Fisher Center for Real Estate & Urban Economics (University of California, Berkeley), 2008

1. Fisher Center for Real Estate & Urban Economics (University of California, Berkeley), 2008 Fisher Center Working Papers “Regulating the Investment Banks and GSE’s After the Subprime Crisis”, Dwight M. Jaffee

2. The working paper offers: • A review of the key factors that led to the subprime crisis • The special features of the investment banks and GSE’s that led to a bailout • A solution by the author to avoid future Investment bank and GSE bailouts

3. 1. National Banking Act of 1863 was a federal charter regulating commercial banks – wildcat banking. It also created the Treasury Department and the Office of the Comptroller of the Currency. 2. The Federal Reserve System was created in 1913 in response to continued financial panic 3. Federal deposit insurance was created in 1933 to stem bank runs in the Great Depression 4. The Glass-Steagall Act passed in 1933 to address conflicts between commercial and investment banks. Glass-Steagall was amended by the Bank Holding Company Act of 1956 and again by the Financial Services Modernization Act of 1999. 5. The Federal Housing Administration (FHA) was created in 1934 – govt’s first residential mortgage insurance program. 6. Fannie Mae was created in 1937 to further support the mortgage markets. Fannie Mae was later split into two entities; GNMA & Fannie Mae. 7. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDCIA) was created in response to the S&L crisis and required regulators take corrective action to any banking firm failing to meet capital or regulatory requirements. Has financial regulation been successful in the past?

4. Government regulation of past financial crises have been successful because: • Regulations have been focused on the key issue of the time • Regulations have been strong, innovative and long standing.

5. So what were the causes of the Subprime Crisis? • Subprime mortgage losses and a Boom Bust Real Estate Cycle • Concentrated & Cash Flow Mismatched Investment Portfolios • Securitization and the Credit Rating Agencies

6. Subprime mortgage losses and a boom bust real estate cycle: Subprime Mortgages failed partly because…. • Poor design, underwriting and origination • Predatory lending • Market institutions were poorly prepared to modify loans in lieu of foreclosure The Federal Reserve is already making changes to the Truth in Lending laws to address predatory lending and HUD is also making parallel changes to RESPA rules.

7. Subprime mortgage losses and a boom bust real estate cycle (continued): Subprime Mortgages also failed due to a decline in US housing prices. A typical scenario for real estate cycles: • Financial innovation expands mortgage lending • Increased lending raises housing demand, which increases housing prices • Increase housing prices fuels expanded lending – circular cycle repeats • Market crash – market prices for housing becomes inconsistent with fundamentals of homeowner affordability.

8. Subprime mortgage losses and a boom bust real estate cycle (continued): Why would investors hold mortgage assets even as the real estate market price fundamental opposed the affordability fundaments? • Investors have made the bet that with no real aggregate housing decline since WWII, the chance of a significant housing price decline was slim. (Author notes there have been a number of regional house price crashes but these have been idiosyncratic events ignored by large investors with a geographic diverse portfolio)

9. Subprime mortgage losses and a boom bust real estate cycle (continued): • Subprime loans represent less than 4% of all US investment securities. The aggregate loss rate of subprime loans in the end may not exceed 25%. • Assuming this is representative of US investment portfolio then the one time loss would be 1% (.04 x .25) • This is not a significant loss to lead to bailouts.

10. Concentrated and Cash Flow Mismatched Investment Portfolios: The flawed investment strategy had two elements: • Portfolios were highly concentrated in subprime mortgages, achieved by over-weighting the asset class and by taking on the riskier tranches in subprime securitizations. • Portfolios where funded with short-term debt with the assets serving as collateral. This strategy is very profitable assuming mortgages losses are minor and the funding can be rolled over frequently.

11. Concentrated and Cash Flow Mismatched Investment Portfolios: However, as housing prices began to fall investment firms were unable to rollover the maturing debt because lenders were not sure of the value of the collateral. Valuation of these securities is complex dependent on the future loss ratio. Thus, lenders unable to value the security reasoned not to lend at all is the most common sense approach.

12. Securitization and the Credit Rating Agencies: The President’s Working Group on Financial Markets (2008 p.1) reports the following as two additional factors that may have contributed to the subprime crisis: • Significant erosion of market discipline by those involved in the securitization process • Flaws in credit rating agencies’ assessments of subprime residential mortgages The author makes the argument these two issues may have aided in the subprime crisis but re-regulation of securitization and rating agencies is misguided.

13. Securitization and the Credit Rating Agencies: Regulations that allowed investors with systemic responsibility to take risky positions is the true problem coupled with the fact that rating agencies have traditionally taken a more conservative approach when rating asset class; albeit this huge mistake with subprime mortgages.

14. So Why Did the Federal Reserve and the Treasury Provide Bailouts? The main reason was because both the investment banks and GSEs were market makers and counterparties which created a systemic risk as an externality.

15. Investment Banks • Market maker and counterparty for derivatives • These derivatives included interest rate, foreign exchange swaps and credit default swaps. • Because of hedging the interconnection of banks is established: Fund A enters into a swap with Fund B because it knows B has hedged a particular risk with Investment Bank C • If one counterparty fails it becomes a domino effect. No one single counterparty has the incentive to prop up the entire transaction. • Inability to meet maturing debt obligations = bankruptcy.

16. GSEs • GSEs may be considered the world’s largest counterparty in interest rate swaps and swaptions (options based on swaps). As such their failure has a systemic effect larger than investment banks. • Essentially, the Treasury was concerned that if GSEs defaulted on their capital market obligations (5 Trillion - debt and MBS combined) GSE’s couldn’t continue to support the US mortgage market. GSEs were eventually put in conservatorship under control of the Federal Housing Finance Agency.

17. How to Regulate Investment Banks and GSE to Avoid Future Bailout First let’s understand the problem. Investment Banks and GSE have two distinct businesses but different business activities: • Both operate highly leveraged and cash flow mismatched portfolios. These funds aggregate information creating price discovery and efficient resource allocations. “Hedge Fund Division” • Both serve systemic mission serving as key counter parties in the Over The Counter derivatives market. (GSE additionally stabilize the mortgage market). “Infrastructure Division”

18. Problem: If the hedge fund division is part of the larger company which includes the infrastructure division and losses are sustained by the hedge fund division then total company bankruptcy is possible. Solution: Separate the two divisions such that the infrastructure division is “bankruptcy remote” from the hedge fund division.

19. The Monoline Insurer Solution: So how do you implement the change? • Follow past precedent from the insurance industry. In 1965 Mortgage Guaranty Insurance Company petitioned to offer private mortgage insurance – a high risk insurance policy. The regulatory response was to allow the firm to be chartered, but only as a monoline insurer. The net effect insures that standard policies holders with limited risk would not be subject to high risk policies offered through the same company. • The practice still holds today and with very good results. Even with the losses arising from the current subprime crisis, there have been no failures among either the private mortgage or the bond insurers.

20. Initial legislation permitted banks to carry out “banking business” – taking deposits and making loans. This separated banks from investments banks but also from any other business lines. In 1956 The Bank Holding Act modified Glass Steagall. Bank holding companies were permitted to own one or more banks and allowed to carry out activities – at the holding company level – “closely related to banking.” The Fed still has oversight and is responsible to ensure the soundness of the subsidiaries. In 1999 Glass Steagall was again modified by the Financial Services Modernization Act. This Act created a “financial holding company” as a special status for a bank holding company, with the ability to operate both investment banking and insurance subsidiaries, along with its commercial banking subsidiaries. Again, the Fed has regulatory authority. Holding companies must meet the Fed’s highest capital standards and holding companies must give the highest priority to the soundness of the commercial bank subsidiaries. The Glass Steagall EvolutionThe banking industry has essentially implemented a monoline approach by way of the Glass Steagall Act of 1932.

21. How to implement Regulation of the Investment Banks Given investment banks are currently operating as subsidiaries within the bank holding companies, risk remains that hedge fund operations may endanger the bank holding company’s viability. The author’s proposal is simple – impose a monoline requirement on any investment bank that wishes to carry out both hedge fund and infrastructure activities, whether it operates independently or as a part of a bank holding company. EFFECT – potential losses by the hedge fund division will not threaten the infrastructure division. Sample Structure - Infrastructure divisions are structured as a separate subsidiary with dedicated capital. This provides the same protection to these subsidiaries currently provided to commercial bank subsidiaries with bank holding companies. Future monoline restrictions can be imposed if the regulator determines an activity has systemic risk.

22. Costs of the Proposal • Administrative costs to isolate infrastructure division with separate subsidiaries. • Restriction that the capital of the protected infrastructure subsidiary cannot be applied to cover losses arising from the activities of any other subsidiaries of the bank holding company.

23. Potential Regulatory Refinement • It could be argued that the risk based capital requirements be raised as a means to improve their future safety. (AIG and Bear Stearns required bailouts even though they met their capital requirements. Their failures were caused by inability to rollover maturing debt – magnified by their solvency concerns.) • Regulators must anticipate financial institutions and markets will continue to innovate and create risky investment vehicles. These risks must be independently remote to eliminate the systemic risk. • Monoline restrictions have the ability to be quickly applied – assuming the risk is identified – to reduce the systemic risk.

24. How to Implement Regulation of GSEs GSE operate two distinct activities: Retained Portfolios & Securitization Retained Portfolios – GSE have “on their own books” approximately 1.5 Trillion of MBS which are funded by the issue of approximately the same amount of corporate debt with three main problems: • Major cash flow mismatch – debt issued to fund the portfolio has a shorter maturity than the MBS • GSEs made significant investment in subprime mortgages • The portfolios are highly leveraged - $40 - $1 Retained Portfolios are eerily similar to hedge fund activities by investment banks – and resemble the same reasons for a bailout.

25. How to Implement Regulation of GSEs GSE operate two distinct activities: Retained Portfolios & Securitization Securitization - qualifying mortgages are securitized into MBS. GSEs currently have 3.5 Trillion in securitized pools. Incidentally, a large portion of the subprime mortgages were retained on the GSEs books rather than being placed into the pools in order to earn a higher coupon rate as the investor.

26. How to Implement Regulation of GSEs The author’s proposal is to once again implement a monoline structure to separate the retained portfolio from the securitization of MBS. Once the GSEs are released from conservatorship, a new entity would be created to accept the retained portfolios which would function as a private sector investment company. The securitization of MBS would remain a governmental agency.

27. New Securitization of MBS Structure –“Middle Income Mortgage Agency” (MIMA) • The securitization of MBS by GSEs will become a governmental agency called MIMA that would essentially provide the same service of government insurance and securitization to middle-income families that FHA / GNMA currently offer to lower income families. • Borrowers would be charged insurance premiums and MIMA would earn a spread to guaranty the loans. • The private markets would still originate and hold mortgages – no governmental crowding. • Private market securitizers of jumbo mortgages would continue to operate business and usual.

28. New Retained Portfolio Structure • Retained mortgage portfolios would be spun off to GSE’s shareholders and would operate similar to a publically traded REIT with the ability to originate mortgages directly. • Shareholders would receive: • Mortgage assets • Bond liabilities • Net worth of the portfolio at the time of spinoff • Intellectual capital of the GSE (software, techniques for interest rate risk hedging etc)

29. Government Sponsored Enterprises should end The author concludes the concept of a privately owned, profit maximizing company combined with a public mission and an implicit government guarantee was a recipe for disaster. The solutions provided above solve this problem. Congressional support of GSEs to support lower-income goals was based in part on the premise that GSEs aid to lower income families was available at no cost – tax the GSE in lieu of making appropriations to HUD. In light of the true cost to bailout Fannie and Freddie, Congress should make the appropriations as a more effective means to assist lower-income families.

30. Conclusions The author offers a framework for the re-regulation of investment banks and GSE with the overriding goal of minimizing the likelihood of future losses on risky portfolios posing a systemic risk requiring a governmental bailout. Key Feature – Risky portfolios (hedge fund divisions or activities) are isolated from the activities that create systemic risk (Infrastructure divisions). Investment banks are already operating as a part of bank holding companies, therefore the only real change is the isolation of the capital of the infrastructure division be bankruptcy remote from any possible failure of the overall holding company. GSE implication are more severe – MBS securitizations become a governmental agency while retained portfolios go to the GSE shareholders functioning without government support.