The Great Financial Crisis (GFC) in 2008 was the most impactful financial collapse and economic downtown since the Great Depression of 1929-1939. It led to a long list of changes that included legislation and a host of revised and new regulations by the government.
The GFC caused regulators, central bankers, and the financial industry itself to think deeply about the causes of financial instability and systemic risk that played a significant role in the crisis, according to the first of a two-part series from The Stoop, the NYU Furman Center Blog.
Donald H. Layton, Senior Visiting Fellow at NYU, wrote in The Stoop that while those changes were numerous, they largely ignored Fannie Mae and Freddie Mac, two massive government sponsored enterprises (GSEs) that it said were at the heart of the Great Financial Crisis.
The blog said that neglect made sense because the Obama administration had intended that Fannie Mae and Freddie Mac would be “wound down” and replaced by something Congress would create. That plan never materialized.
Layton is the former CEO of Freddie Mac.
By about 2017 it was a prevailing view among policymakers that for the foreseeable future, F&F would continue to anchor the U.S. housing finance system. After all, The Stoop said, Congress was not focusing on a replacement and also in part because of the two agencies’ improved operating performance and risk profile.
3 Sources of Potential Financial Instability
In the series’ first part, The Stoop examines several of the system’s weaknesses that were rooted in a structure Congress created for the GSEs, and how that led to three specific sources of potential financial instability.
Part 1 reviews how two of the three identified sources of financial instability — (1) the excessive concentration of mortgage interest rate and liquidity risk, and (2) significant undercapitalization — effectively have been contained, mainly via actions taken during conservatorship, a major policy success that The Stoop said is rarely discussed in the industry or government.
According to Layton, the third major risk that could lead to financial instability for F&F is excessive concentration of mortgage credit risk, some that remains unresolved despite advances made between 2013 and 2019. The Stoop said in fact, it is heading in the wrong direction.
Prior to Great Depression, housing finance wasn’t something the U.S. government took much interest in. But, starting in 1932, it began to play a significant role, and by the late 1930s, it was its dominant force. That’s something it has since maintained, The Stoop said.
Part 1 delves heavily in the federal government reaction when it created a series of specialized financial institutions focused on residential mortgage lending. Those included savings and loans that were the mainstay of residential mortgage lending in the immediate post-war decades; F&F, which assumed that role through the 1980s; the Federal Home Loan Banks (FHLBs); the Federal Housing Administration (FHA); the Federal Savings and Loan Insurance Corp. (FSLIC), a counterpart to the FDIC; and others. Think of it as Congress creating a parallel banking system dedicated to residential housing finance.
Its purpose was to allow homeownership policy to be implemented in a focused way, and to effectively channel subsidies to “help homeownership.”
One type of subsidy was light capital requirements on the various specialized mortgage institutions that were created in order to make mortgages less expensive. But light capital requirements can be problematic. The Stoop said that organizations with concentrated risk such as mortgage assets are subject to higher levels of instability, while diversification of mortgage assets across the broader banking and financial system would have been considerably more stable.
Those specialized mortgage institutions were vulnerable, however, as large losses could rapidly escalate into a crisis.
The Enduring ‘American Mortgage’
Layton also detailed how after World War II, the standard U.S. mortgage became what is now known internationally as the “American mortgage.” The Stoop says that type of mortgage has is notable for the a long-term repayment period, that at first, was set at 15 years but in the 1960s was standardized at 30 years and by a fixed interest rate for the same time period. Borrowers could make prepayments at any time for any reason without penalty.
That is an extremely borrower-friendly structure that grew out of a government agency that did not need to worry about liquidity or interest rate risk.
However, when this same structure became standard for private sector lenders after World War II, the resulting liquidity and interest rate risk became quite problematic, The Stoop said.
“Simply put, at that time, no lender funded by deposits or the debt markets had access to funds to match the liquidity or interest rate risk profile of a balance sheet dominated by American-style mortgages. Instead, those institutions would be short-funded, creating a tremendous concentration of interest rate and liquidity risk, a source of potential major financial instability,”
Part 2 of the series will look at F&F’s undue concentration of mortgage credit risk and how that risk was on a path to substantial containment that started in 2013, but because of a combination of intended and unintended consequences, began to head in the wrong direction around 2020.
The post Great Financial Crisis: How 2 Major Sources of Risk Have Been Contained first appeared on The MortgagePoint.
