SUSTAINABLE MORTGAGE
FUNDING FOR SUSTAINABLE
HOUSING MARKETS
Presentation for the
European Network of Housing Research International Conference
Mixité: an urban and housing issue?, Toulouse, France
5. - 8. July 2011
Presenter: Stefan Kofner, MCIH
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Contents
I. The idea of sustainability
II. Mortgage credit funding instruments
III. The housing cycle
IV. Sustainable mortgage funding
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• “A high-quality and
progressive land culture
necessarily requires an
abundant and steady in-flow
of productive capital, it is
simply impossible without
this. ...
• We have no better means to
set in motion the existing
capital, the entrepreneurial
spirit and the manpower, as
the real credit.”
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Credit
Primary facilities
Whole Loan from other
Sale Mortgage banks
Lender Unsecured
Bank
Bonds
Debt Refinan-
Asset- Mortgage cing
RMBS Covered
Sale Credit Bonds
Equity
Contract
saving
schemes
Transfer
Risk-
Deposits
CDO
Investors
•Pensions Funds
•Investment Funds
•Conduits
•Insurances
MI CDS CLN •Foreign Investors
Stefan Kofner SustFunding 4 •Private Individuals
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Sustainability and mortgage funding
• Apply concept of sustainability to mortgage funding
instruments
• availability and price of refinancing steady access of
borrowers to mortgage credit steady development of
primary mortgage rates steady flow of housing
investment
• Our understanding of housing market cycles and bubbles
and their relation with primary and secondary mortgage
markets is only superficial – that is one of the reasons for
the “great housing bubble” we have seen.
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Is this sustainable?
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Or this?
MBS-issues in billion dollars
$200
Subpr im e & Other
Alt-A
$30 Prime Jumbo
$5 2 Freddie Mac & Fannie Mae
$150
$37 $16
$3 4 $8 $
$20 $14 $7
$100
$1 9 1 $4
$50 $94 $99 $97
$8 5
$0
Mär z-2007 Juni-2007 September-2007 Dezember-2007
$191 billion $181 billio n $137 billion $109 billion
Source: Inside Mortgage Finance
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Or that?
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Take your time!
Broker places mortgage loans to LEGEND KEY
End borrowers Broker borrowers for fee O&G – interest and principal
$ SPV – special purpose vehicle
I&P ($)
Mortgages SPE – special purpose enterprise
SIV – special investment vehicle
Typically a specialized
MBS – mortgage backed securities
Servicer Originator mortgage bank
$
Insurance Can assume part of risks
I&P ($) Mortgages company (insurance of mortgage
Conduit/trust/ loans, insurance of MBS
SPV/SPE/SIV $ returns).
Manages the flow of interests
and principal (I&P); usually, but
not necessarilly the Originator
MBS
Investment bank Banks, insurance
(underwriter) $ companies, mutual
Founder: loan originator or funds, hedge funds…
investment bank
MBS, I&P ($)
Purpose: transfering ownerhship
Rating agency Institutional
of claims (loans) and collateral
(mortgages) in order to issue investor $
Organizes issuing of
mortgage backed securities MBSs and places MBSs
(bonds). to investors in financial
Financial
markets. returns ($)
Exposure of founder: implicit Assigns credit
guarantee in case of large losses. rating to issued End lenders
MBSs.
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The Technology has Evolved Through Several Stages
Stages and Innovations Structured Finance (Securitization)
Extensive use of Credit Derivatives
Credit Risk transfer (CDS)
Without Asset transfer
Synthetic CDO Securitization 4th Stage
Multiple Class Tradable
Derivative Securities 3rd Stage
Tranching & Subordination Innovation
Of Cash flows Conventional CDO What is the
Innovation?
Multiple Class of Tradable
Derivative Securities
(Structured Claims) Structured ABS with Tranching 2nd Stage Innovation
What is the innovation?
Single Class Tradable
Derivative Security 1ST Stage Innovation
Basic Structured Finance (ABS) What is the innovation?
Primitive Assets/Receivables
Illiquid Assets (Primitive Asset)
Mortgages, consumer credit (auto loans, credit card), equipment leases
commercial loans, student loans, aircraft lease, royalties, future flows, etc
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Valdeluz in Spain, where 700 people live in a town planned for 30,000
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Residential construction volume in Western Europe 1991-2012 in prices of 2009
Mrd. €
750
700
Average growth
1991 - 2007: 1,90% per year
650
600
2007 - 2010:
-22,2%
550
2010 under level of 1994
500
450
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: Euroconstruct.
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Residential construction volume by country 2010 / 2007
Change in %
Land 2010 / 2007
Ireland -56,5
Spain -50,6 dramatic decrease
Portugal -22,9
Denmark -18,1
Italiy -16,8
Great Britain -12,8
France -12,5
Strong decreas
Finland -11,6
Hungary -9,6
Czech Republic -7,9
Netherlands -7,4
Norway -7,3
Austria -5,4
Moderate decrease
Belgium -3,6
Sweden -2,6
Slowakei 1,3
Switzerland 2,2
Germany 2,3
Moderate increase
Poland 27,8
Source: Euroconstruct.
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How sustainable is your business model?
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Cash Flow
Investment
Interest/Principal
Trustee
Asset sale
Originator SPV
Purchase price
Interest/Principal
Interest/Principal
Issuances Issue
proceeds
Payment Credit
Payout/
obligation enhancement
Receivables
Consortium
Enhancer
Placement Investment
Borrower Quality
assessment
Investor
Rating-Agency
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Mortgage-specific and non-specific
funding instruments
• Some refinancing instruments define minimum requirements relating
to the mortgages to be refinanced. Such requirements can pertain to
(inter alia):
• the length of fixed-rate periods (“congruent coverage”),
• the determination of the mortgage lending value,
• minimum LTV,
• minimum credit scores of borrowers.
• Classification of instruments according to the intensity of such
requirements: deposits and unsecured bank bonds vs. covered
bonds, loan purchase criteria of Fannie Mae and Freddie Mac
• private securitization: characteristics of the loans have an effect upon
the rating of the issuance
• Why covered bonds?
• Quality of the loan portfolio is a critical parameter for the funding conditions of
a bank.
• In inefficient markets covered bonds have the characteristics of a public good.
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How to define the housing cycle?
Peak
Variable
Recession
Recovery
Trough
Time
Housing cycle: Similar cyclical developments
of certain time series variables like building permits, building
completions, real estate prices, default rates of mortgage borrowers,
real estate investment and sales activities, vacancy rates, volume of
newly granted mortgage loans and so forth around a long-term trend.
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900 000
800 000
700 000
600 000
500 000
400 000
300 000
200 000
100 000
‐
1970 …………….
1972 …………….
1974 …………….
1976 …………….
1978 …………….
1980 …………….
1982 …………….
1984 …………….
1986 …………….
1988 …………….
1990 …………….
1992 …………….
1994 …………….
1996 …………….
1998 …………….
2000 …………….
2002 …………….
2004 …………….
2006 …………….
2008 …………….
Building permits for dwellings in residential and non-residential construction
Former federal territory (from the year 2005 without West Berlin)
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Wohnungsbau in 1.000 WE
800
Wohnungen in Ein- und Zweifamilienhäusern
Geschosswohnungen und
sonstige Wohnungsfertigstellungen
600
400
200
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Building completions of dwellings in residential and non-residential buildings
Germany 1950-2007
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16.000
14.959
14.000
12.087
12.000
10.707
9.750
10.000
9.104
8.471
8.000
6.811
6.502
6.000 5.636
5.054
4.897
4.278
4.091
3.251
4.000
2.736 2.826
2.000
0
Total completions of dwellings in residential and non-residential buildings
Hamburg 1970-2006
Sources: Statistisches Bundesamt, Lange Reihe Baugenehmigungen und Baufertigstellungen 4.3
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Residential completions Spain vs. Germany 1991-2012
17,5 completions per 1.000
1 000 dwellings Inhabitants in 2007
900
3x Western European average
800 West per
Spain Germany 1.000
700 year heads
1951- 10,22
600 1960
Germany 1961- 9,58
500 1970
1971- 7,93
400 1980
1981- 4,77
300 1990
200
100
0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: Euroconstruct.
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Residential investment Germany % change 2000-2012
8
6
4
2
0
-2
-4
-6
-8
2000 2002 2004 2006 2008 2010 2012
Sources: Statistisches Bundesamt, ifo Institut
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Bubbles or cycles?
• Term “bubble” is obviously
inconsistent with the concept
of efficient markets
• house prices reaching a
temporary and unsustainable
peak
• The only “rational”
explanation for the rising
values is the common ( and
fundamentally unfounded)
expectation of rising values.
• culturally bound
• relationship bubble / cycle?
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Average Annual Real Price Growth By OECD Country
Country 1970-1999 2000-2006 Country 1970-1999 2000-2006
U.S. 0.012 0.055 Netherlands 0.023 0.027
Japan 0.010 -0.045 Belgium 0.019 0.064
Germany 0.001 -0.029 Sweden -0.002 0.059
France 0.010 0.075 Switzerland 0.000 0.019
Great Britain 0.022 0.068 Denmark 0.011 0.065
Italy 0.012 0.051 Norway 0.012 0.047
Canada 0.013 0.060 Finland 0.009 0.040
Spain 0.019 0.081 New Zealand 0.014 0.080
Australia 0.015 0.065 Ireland 0.022 0.059
Average 1970-1999 0.012
2000-2006 0.046
Source: Erik Hurst 2009
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0,12
0,09
0,06
0,03
0,00
-0,03
-0,06
-0,09
-0,12
U.S. Real House Price Appreciation: 1976 – 2008 (OFHEO Data)
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Real House Price Growth
Italy - UK - Japan: 1978 - 2006
0,250
0,200
0,150
0,100
0,050
Italy
UK
0,000
-0,050
Japan
-0,100
-0,150
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Theories of the housing cycle
• Relationship housing cycle / business cycle
• Leamer in 2007: “I have not been able to find any
macro-economic textbook that places real estate
front and center, where it belongs.”
• Maybe the earth orbits around the sun?
• “Endogenous factors”:
• Time lags
• Information inefficiencies
• Bounded rationality
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Problems of price formation
• Inelastic supply and demand curves
• initial overshooting of rents and house prices
• Supply adjusts in the long run
• Development time lags induce pig cycles
• credit-driven price cycles (access to mortgage credit,
interest rate cycles)
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N1
Ak
N0
p1 Supply and demand
being relatively
inelastic considerable
price movements
p0 necessary in the
short run to clear
the market
y0 y1
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Shape of the supply curve of housing
Reaction on rising prices / rents if
p Ak new demand was not anticipated
Short run: almost no increase in supply
Time required for: Planning, Building
permit proceedings, Construction,
Marketing
possibly further lags, e.g. scarce
Al housing land
p0
y0
y
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Adjustment after an increase in housing demand
p Ak Ak
0 1 So far only arguments for
overshooting prices in case
of a shock
No explanation for cyclical
p1 developments in time
A0l
p2
p0
N1l
N0l
y0 y1 y2
y
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Agricultural price cycles
(especially with “livestock”)
Production
cycle
Price
cycle
Time
Preise in €/kg
0.00
0.50
1.00
1.50
2.00
2.50
01M1990
08M1990
Stefan Kofner
03M1991
10M1991
05M1992
Quelle: Statistik Austria, Schmid
12M1992
07M1993
02M1994
09M1994
04M1995
11M1995
06M1996
01M1997
Deutschland
08M1997
03M1998
Pork meat prices in Austria and Germany in €/kg
10M1998
SustFunding
05M1999
Österreich
12M1999
07M2000
02M2001
09M2001
04M2002
37
11M2002
06M2003
01M2004
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The suppliers are responding to
current prices.
The Cobweb Theorem “Biological lag”: time required until
market effectiveness of production
decisions
“Psychological lag”: time required
for the realization of changing
market situations
Price
Expansion
P Hi
Rising Falling
Prices Prices
P Lo
Contraction D
S
Quantity
Q Lo Q Hi
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Pt St+k
St1
Pt1 St2
St3
Pt3 St4
St5
St6
Pt4
Pt2 D
Qt+k
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The housing market – a cobweb?
• The housing market is a market fitting well into the
assumptions of the cobweb theorem.
• Convergence or divergence of the model is a question of
the relative slopes of the supply and demand curves.
• Model explains dynamic cyclical developments of
quantities and prices after an initial shock.
• “For housing it’s the cycle that is persistent. Once the
cycle starts, it keeps on going. Like a pebble thrown into a
smooth pond of water.” (Leamer 2007, p. 3)
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Regional or nationwide cycles?
• Hurst: extreme heterogeneity within metro areas with
respect to housing price changes
• No wonder: regional markets
• National level cycles induced, if the same shock event hits
many regional housing markets at the same time (e.g.
interest rates, migration balance, national tax regulation)
• market volatility higher on the regional than on the
national level
• Different types of real estate / different regions may have
different development time lags
• Understand cause and effect: Real estate investment a
major explanatory factor of the general business cycle?
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Building cycle or Kuznets cycle
(construction cycle)
• During economic booms, demand
for labor increases which in turn
puts pressure on wages
• Increased economic activity
causes new family formations
• Sparks the demand for new
housing units
• Boosts the economic output more
• Process begins again
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Building cycle has 4 phases
1. Development: Demand picks up, and housing starts
follows. Low vacancy rates and rising rents. Reaches
maturity after about 3 – 5 years. Aggressive bidding up
of land prices is a turning point
2. Overbuilding: Housing starts outpace home sales
3. Adjustment : Builders react to declining demand and
curtail housing starts
4. Acquisition: Housing starts continue to decline. Home
sales are still firm. Building activity is further reduced
though vacancy rates have peaked and rent
recessions have ceased.
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The Cantor-Wenninger credit cycle
1. Demand for capital assets and investment increases.
2. Rising asset prices financed with higher leverage and lower credit standards.
3. Increased shock vulnerability because of riskier financing methods, e.g. higher
leverage, maturity mismatch
4. Turning point of profit expectations Cash flows, profits and asset prices
begin to decline.
5. The “credit crunch” begins: borrowers want to refinance short-term debt, but
lenders want their money back.
6. Financial distress spreads: Borrowers fail to roll over loans. Lenders do not get
paid.
7. Assets are sold at distressed values. Rising number of insolvencies. Distress
can become contagious. Fight for quality and liquidity and possibly lender-of-
last-resort intervention.
8. Nonperforming loans and related depreciations increase.
9. Highly leveraged banks loose equity capital and regulatory screw tightened.
The “credit channel” gets partially or fully blocked. The credit crunch spreads.
10. General spending decrease and economic slowdown
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Dynamic Growth
lending stan-
dards continu-
ously lowered
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Critical perspective on the credit cycle
• a set of stylized developments of certain capital- and
asset-market variables during a boom and bust cycle
• set of reasons for the initial increase in demand for capital
assets and for the failure of capital assets to generate the
expected profits arbitrarily chosen
• distinction between primary and secondary credit markets
is not always clear.
• However, one thing is certain, a housing cycle is virtually
unthinkable without an accompanying credit and
mortgage credit funding cycle.
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Causal chain of Excess liquidity in need of
a housing bubble investment opportunities
•Securitization
1 markets Additional
•Quasi-Insurance- demand 4
markets
Relaxation of lending standards
New target Collateral object
2 groups > personal 3
creditworthiness
Unstable Situation:
Credit- and Price bubble
burst is programmed
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Purification crisis
START
Actual occasion:
e.g. rising short-term
interest rates
1 4
Tightening of risk selection results in
Number non-performing
loans and default rates
2 3 going up
• decreasing consumption
• decreasing GDP growth
adaptive expectations • increasing unemployment
Exaggerations cannot be ruled out during a purification crisis! 48
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System-inherent factors
accelerating decelerating neutral unclear
Taxation and subsidies X
Share of non-recourse U.S. Germany *)
mortgages • Adjustable Rate
Mortgages (ARM)
Market-oriented appraisal of U.S. Germany • 5/1, 7/1, 10/1 ARMs
collateral • Interest Only
Mortgages
Cyclical lending standards U.S. Germany • Teaser rates
Cyclical LTV requirements U.S. Germany • Grace periods
• „Option Adjustable
Share of adjustable rate U.S. Germany Rate Mortgage“
mortgages • Cash-out refinancing
• Foreign currency
Share of loans with innovative U.S. Germany loans
characteristics * • …
• direction of influence of these factors shaped by institutional design and
changing patterns of human behavior.
• e.g. non-recourse mortgages, appraisal, “innovative” loan characteristics
• Running a mortgage system with several accelerating factors active at
the same time is dangerous because of mutual reinforcement
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Development of real interest rates in Spain
30,0
25,0
20,0
15,0
10,0
5,0
0,0
-5,0
-10,0
-15,0
Hypothekenzins, nominal Inflationsrate Hypothekenzins, real
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Why moderate housing cycles?
• Allocative efficiency reasons
• Economic growth considerations
• Distributional arguments
• Urban-planning reasons
• Housing policy deliberations
• Macroeconomic stabilization policy considerations
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Towards a definition of a sustainable
mortgage funding instrument
• Focus on continuous availability of the instrument in all
phases of the housing cycle at an “affordable” interest rate
• order the instruments along a sustainability continuum
• concept of sustainability relates to times of stress as well
as to boom phases
• Stress-resistant funding means are institutionally
unsuitable to refinance low-quality mortgages
• system-inherent factors act as “buffers” – or not
• assessment of sustainability: secondary market liquidity
and issuance activity.
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Pessimistic change in risk perception
price A0
A1
N0
N2 N1
circulation
Decreasing sustainability
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Optimistic change in risk perception
price A1
A0
N1
N0
circulation
Decreasing sustainability
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How did the different funding instruments
perform?
• Shorter term credit facilities from other
banks: Remember Northern Rock?
• Mortgage securitization: market almost
disappeared overnight in the U.S.
• Unsecured bank bonds:
• After the Lehman collapse no underwritings
for six months.
• swap spreads worse than covered bonds
and far worse than German Pfandbriefe.
• Bank deposits profited from public
guarantees
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And how did the Pfandbrief perform?
New Issuance of Mor tgage Pfandbriefe 2003-2009
70000
• Issue volume and
60000 nominal value of
outstanding Mortgage
50000
Pfandbriefe rose
strongly in 2008 (by
million Euro
40000
114 per cent).
30000
• In the fourth quarter
20000
of 2008 however, the
volume of Pfandbriefe
10000 sold fell considerably.
0
05
07
03
4
06
08
9
0
0
20
20
20
20
20
20
20
Source: vdp 2010b, European Covered Bond Council 2009
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And how did the Pfandbrief perform?
• Similar to other funding tools tradability of Pfandbriefe was
temporarily restricted.
• In the middle of the year 2008 risk premiums began to rise.
• Price formation was “liquidity-driven” after September 15
• Market relaxation in the course of the year 2009
• Spreads narrowed markedly after first quarter of 2009
• When the risk attitudes normalized investors shifted their
capital away from guaranteed bank deposits, guaranteed bank
bonds and public bonds.
• Compared with other mortgage funding instruments the
Pfandbrief fared reasonably well and was able to maintain
access to liquidity by and large, if somewhat restricted and
dearer.
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Swap Spread of German Pfand briefe co mpared to Eu ropean Covered Bonds and European Sen io r Unsecured Bank Debt
(bp)
300
250
200
150
100
50
0
-50
Jan 99 Jan 01 Jan 03 Jan 05 Jan 07 Jan 09
Swap Spread European Senior Unsecured Bank Debt (iBoxxprCorpBNKSen)
Swap Spread European Covered Bonds (iBoxxprCov)
Swap Spread German Pfandbriefe (IBOXXprCovDE)
Source: Commerzbank Credit Research 2009
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The role of government intervention
• Admittedly, government intervention has helped.
• bail out of HRE in early October → implicit state guarantee for
all bigger banks regarded as relevant to the system.
• EU finance minister’s rescue package: commitment to bail out
any bank constituting a systemic risk in the banking market and
common principles for the re-capitalization of ailing institutions
→ reestablished trust
• German government’s declaration contained in the Explanatory
Memorandum of the Financial Markets Stabilization Act
(Finanzmarktstabilisierungsgesetz) from 13. October 2008.
• European Central Bank’s 60 billion Euro purchase program for
covered bonds
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Mortgage Industry
Borrower Food Chain
Borrowers apply for credit at
brokers or lenders
Mortgage
brokers submit risks
Lender
broker
for underwriting
Retail lenders sell the mortgages
to wholesale lenders for bundling
Wholesale
Wholesale lenders sell conforming
mortgages to securitising agencies
lender Wholesale lenders use investment banks to
securitise non-conforming mortgages
privileged by the state
Fannie Mae Investment
FreddieMac bank
Agency MBS Nonagency MBS:
•Prime Jumbo
•Alt-A Rating
•Subprime
Agency
SPVs
CDO Conduits Insurer
Trusts Final
CDO2
Trusts Investors Source: following
Bitner 2008, p. 28
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Diversification of the funding mix
• not perfectly predictable how the different funding sources
will be affected in a future secondary market liquidity crisis
• good idea to spread the refunding risk
• Balanced funding mix recommended for “systemic” banks
and for the whole banking sector to enhance shock
resilience of the system
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Maturity transformation or golden rule of
accounting?
• Disturbances or fluctuations at the secondary mortgage
markets generally affect both, the circulation and the
issuance market.
• The issuance market however will usually be hit more
early and directly.
• At the circulation market, the exit options are crucial:
Pfandbrief vs. short-term bank credit
• The maturity structure of all refinancing means circulating
determine the shock absorption capacity of the system.
The longer the average maturity, the better.
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Maturity mismatch creates roll over risk
• Any mismatch of maturities between assets (i.e. any
violation of the golden rule) and liabilities side (or rather
any maturity overhang on the assets side) creates a “roll
over risk”, i.e. interest rate and loan extension risk.
• danger of shifting liquidity preferences – liquidity crisis
• difficult to roll forward a position
• liquidity of assets can suddenly change
• Conduit and ABS suffered from illiquidity of CDOs
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Just enforce the golden rule?
• The golden rule is essentially meant to assure insolvency-
resistance by eliminating the roll over risk.
• But: One of the functions of a bank is maturity
transformation.
• But: The roll over risk is inevitable because the general
liquidity preference of investors provides for an upwardly
directed yield curve and thus an incentive for maturity
mismatching for banks and borrowers.
• The cost of enforcement of the golden rule seems
unbearable, inter alia higher long-term interest rates
• Better ask for the optimal degree of mismatching
possibly market failure
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The key to stability
• Making the borrowers weatherproof is not a panacea.
• Less vulnerable borrowers could mean more vulnerable
lenders.
• Or less vulnerable lenders could mean more secondary
mort-gage market volatility.
• The challenge is to distribute the roll over risk in a way
that fosters the stability of the whole system.
• Arguably, it may be easier for lender to manage the roll
over risk than for borrowers.
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How can we moderate the housing cycle?
• Pig cycle
• relax supply-side rigidities (e.g. land supply)
• stabilize the expectations of investors
• Credit cycle
• Timing of monetary policy
• Definition of monetary stability incl. key asset prices
• Sustainable lending practices
• Possibility to remove credit risk from the balance sheet
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• „Housing is the most important sector in our economic
recessions and any attempt to control the business cycle
needs to focus especially on residential investment.”
(Leamer 2007, pp. 1-2).