Liquidity Risk and the Ongoing Recession

On July 19, 2011, in Lehman Brothers, liquidity, by Jon Lewis

The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises.  George Chacko, Carolyn L. Evans, Hans Gunawan, and Anders Sjöman.  FT Press 2011, pp.269, $34.99   It has been nearly three years since Lehman Brothers filed for bankruptcy protection.  Unemployment nevertheless remains close to 10%, the housing market has not [...]

The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises.  George Chacko, Carolyn L. Evans, Hans Gunawan, and Anders Sjöman.  FT Press 2011, pp.269, $34.99


It has been nearly three years since Lehman Brothers filed for bankruptcy protection.  Unemployment nevertheless remains close to 10%, the housing market has not yet recovered, and recent college graduates find themselves underemployed and often living back home with their parents.  Despite the bailouts, deficit spending, and the Federal Reserve’s policy of quantitative easing, there has yet to be a recovery from the financial crisis of 2008.   Why is this the case?  Did the Obama Administration so completely fail to respond adequately to the faltering economy?  Was there too much federal government intervention or too little?

Although it does not attempt to answer these questions directly, The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises does provide a framework for understanding what exactly transpired in 2008.    It also helps explain, to some degree, why the anticipated recovery did not come to fruition as policy makers had planned.  Co-written by four experts in economics and finance, The Global Economic System is a monograph that would be inaccessible to readers without a prior knowledge of basic economics and recent financial history.  The authors themselves acknowledge that the book was “written assuming that the reader has some familiarity with finance and economics.”   That said, an advanced undergraduate business school student would be able to learn much from this recent work of scholarship.

Chacko and Evans (both of Santa Clara University), Gunawan (Skyline Solar), and Sjöman (Voddler) draw upon the concept of a peso problem, referring to a hidden – and generally unobservable – risk factor in financial market data.  The authors argue that, during the period prior to the 2008-2009 economic crisis, there was “an extremely pervasive peso problem, touching our entire society.  It is present in every market (both financial and nonfinancial), it affects most financial institutions ranging from banks to hedge funds, it has always been there, and it will always continue to be there.  This latent risk factor is liquidity risk.”

The purpose of their work, in the authors’ formulation, “is to not only provide a detailed description of the concept of liquidity risk but also to lay out how this risk affects financial institutions and thereby gets transmitted into the global economic system.”  They attempt to do so through case studies of the Great Depression, Japan’s Lost Decade, and what the authors term The Great Recession (of 2008 to the present).

For those readers unfamiliar with liquidity, liquidity risk, liquidity shock, and other related concepts, Chapter 2 provides a comprehensive and readable overview.   The authors utilize graphs and discuss how an understanding of bid and ask curves helps to illuminate the concept of liquidity.   Liquidity risk, in their formulation, refers to “the risk of facing an illiquid market for a good or a financial security.”  The authors provide a useful, although perhaps a slightly too technical, definition, of liquidity shock as “a dramatic increase in the price volatility of a security and a dramatic decrease in trading volume with more sellers than buyers for the security, and it leads to a dramatic decrease in the price of the security.”  These are not easy concepts to define; the writers do an admirable job with difficult material.

Although tangential to the larger thesis, the authors’ discussion of how insurance companies utilize what they term liquidity-driven investing is worth consideration.  They define liquidity-driven investing (LdQI) as “an investment approach used by many institutional investors that have liability streams to capitalize on liquidity risk premiums in financial markets.”  More significantly, they demonstrate how an insurance company is able to use this approach.  The authors also discuss how such a company can, under certain circumstances, become a distressed seller.

In Chapter 5, the authors employ a six-stage approach to demonstrate how, during the Great Recession, a liquidity shock spread from the financial sector to the nonfinancial sector.  The stages are as follows: an initial trigger; a change in the liquidity demanded throughout the economy; changes in bank balance sheets; how banks change their activities to bolster their balance sheets; fewer funds available for assets with low liquidity and increased investment in highly liquid assets; and real effects observed throughout the economy.

As they write in their Conclusion, “[t]he key to understanding how a liquidity shock spreads is the transmission process that occurs via the normal responses of banks to changes in their balance sheets and funding availability.”   In their formulation, during Great Recession, the initial liquidity shock was in the MBSs (mortgage backed securities) and the derivatives market.   The transmission of this liquidity shock from the financial sector to the nonfinancial sector resulted in a credit crunch.

Given that the authors spent well over two hundred pages discussing liquidity shocks, one would have thought they would have had more salient policy recommendations for how best to avoid, if not lessen, a liquidity shock.  The authors do rightly acknowledge that changing bank accounting rules to prevent banks from liquidating their assets in response to a sudden reduction of capital merely results in “zombie banks – banks that are in reality troubled, or even dead, but they are still seemingly healthy by accounting standards.”  They provide brief discussions of bank nationalization, debt guarantees, central bank lending, monetary policy, and fiscal spending.

While acknowledging that the approaches that could prevent liquidity crises also may, in turn, inhibit economic growth, the authors ultimately conclude “in the end, it may be the case that liquidity crises go hand-in-hand with an efficiently functioning economic system.”  Some readers will find this conclusion, while technically correct, less than satisfactory.   Others will recognize that the authors are just being realistic; liquidity shocks are, in a word, normal.

In conclusion, The Global Economic System is a comprehensive study of how liquidity risk helps to explain the financial crisis of 2008 and the ongoing recession.  Those working on the Hill on financial services reform would have a lot to gain from taking the authors’ thesis seriously.

Jon Lewis (c) 2011

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Fannie, Freddie, and the U.S. Covered Bond Act of 2011

On July 13, 2011, in Dodd-Frank, Fannie Mae and Freddie Mac, housing, moral hazard, by Jon Lewis

The American Mortgage System: Crisis and Reform.  Edited by Susan M. Wachter and Marvin M. Smith.  University of Pennsylvania Press 2011, pp.392, $49.95 There is a direct correlation between the housing bubble and the freezing up of the credit markets in 2008.   Indeed, many commentators have held the largely unregulated derivatives market – much of [...]

The American Mortgage System: Crisis and Reform.  Edited by Susan M. Wachter and Marvin M. Smith.  University of Pennsylvania Press 2011, pp.392, $49.95

There is a direct correlation between the housing bubble and the freezing up of the credit markets in 2008.   Indeed, many commentators have held the largely unregulated derivatives market – much of it based on securitized mortgages – responsible for nearly bringing down the entire financial system.  The Dodd-Frank Act has attempted to reform the derivatives market by imposing a clearing requirement on swaps.   That said, the ongoing challenge is how to reform the housing market itself so working Americans can afford to purchase homes.   A separate question, of course, is whether the federal government’s emphasis on homeownership for all (or as many as possible) during a time of exceedingly low interest rates was itself partially to blame for the financial crisis.

With housing apparently now back on President Obama’s agenda, the release of The American Mortgage System: Crisis and Reform could not have come at a more opportune time.  Edited by Susan M. Wachter, from the Wharton School and PennDesign, and Marvin M. Smith, from the Federal Reserve Bank of Philadelphia, this volume contains a collection of fifteen essays on the housing crisis, its community impact, and ways to reevaluate and to reform housing and mortgage finance.

In their Introduction, Smith and Wachter premise their argument on the notion that, in order for the United States to have a sustainable mortgage system, it is necessary to remake that system, and that redesign is indeed possible.  They call for a separation of “innovations that increased – and sustained – homeownership from those that merely increased profits and risk.”

Although they acknowledge that the current system is broken, Smith and Wachter emphatically do not want to replace long-term fixed rate mortgage with an entirely new system.  Indeed, the authors argue that “[w]ith interest rates preparing to rise and sovereign debt at nosebleed levels, consumers need the long-term, fixed-rate mortgage now more than ever.”  They note that the focus of the collection is “[h]ow to create such a system and safeguard it from recurrences of the recent catastrophe.”   Smith and Wachtel are thus more interested in reforming, rather than fundamentally restructuring, housing finance.

For readers interested in an accessible and brief introduction to Fannie Mae and Freddie Mac, Chapter 1 is worth particular consideration.  In “The Secondary Market for Housing Finance in the United States,” New York University faculty members Ingrid Gould Ellen, John Napier Tye, and Mark A. Willis, enumerate what they consider to be the strengths and weaknesses of the GSE (government-sponsored enterprise) model prior to the federal government’s putting Fannie Mae and Freddie Mac into conservatorship.

The authors are on the mark in citing the following as weaknesses: the implicit federal guarantee which made Fannie and Freddie susceptible to moral hazard; a favored regulatory status which created “a net bias toward investing in housing in the economy overall”; lack of proper oversight; duopoly power; a race to the bottom with lower underwriting standards; and their too-big-to-fail large size, which concentrated systemic risk.

It is notable that the authors point out how Fannie and Freddie’s structure created a net bias toward investment into the housing sector.   Although this is not necessarily an original point, it is nevertheless an important one.   The very existence of the GSEs (and indeed, the mortgage interest tax deduction) provides incentives for individuals to invest in housing, rather than in savings or in the money market.

Ellen, Tye, and Willis conclude with the observation that, while the GSEs should indeed be improved, “it would be a mistake to assume that simply reforming the GSEs, without making significant reforms to the private-label market would prevent another crisis.”  While technically correct, this misses the larger point; namely, that the GSEs, at least prior to their being placed into conservatorship, were very unique entities in which an implicit guarantee allowed gains to accrue to shareholders, with losses socialized and, hence, passed on to taxpayers.

In Chapter 13, “Improving U.S. Housing Finance Through Reform of Fannie Mae and Freddie Mac: A Framework for Evaluating Alternatives,” co-authors Ingrid Gould Ellen and Mark A. Willis list nine characteristics that, in their view, can be utilized to distinguish among the different approaches for reforming the secondary mortgage market: credit enhancement; regulation; securitization of non-favored products; market concentration; provision of credit to underserved markets; financing multi-family rental properties; allowing direct investments; methods of ownership; and transition issues.

The authors devote significant attention to the question of credit enhancement, which they consider “[a]rguably the most critical feature of any proposal.”  Free market advocates who would like to see the federal government exit the mortgage guarantee business entirely (something that is unlikely in the near term) would likely disagree with the authors on various points.

That said, their proposal for limiting federal guarantees to mortgage backed securities only – as opposed to corporate obligations and debt – should be given serious consideration.  They argue that “to limit moral hazard and taxpayer risk, the government should only guarantee MBS holders’ timely payment of interest and principal in the case of default rather than guaranteeing the corporate obligations of the issuer or even the underlying mortgage debt.”  Ellen and Willis should be commended for their acknowledgment of the correlation between the GSEs’ moral hazard problem and taxpayer risk.

In light of the House Financial Services Committee’s recent vote in approval of H.R. 940, the United States Covered Bond Act of 2011, perhaps the most salient aspect of Ellen and Willis’ essay is to be found in their discussion of covered bonds in their Appendix B.   They argue that covered bonds differ from mortgage-backed securities (MBS) in two ways: the covered bonds, unlike MBSs remain on a bank’s balance sheet and that bonds are usually regulated so as to be over-collateralized, with the mortgage pool exceeding the value of outstanding bonds.   Although the authors doubt the likelihood that covered bonds will replace the GSE MBS system of housing finance, they do suggest that “[I]n a more radical restructuring, the GSEs could be abolished, and the entire system could switch to covered bonds, or the GSEs could be reformed into covered bond issuers.”  This, in their view, “would seriously disrupt the housing finance system.”

Covered bonds do offer significant promise.  The Senate should take up similar legislation.  It should be noted, however, that George Soros’ proposal to eventually wind down the GSEs and to replace the current housing finance system with a Danish-style covered bond system based on the principle of balance would not be the best option for a dynamic American housing finance system.  What would be far more preferable would be to allow market forces to operate as freely as possible and to allow consumers and investors to have choices.  Indeed, as Ellen and Willis astutely note, covered bonds “could directly compete with the GSEs in the prime mortgage market.”  This may be the best option.

The goal should not be to replace the current American housing finance system with a model that has worked, until now at least, exceedingly well in a relatively geographically small and homogenous Nordic country and to expect that that model could be replicated in the United States.   Furthermore, Soros’ proposal that the GSEs should now begin to introduce securities based upon the Danish principle of balance should be rejected.  If this is to be done at all, it should be done by the private sector under a proper regulatory framework established by Congress, not by the GSEs.

In conclusion, bold thinking is needed to reform the American housing market.  Reforming the GSEs is a good idea.  Replacing them entirely and minimizing the federal government’s involvement in promoting the housing sector at the expense of other sectors of the economy, while still preserving opportunities for responsible homeownership, would be even better.  For those policymakers interested in a recent collection of essays on housing finance, The American Mortgage System: Crisis and Reform is worth ample consideration.

Jon Lewis (c) 2011

After the Bubble: Credit and Housing

On July 4, 2011, in Fannie Mae and Freddie Mac, housing, by Jon Lewis

Moving Forward: The Future of Consumer Credit and Mortgage Finance.  Edited by Nicolas P. Retsinas and Eric S. Belsky.  Brookings Institution Press 2011, pp. 264, $28.95 Although there are indications that the housing market may be improving, particularly in rural states with large agricultural, energy, and industrial sectors, the housing market is unlikely to recover [...]

Moving Forward: The Future of Consumer Credit and Mortgage Finance.  Edited by Nicolas P. Retsinas and Eric S. Belsky.  Brookings Institution Press 2011, pp. 264, $28.95

Although there are indications that the housing market may be improving, particularly in rural states with large agricultural, energy, and industrial sectors, the housing market is unlikely to recover fully any time soon.  Adding to the uncertainty about the future of home purchases is the fact that a significant number of recent college graduates are returning home to live with their parents, likely delaying their path to homeownership.

Minority and low-income communities, where homeownership was always more of a challenge than for middle-class and affluent Americans, have been hurt the hardest by ongoing unemployment.  Although it is difficult to generalize about the national housing market, marked minority unemployment makes it less likely that members of these communities will be purchasing homes in the same numbers as they did in the mid-2000s when consumer credit was more readily accessible.

Moving Forward: The Future of Consumer Credit and Mortgage Finance is the product of a February 2010 conference held at the Harvard Business School.  Convened by the university’s Joint Center for Housing Studies, participants met “to explore the roots of the crisis that caused credit markets to seize up in late 2008 and more, important, to focus on the way forward.”   Edited by Nicholas P. Retsinas and Eric S. Belsky, both of Harvard, Moving Forward contains academic papers on such disparate topics as how best to serve the short-term credit needs of low-income consumers; a retrospective on the Home Mortgage Disclosure Act; and a case study of payday lending in the context of the regulation of consumer financial products.  The overall theme of the conference, as enunciated by Retsinas and Belsky in their Introduction, was how to “reopen the spigots of credit to low- and moderate-income Americans” in an efficient and fair manner.

Although each chapter provides a different perspective on the housing market, two stood out as particularly engaging.  In Chapter 1, “Rebuilding the Housing Finance System after the Boom and Bust in Nonprime Mortgage Lending,” Belsky and Nela Richardson, also from Harvard, present a fairly objective overview of the boom and bust cycle in the nonprime and nontraditional mortgage lending markets and provide their vision for better mortgage markets.   The authors identify four broad factors, which, in their opinion, were essential in the causation of the nonprime boom and subsequent bust: global liquidity and low interest rates; relaxed underwriting standards; financial engineering (i.e., derivatives such as credit-default swaps and synthetic CDOs); and regulatory and market failures.   These are all reasonable factors to cite; the authors, however, could have devoted more attention to the role played by monetary policy in fueling the initial housing boom, wherein the Federal Reserve kept the federal funds rate unnaturally low.

Although their historical analysis is largely dispassionate, Belsky and Richardson adamantly reject the notion that the Community Reinvestment Act had a major role in fostering the housing crisis. “But the problem was not, as some have argued, the Community Reinvestment Act (CRA) which places affirmative obligations on banks and thrifts to lend in low- and moderate-income communities.  CRA played a minor role at best.”   With regard to Fannie Mae and Freddie Mac (it should be noted that Freddie Mac provided funding for the conference and that the editors did rightly disclose this fact), the authors contend that the GSEs would have performed better had there been more regulation of financial institutions in the private-label securities market and the nonprime market, in general.

In their view, regulatory failure, rather than the structural problems inherent in the government-sponsored enterprises, is to blame. “If there is fault to be found with capital requirements and the goals of Fannie Mae and Freddie Mac, it is not with the effort to regulate capital standards or to impose goals for low- and moderate-income lending, but rather with the actual standards that were promulgated.”  This misses a larger point; namely, that the main problem with Fannie and Freddie was less about regulation, per se, and more systemic, wherein implicit government guarantees allowed the GSEs to issue agency debt that was perceived by investors as inherently less risky than corporate bonds.

Not surprisingly, the authors, in their discussion of how to improve the housing finance system do not call for winding down Fannie and Freddie in a reasonable and timely manner that protects taxpayers.  Nor do they seem to acknowledge the problem of the Federal Reserve having interest rate-sensitive GSE securities on its balance sheet.   To the contrary, they argue that, “it is clear that federal insurances and guarantees are vital to the stability of the mortgage finance system, the broader financial system, and the national economy.”   This point is highly debatable, as a subsequent chapter of the book makes clear.

In “Alternative Forms of Mortgage Finance: What Can We Learn from Other Countries?,” Michael Lea takes a comparative approach to mortgage finance and demonstrates how very unique the American system actually is.  Lea, of San Diego State University, points out that, when compared with other industrialized countries, the United States “has the highest level of government involvement, the greatest use of securitization, and a product mix dominated by the long-term fixed rate mortgage.”  Indeed, readers would be interested to learn that “[t]he United States is unusual its use of all three types of government-supported mortgage institutions or guarantee programs: mortgage insurance, mortgage guarantees, and government-sponsored mortgage enterprises.”

In his discussion of what the United States could learn from other countries, Lea singles out Denmark for special treatment.  According to Lea, “Denmark is the only country in the world other than the United States in which the dominant product is the long-term fixed-rate mortgage that can be prepaid without penalty.”  What makes Denmark’s mortgage finance system different, however, is that it utilizes the principle of balance and also has its “funding through the issuance of covered bonds.”   Denmark’s system thus allows for borrowers to repay their mortgages through the bond market should rates rise and also keeps the credit risk on the lender’s balance sheet (as opposed to the American system wherein GSEs securitize mortgages into mortgage-backed securities that are then sold to investors).

Lea does a great service by providing this comparative perspective.   His discussion of Denmark, however, must be tempered with the very recent conflict between Moody’s, the credit rating agency, and Danish banks.   That said, Lea is on the mark in his observation that “[r]estricting the government role to guarantees without portfolio accumulation of mortgages would reduce the systemic risk of the U.S. housing finance system in line with the more targeted and stable Canadian system.”  Canada, as Lea notes, has a comparable rate of homeownership to that the United States, but does not have a government-sponsored enterprise such as Fannie and Freddie.

In conclusion, the housing market will likely not recover in the near term.  There are signs, however, that the market may be slightly improving.    In the meantime, it would be useful for policymakers to think critically about the ways to improve mortgage finance.  Winding down Fannie and Freddie would be a good first start.   For those interested in recent academic literature on housing and consumer credit, Moving Forward is worth a read.

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