, we can highlight questions the crisis points ... out.

First, this crisis has been propelled by a loss of confidence in ratings agencies... There is room for debate over whether the errors ... stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for their ratings and can shop for the highest rating. But there is no room for doubt that ... the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings? ... What, if any, legislative response is appropriate to address the ratings concerns?

Second, how should policymakers address crises centred on non-financial institutions? ... The problem this time is not that banks lack capital or cannot fund themselves. It is that the solvency of a range of non-banks is in question... Is it wise to push banks to become public financial utilities in times of crisis? Should there be more lending and/or regulation of the non-bank financial institutions?

Third, what is the role for public authorities in supporting the flow of credit to the housing sector? ... I am among the many with serious doubts about the wisdom of the government quasi-guarantees that supported the government-sponsored entities, Fannie Mae ... and Freddie Mac ... But surely if there is ever a moment when they should expand their activities it is now, when mortgage liquidity is drying up. No doubt, credit standards in the subprime market were too low for too long. Now, as borrowers face higher costs as their adjustable rate mortgages are reset, is not the time for the authorities to get religion and discourage the provision of credit.

This crisis could have a silver lining if it leads to the careful reflection on these vital questions.

Comments

[Bruce Webb]

I don't have any problem with having Fannie Mae and Freddie Mac announcing they will buy properly screened NEW loans, nor would I have problem with them sponsoring a program to restructure existing mortgages, but what Wall Street is pushing for is to dump some bad paper.

We have three fundamental problems. One there is a lack of liquidity to fund new loans, two there is a pool of borrowers that have loans that are either not performing or at grave risk of not performing, three we have a group of investors who did not fully understand what they were buying or were simply blinded by greed.

We can restore liquidity to the system, we can systematically refinance some loans. But we should not directly bail out investors and still less the firms that created and marketed these bastardized products to begin with.

There seems to be a determined effort to blur the distinction between firms like Countrywide which were in the business of making loans, and firms like Bear Sterns that were buying those loans and creating complicated securities by calling them both 'lenders'. Well in a way, but functionally they played different roles in the overall process.

[im1dc]

Larry Summers remarks struck me as very odd. I don't know and can't tell if they reflect his new Hedge Fund employer's POV or his own.

I want to believe he is tell us his true and honest analysis and Policy recommendations, but now I just don't now.

With Mankiw I know he is telling us from his heart, ditto Delong and Thoma.

Summers may be "talking his book" as they say on the Street.

UGH!

[Bruce Wilder]

Bruce Webb: "We have three fundamental problems. One there is a lack of liquidity to fund new loans, two there is a pool of borrowers that have loans that are either not performing or at grave risk of not performing, three we have a group of investors who did not fully understand what they were buying or were simply blinded by greed."

I'd say there is a fourth fundamental problem: lending institutions are actively preying on the middle class.

Mark Thoma provided a link earlier: this New York Times article on Countrywide lending practices is a real eye-opener.

There have been a lot of narratives floated about how the burgeoning sub-prime market was a product of naive or greedy speculation and the like, but the New York Times makes it clear that Countrywide was engaged in predatory lending.

[Lafayette]

LS: But there is no room for doubt that ... the ratings agencies dropped the ball.

Earth to Larry ...

Oh, it’s the “ratings agencies” that dropped the ball?

I rather thought it was the brokers who set-up clients and banks/credit institutions that approved the loans that were to blame.

Thanks, Larry, for getting enlightening us. Now, everyone can get back to offering loans to suckers who haven't enough good sense to understand that they can’t pay for them.

We'll make the credit rating agencies pay through the nose for the disruption in lives. That should cover about one millionth of the damages that are bound to occur.

Should there be more lending and/or regulation of the non-bank financial institutions?

Call Bernanke on this one. He’ll tell you that the Fed has all the authority necessary to supervise and regulate credit markets. Ask him, rather, why it was not being applied and whose watch was it when this negligence occurred.

Earth to Larry, earth to Larry … come in, Larry.

[ken melvin]

Passing strange the lack of mention of the homebuyer/owner. no? In re refinancing, Bruce the Wilder is right; there were all those assets just sitting there for the taking.

[Bruce Webb]

I don't doubt that Countrywide was over aggressive, on the other hand you can only push that so far, you are always at the risk of pushing the customer to another lender. People who didn't work through a broker they trust or check out multiple lenders are to some degree guilty of ignoring the solid principle of caveat emptor. Ditech spends a ton of ad money trying to make that point.

At this point I don't believe lenders have any legal fiduciary responsibilities to borrowers. Maybe that needs to change, but as far as I know they are in the same position of the person selling you a car, that is subject to various types of disclosure but in the end on the other side of the contract.

Predation exists certainly, I just don't know whether it is a fundamental problem. I do know all parties here want to come off as the victim as opposed to co-conspirator in what amounts to loan fraud.

[Lafayette]

BW: I do know all parties here want to come off as the victim as opposed to co-conspirator in what amounts to loan fraud.

Perp walks

Nothing will separate the wheat from the chaff, in this scandal, like a few "perp walks".

Both fraud was committed at the sales level and negligence in oversight by the Fed of the credit institutions selling the realty loans.

[Bruce Wilder]

Bruce Webb: "At this point I don't believe lenders have any legal fiduciary responsibilities to borrowers. Maybe that needs to change, but as far as I know they are in the same position of the person selling you a car, that is subject to various types of disclosure but in the end on the other side of the contract.

Of course, the devil is in the details, but I was actually shocked by some of the practices detailed in the N.Y. Times. You can say that people should use a broker they trust, but maybe they trusted the wrong broker.

I am an empiricist, when it comes to judging "market failure" and the need for regulatory oversight. If a practice wouldn't exist in a competitive market with rational and well-informed consumers, and it does exist, that's a market failure -- a regulatory intervention should be regarded as necessary. With the examples in hand, let the theorists figure out a remedy.

An institution the size of Countrywide is vastly better organized than any of their customers, and if they are, essentially, organized to fleece their customers -- that's a problem. Obviously, if they are able to grow into a multi-billion dollar entity while doing so, market competition and caveat emptor is not cutting it.

Just as one example of a Countrywide practice, I would regard prohibitory prepayment penalties on long-term loans, particularly loans with adjusting rates, as something that ought to be prohibited. That opens a door to a form of exploitation I can't stomach. (Of course, I am the kind of bleeding heart liberal, who wants to enforce usury laws, putting a ceiling on credit card interest.)

I don't know what the laws and court rulings on loan contracts permit, require or prohibit, beyond disclosure of terms. (Failure to disclose terms does not necessarily carry much of a penalty for an outfit like Countrywide, which is securitizing the mortgage, since the principle after-the-fact penalty for a truth-in-lending violation is subordination in the case of default.) But, common-law and UBC regulation of transactions is standard practice, so regulation of loan terms would be no big precedent. If we can regulate the terms offered by parking lots (yes, those "no liability" signs are total b.s.), we can regulate home loan lenders even more than we already do.

[Peter Schaeffer]

Bruce Webb,

“I don't have any problem with having Fannie Mae and Freddie Mac announcing they will buy properly screened NEW loans”

I agree, but what is the point? Properly screened new loans are quite saleable as it is. The mortgage market hasn’t frozen or dried up. Standards have risen. However, I don’t think anyone wants to return to the folly of the recent past.

“There seems to be a determined effort to blur the distinction between firms like Countrywide which were in the business of making loans, and firms like Bear Sterns that were buying those loans and creating complicated securities by calling them both 'lenders'.”

I disagree. Both Countrywide and Bear Sterns played their respective roles. Countrywide made loans based on inadequate documentation, high LTV ratios, poor FICO scores, etc. Worse, Countrywide did 2/28 ARMs and who knows what other junk mortgages. Bears Sterns bought the MBS based on these loans. Both are guilty of grievous financial malfeasance. Neither should get any help from the government.

“Well in a way, but functionally they played different roles in the overall process.”

Agreed.

[Peter Schaeffer]

Bruce Wilder,

I had some very personal exposure to the subprime lending market this year including New Century Financial (just before it failed). A very ugly business. I knew enough to recognize the trash these firms were offering. However, not everyone did/does.

Is a regulatory response warranted? In my opinion, yes it is. However, I also favor restoring state regulation of consumer interest rates. I voted against legalization of home equity loans when I had the chance (it passed).

In my view, the American economy is dangerously dependent on household debt. Others disagree.

[dd]

We're at Gettysburg and the issue is whether the credit markets can withstand the losses and the banks can act as shock absorbers. Geithner warned us of this and he seems to have a plan. So, forget Freddie and Fannie. My money is on Geithner's ability to negotiate a cease fire.

[dd]

Then again, paine had a different bet:
"i see
a dead zone next time
so big and so fast
a while still solvent and still operating rescue
will be
" practically" impossible
financial infrastructure"

[bruce webb]

Peter S

Well I have to disagree. Lots of the smaller lenders had access to all funds cut off, no matter what the quality. The mortgage market has frozen many places,

Bruce Wilder

Prepayment penalties are a feature and not a bug. They serve the same basic function as points, you lower the cost of credit by paying a lump sum. They just happen to come within the term of the loan. Without prepayment loans with initial low rates wouldn't exist. People think all 2/28s are inherently predatory. Well they aren't, in the right circumstances they are a valuable tool. Rarely would they make sense for the average homeowner and given that most of these products are ostensibly limited to owner occupied the likelihood is pretty high that any given 2/28 is fraudulent but chances are pretty good the fraud is on the borrower end, a real estate investor masquerading as a sub prime borrower to maximize leverage in a hot market. In a bubble market the prepayment is just part of the transaction cost to extract the equity. For a speculator the key is to lower carrying costs during the loan term, prepayment penalties are just part of the price of playing the game. Stated/stated works the same way in many of the cass the borrower is more perp than victim.

I spent a pretty short time in the industry: july 2006 to mar 2007 but it was an eyeopener and perfectly timed to see all this unravel close up.

[Jeopardy]

No way! Those GSEs are grossly under-capitalized. If not for the backing from our govt, they would have been rated much lower than AAA. Asking them to take on more loans is just transferring the risk to tax payers, and setting up the stage for a bailout.

[dd]

GSE's can't even unwind the derivatives enough to get a decent financial statement together. But no problemo as the accounting industry has decided to enshrine myth as reality. See FT's "Pursuit of Convergence is coming at too high a cost":
Under SFAS 157 & 159 "....financial instruments (including mortgage-backed-securities) are stated on balance sheets at their "fair" values, which are taken from markets where possible, or for more complex securities are estimated from valuation models." http://tinyurl.com/2on2q9
The dog is chasing it's tail.

[calmo]

Following dd's remarkBut no problemo as the accounting industry has decided to enshrine myth as reality. and wondering if that transition (myth -> reality) is just a decision or 2...or whether it is the business of the bean counters to certify (pronounce over and above what your old (aging...half blind...you cannot even read this can you?) eyes are telling you) what is "fair value", or more to the point, "market value" --especially in those 'dead zones' to use paine's phrase.
We are used to certification bodies to ensure that our melamine is not contaminated with dog hair...and now that the sky is turning a violet shade we look for that stamp that says 'the sky is blue'...those dare devil accountants provide it with gusto.
Frankly, any other course is bad for business...that would be increasingly their's, no?

[Lafayette]

From the NYT article "Countrywide lending practices"

Famous last words:

Now, with the entire mortgage business on tenterhooks and industry practices under scrutiny by securities regulators and banking industry overseers, Countrywide’s money machine is sputtering.

I particularly like this bit: "Now, with ... industry practices under scrutiny".

In this nation of intelligent people, where was "before"? Waiting to happen, whilst everyone was celebrating those making a megabuck?

This mess was bound to happen in any country on earth where the "ends justify the means".

Hello America!

[dd]

Welcome back calmo; miss your prose. Hope all is well.

[calmo]

And a pleasure to read you too, dd.
Now, what have you done with paine?

[dd]

don't know
awaiting his insights
but have kept track and can post
the past as present
until a reappearance
otherwise my sad imitation
must suffice

[Lafayette]

PS: In my view, the American economy is dangerously dependent on household debt. Others disagree.

Thanks for identifying the problem. (Somehow I doubt it's news, however.) Now have a try at the solution?

Like children, America has been traipsing to Wal-Mart (et al) for decades to lap up cheap products from a country that continues to loan us the money to indulge in our addiction. (Imagine South American Drug Kings lending Americans the money with which to buy narcotics. The scenario is analogous.)

What is your solution to this addiction? No administration in the past fifty years has been able to resolve the problem by which Americans save too little and spend to much.

We raise unilaterally tariffs against Chinese goods? We devalue the dollar against the renminbi? We continue uselessly jawboning them to revalue the renminbi? We nuke China back to the Stone Age?

Any suggestions ... ?

[Lafayette]

laf: Any suggestions ... ?

I thought not. Just complain, complain, complain.

Complaining is the easy part, boys and girls. Proposing solutions is the hard part.

[dd]

Easy to get Americans to save. Give tax-free interest on savings accounts. Americans love tax avoidance.

[Lafayette]

dd: Give tax-free interest on savings accounts. Americans love tax avoidance.

Can't get no ... satisfaction

Total taxation as reported in GDP (yes, taxation IS reported in the GDP) in the US represents a tad less than 30%. In European countries it is as high a bit more 50% and rarely lower than 35%. The Irish, bless them, come in at 31%. The Value-Added-Tax alone represents about 20% uniformly across Europe. (Go here to see the entire list.)

So, pray tell, whatever can the Yanks be complaining about? Or is it that they can't get no satisfaction, as the song goes.

Maybe they're looking in the wrong places? (Snicker, snicker ...)

[dd]

Laf, the issue is savings not sex.
As to European taxation it is irrelevant. The question posed was what will get Americans to save. No income tax (federal or state) on FDIC insured accounts will find Americans pouring money into accounts. Eliminate the capital gains giveaway and even more money will find it's way into traditional savings.
The tax structure penalizes traditional savings, encourages consumption and equities investing. Change incentives and change behavior.

[Lafayette]

dd: Laf, the issue is savings not sex.

Which is why I live in France ...

You guys got it ALL wrong, wrong, wrong! ;^)

[dd]

hahahhaaaa
so you think!

[dd]

you posed the question Laf
and that says it all

[dd]

;)

[Lafayette]

dd: No income tax (federal or state) on FDIC insured accounts will find Americans pouring money into accounts.

Ok, let's look at this supposition, because I am not convinced of it.

You are supposing that "financial incentives" are sufficient to change American behaviour as regards savings. I doubt that seriously. There are two countervailing factors at work.

Savings (in the traditional sense of the word, that is, savings accounts) have undergone a fundamental morphing. Americans are indeed incentivized by ROI and have turned from savings accounts to equity markets for the higher-but-riskier return than lower-but-riskless savings accounts or even money-market rates.

The second factor is the exaggerated propensity to use credit for immediate consumption. Americans don't spend wisely, that is, save-to-spend -- so they get themselves into serious debt.

This latter factor has made highly fragile their financial wherewithal to sustain debt and, at the slightest change in personal revenue, they are tipped into insolvency.

The irony of the situation is that it is not constrained to the poor. Indications are that even the relatively well-off incurred important debt to benefit from realty asset revaluations (i.e., the realty bubble). Perhaps they thought intermediate loans -- that they could pay out of income -- would suffice until they resold the property and pocketed a handsome gain. For some, in at the beginning, flipping-a-condo probably worked. There was insufficient taxation to de-incentivize immediate gain in a very short-term realty resale.

Such speculation was pure greed at work. In any investment strategy, one must take into account a diversification not of investment, but of risks. Savings are low-risk/low-return in any net worth portfolio and absolutely necessary -- regardless of the tax rate.

Furthermore, remember, for those savings to be protected in an FDIC account (up to 100K$, is it?), someone has to pay the insurance. Who? That is what the interest rate tax is for partly. The US Treasury assumes the rest.

[dd]

Laf we are going in circles maybe?
Think there is agreement that the US system penalizes traditional FDIC savings and encourages investment and consumption. Would Americans change their behavior if the incentives changed? I think so; apparently you don't; but consider that 40 years ago most Americans were savers as investing was beyond their reach literally (no brokerage firms in my neighborhood; only S&L and banks).
Now Americans are increasingly learning to invest as the retirement system changed from defined benefit to self-funding. The incentives changed and Americans changed their behaviors to investment and yes consumption.
If the system changed again, Americans would change accordingly as we are very responsive to advertising stimuli and tax incentives.

[Lafayette]

dd: If the system changed again, Americans would change accordingly as we are very responsive to advertising stimuli and tax incentives.

The "system", as you call it, is simply human behaviour. Yes, the employment of disposable income (reserved as "savings") has changed from less risky to more risky investments. Out the window go grandpappy savings account and in come hyper-marketed equity investment accounts.

People are therefore willingly assuming more risk for greater returns. I doubt therefore that any less taxation on low-risk (FDIC guaranteed) accounts are going to have any affect whatsoever on the rate of savings.

People are hooked on buying immediately on credit. It is, I suggest, a social phenomenon impervious to tweaking saving-account taxation.

[dd]

People are assuming greater risk and it makes me laugh that greater returns are always assumed. When the greater loss hits, along with tax incentives, greater savings will result.
I've much enjoyed the last 20 years but understand that a reversion to mean is upon us; perhaps not now but certainly soon.

[Lafayette]

dd: When the greater loss hits, along with tax incentives, greater savings will result.

This will require a severe recession, if not a depression, and unemployment rates that are politically unacceptable.

A mild recession over half a year may work the sub-prime debt out of financial markets, given that banks were very profitable in the first half of this year. IF THIS HAPPENS, America is back in business -- but has lost almost totally its credibility to restrain speculative financial frenzy.

The last bolt holding reserve currency nations to the dollar has broken and a trickle-that-becomes-a-river (out of the dollar) is already underway. Where will this money go? Not to the US, but Europe -- and perhaps even to the China (of all places ...)

A lower dollar should increase exports, but to what extent is unknown -- besides, exports have never had the wherewithal to get America out of a recession. They are in the single-digits as a percentage of GDP (about 7%, as I recall).