Housing, Liquidity and You

I was just watching testimony of Alan Greenspan before Congress in his attempt to remove any culpability for the housing crisis. He brought up securitization and the expansion of sub prime mortgages as the major reason for the bubble. I understand that these products enabled the expansion of loan origination, but let’s get real, there wouldn’t have been near the amount of loans if interest rates weren’t allowed to remain artificially low for some time. Here’s my attempt to balance the rhetoric.

One interesting point I wasn’t aware of was the revelation made by Fannie Mae in September 2009 regarding the sizable amount of sub-prime mortgages they held at the time the music stopped in 2008. I heard a number that as little as 25% of their portfolio was actually traditional 30-year fixed, single family mortgages. During 2005-2007 Fannie and Freddie accounted for about 40% of all loans originated during that period. Another point to make regarding their role in the crisis is the fact that the implicit backing of the U.S. government allowed their borrowing rates to be much lower than what a free market would have assigned. The demand for their debt and the packaging of their debt with others of lower quality helped expand the prevalence of the mortgage-backed securities market.

There is a lot of blame being passed around for the “shadow banking system.” This comprised of debt that was securitized and sold in what turned out to be a fairly illiquid market. In Wikipedia there is a reference to Paul Krugman in which he supposedly said that the shadow banking system was at the “core of what happened.” Think of it this way, what if all of that debt was actually held by the banks instead of being dispersed globally? The result would have been much more disastrous for our banking system. One might argue that banks wouldn’t have originated that many loans if they intended to hold onto them. That may or may not be true, but were those purchasing these securities that much more ignorant than those running the banks. In short, no. The reality is that there was a tremendous desire for yield on investments. Fund managers leveraged themselves in order to buy a higher guaranteed rate of return. That guarantee that led to the high credit rating for mortgage-backed securities was the addition of Fannie and Freddie debt to the packaged loan security–which was implicitly backed by the Federal Government. In the end, the process of securitization helped to limit risk, but it was the distortion created by a low yield environment, Federal guarantees, and inept government cartel of ratings agencies that provided the fertile ground this market to grow.

Lastly, I would like to address Greenspan’s continued comments about his role as Chairman of the Federal Reserve. Certainly Fed interest rate policy has a much larger impact on short term interest rates, but short term rates still create a baseline with which long-term rates are based. There is a very predictable interest rate spread between yields for short term Treasury debt and that of longer maturities. That spread may vary, but there is little chance that long term yields will rise beyond a certain point without a move by the Fed. The Fed holding the line with irrationally low rates allowed for mortgage rates to remain low for a long time. That is only one facet of the impact their policy has on long-term Treasury rates, but there are others that promote trade deficits–which helped suppress long term Treasury yields due to foreign purchase of our debt.