Tuesday, August 31, 2010

Explaining the Housing Bubble

By Adam J. Levitin and Susan M. Wachter

Abstract: There is little consensus as to the cause of the housing bubble that precipitated the financial crisis of 2008. Numerous explanations exist: misguided monetary policy; government policies encouraging affordable homeownership; irrational consumer expectations of rising housing prices; inelastic housing supply. None of these explanations, however, is capable of fully explaining the housing bubble, much less the parallel commercial real estate bubble.

This Article posits a new explanation for the housing bubble. It demonstrates that the bubble was a supply-side phenomenon, attributable to an excess of mispriced mortgage finance: mortgage finance spreads declined and volume increased, even as risk increased, a confluence attributable only to an oversupply of mortgage finance.

The mortgage finance supply glut occurred because markets failed to price risk correctly due to the complexity and heterogeneity of the private-label mortgage-backed securities (MBS) that began to dominate the market in 2004. The rise of private-label MBS exacerbated informational asymmetries between the financial institutions that intermediate mortgage finance and MBS investors. The result was overinvestment in MBS that boosted the financial intermediaries’ profits and enabled borrowers to bid up housing prices.

Despite mortgage securitization’s inherent informational asymmetries, it is critical for the continued availability of the long-term fixed-rate mortgage, which has been the bedrock of American homeownership since the Depression. The benefits of securitization, therefore, must be reconciled with the need for economic stability. The Article proposes the standardization of MBS to reduce complexity and heterogeneity in order to rebuild a sustainable, stable housing finance market based around the long-term fixed-rate mortgage.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1669401

Monday, August 30, 2010

Canada’s Very Own Mortgage Mess: The Laws and Programs Behind a National Dilemma

By Nathan Hume, University of Toronto - Faculty of Law

Abstract: Canadian house prices require explanation. Despite a deep global recession and persistent credit crisis, they remain near record highs while prices elsewhere have plummeted. This article offers an institutional account of that anomaly. The insurance and securitization programs of the Canada Mortgage and Housing Corporation have insulated the Canadian mortgage and housing markets from recent turbulence. These large, unfamiliar programs also distort and may ultimately destabilize the Canadian economy. Arguments about asset bubbles are unproductive. This article explains these programs, their effects and their legal framework so that we can better discuss what to do with them.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1654340

Friday, August 27, 2010

FSA outlines a fundamental review of trading activity regulation

The Financial Services Authority (FSA) has today published a discussion paper (DP) that considers fundamental changes to the regulation of trading activities – one of the key recommendations of the Turner Review following material trading losses incurred during the crisis.

Since the Turner Review was published, the Basel Committee on Banking Supervision (BCBS) has proposed several reforms to the prudential regime for banks and in addition has mandated a fundamental review of trading activities called for in the Turner Review.

The FSA believes that the delivery of a new, robust, long-term, approach to prudential requirements for trading activities is one of the key areas of regulatory reform that must be delivered to build a stronger financial system. The outcome of the BCBS’s fundamental review is central to achieving this objective internationally.

The DP describes the FSA’s current views and ideas in relation to major areas of reform that need to be considered to address areas of structural weakness that exacerbated the build up of risk before the financial crisis.

Paul Sharma, FSA director of prudential policy, said:

"There are clear benefits of participants in traded financial markets taking risks to facilitate a more efficient allocation of resources across the economy – where these gains in efficiency are real and the risks posed are adequately captured or controlled we are not seeking to undermine these activities.

"However, the financial crisis has highlighted that, for trading activities in particular, an over-reliance on the principles of efficient financial markets can lead to severe consequences when risks are misunderstood at a system-wide level. The balance needs to be redressed to ensure that risks posed to the system as a whole are more adequately reflected in the structure of prudential regulation."

The DP sets out a number of recommendations which are grouped into three key areas:

  1. Valuation: We recommend an increased regulatory focus on the valuation of traded positions and think there is a need for a specific assessment of valuation uncertainty.
  2. Coverage, coherence and the capital framework: We recommend changing the structure of the capital framework to bring greater coherence and reduce the opportunities for structural arbitrage within the banking sector and the wider financial system.
  3. Risk management and modelling: We recommend specific measures aimed at improving firms’ risk management and modelling standards, and ensuring that these are aligned with regulatory objectives.

The closing date for responses is 26 November 2010. The FSA will issue a feedback statement in the first half of 2011.


  1. The Discussion Paper can be found on the FSA website.
  2. The Turner Review can be found on the FSA website.
  3. The FSA regulates the financial services industry and has five objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection for consumers; fighting financial crime; and contributing to the protection and enhancement of the stability of the UK financial system.
  4. See also FT Alphaville's summaries; Part 1, Part 2 and Part 3.

FHFA Releases First Conservator’s Report on the Enterprises’ Financial Condition

Washington, DC - August 26, 2010 - The Federal Housing Finance Agency (FHFA) today released its first Conservator’s Report on the Enterprises’ Financial Condition. The Conservator’s Report provides an overview of key aspects of the financial condition of Fannie Mae and Freddie Mac (the Enterprises) during conservatorship. The report will be released on a quarterly basis following the filing of the Enterprises’ financial results with the Securities and Exchange Commission (SEC).

“FHFA initiated the Conservator’s Report to enhance public understanding of Fannie Mae’s and Freddie Mac’s financial performance and condition leading up to and during conservatorship,” said FHFA Acting Director Edward J. DeMarco.

The report includes information on Enterprise presence in the mortgage market; credit quality of Enterprise mortgage purchases; sources of Enterprise losses and capital reductions; and Enterprise loss mitigation activity. Information presented in the report includes:

• The key driver in the decline of the Enterprises’ capital from the end of 2007 through the second quarter of 2010 was the Single-Family Credit Guarantee business segment, which accounted for 73 percent of the capital reduction over that period. The bulk of this capital reduction was associated with losses from mortgages originated in 2006 and 2007.
• The Investments and Capital Markets business segment (which includes the retained portfolio and credit losses associated with private-label mortgage-backed securities) accounted for 9 percent of the capital reduction over the same period.
• Since the establishment of the conservatorships, the credit quality of the Enterprises’ new mortgage acquisitions has improved substantially. Single-family mortgages acquired by the Enterprises during conservatorship have, on average, higher credit scores and lower loanto- value ratios, resulting in lower early cumulative default rates.

Download the full report here: www.fhfa.gov/webfiles/16591/ConservatorsRpt82610.pdf

Wednesday, August 25, 2010

Structured Finance Influence on Financial Market Stability: Evaluation of current regulatory developments

by Sebastian A. Schuetz of the University of L√ľneburg

Abstract: In 2007 the world faced one of the biggest financial crises ever. It was the third important financial crisis in the last 12 years. Spillovers to the real economy and moral hazard behaviour of carpetbaggers resulted in enormous pressure on worldwide political institutions to approve a more rigorous regulation on financial institutions and predict financial crises via early warning systems. We analyzed the performance of structured finance ratings and structured finance issuance/outstanding to detect the main shortcomings of the subprime crisis. Afterwards we explain the behaviour of market participants with theoretical models and a survey of institutions involved in securitization. With the conclusions of this analysis we evaluate the EU regulation on credit rating agencies and current Basel II enhancements. Finally we can determine that most regulatory enhancements are in accordance with our analyzed shortcomings. Some approaches like the introduction of a leverage ratio are counterproductive and a danger for worldwide economic growth.

Download here: www.defaultrisk.com/pp_super_75.htm

Thursday, August 12, 2010

Oliver Wyman: Risk Management Practices Still Inadequate

The second Oliver Wyman / Financial Times Global Emerging Risks Survey of 650 senior executives at global companies with revenues of more than $1 billion finds that most executives consider their firms' risk management practices to be inadequate. Despite significant investments in improving their risk management capabilities since the financial crisis first started, over 60% of senior managers still believe their firms are "ineffective" or only "moderately effective" at incorporating emerging risks into their decision making.

"I'm surprised at how little progress has been made. So many companies have worked to improve their risk management practices since the financial crisis started," says Oliver Wyman partner Alex Wittenberg. "Yet many of the current approaches to managing emerging risks are not providing companies with the business information they need, leaving many vulnerable to a wide range of potential sudden shocks."

The results clearly show that even with their renewed focus on managing risk, most companies still fail to take information about emerging risks into account. Emerging risks are defined as both new risks, such as this year's eruption of volcanic ash in Iceland, and familiar risks in unfamiliar conditions, as when volatile commodity prices suddenly become some of the largest costs for businesses such as airlines and consumer products manufacturers. That general lack of progress is especially troubling given that 71% of respondents view global recession as the greatest risk to their business.

This report makes recommendations for how risk management programs should address not only traditional risks but also new risks that threaten to change the rules of the game.

Reasons for the serious disconnect between companies' approaches to assessing risks and effectively using the information to make better decisions highlighted in the report include:

Many boards of directors receive emerging risk information only infrequently.

Many executives rely on basic, "static" risk analytics and tools rather than multidimensional approaches that take advantage of a wide range of outside data.

Immediate and pressing financial events have pushed risks not directly related to their business, such as climate change or pandemics, off most executives' radar screens.

Only half of executives surveyed integrate emerging risk information into their strategic planning process.

For more information about this report, please visit www.oliverwyman.com/ow/risk_survey_2010.htm

Monday, August 2, 2010

Into the Abyss: What If Nothing is Risk Free? (SSRN)

By Aswath Damodaran, New York University - Stern School of Business

Abstract: In corporate finance and investment analysis, we assume that there is an investment with a guaranteed return that offers both firms and investors a “risk free” choice. This assumption, innocuous though it may seem, is a critical component of both risk and return models and corporate financial theory. But what if there is no risk free investment? During the banking crisis of 2008, this question came to the fore, as investors began questioning the credit worthiness of US treasuries, UK gilts and German bonds. In effect, the fear that governments can default, hitherto restricted to risky, emerging markets, had seeped into developed markets as well. In this paper, we examine why governments may default, even on local currency bonds, and the consequences. We also look at how best to estimate a risk free rate, when no default free entity exists, and the effects on both investors and firms. In particular, we argue that the absence of a risk free investment will make investors collectively more risk averse, thus reducing the prices of all risky assets, and induce firms to borrow less money and pay out lower dividends.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164