Reform is defined as both changing and improving something by correcting its faults. In the real estate business, faults are considered those traits which prevent a property or company from performing adequately the function for which it is used. When examining such faults it can be helpful to categorize them in a fashion that makes the decision of whether or not to reform clearer. Faults related to design, or obsolescence, require a different response than those related to, for example, depreciation or the natural ‘wear and tear’ a business or house experiences over its useful lifetime. While addressing depreciation can help maintain the current value of the as-set, reform is by definition the act of addressing that asset’s obsolescence.
The collapse of Fannie Mae and Freddie Mac, like any corporate failure, presents an obligation of vested parties to assess any obsolescence these institutions may have had such that the most appropriate choices can be made with respect to their future. Identifying how these firms are designed, what they are designed to do, and how they proved to be either inadequate or super-adequate to their purpose will highlight what needs to be changed to affect real reform. This does not mean that their failure could not have been the result of a deprecation that is addressed by, for example, getting new employees, but without isolating the obsolescence such a determination would be impossible.
Though much has been written on this subject, the fact that these institutions became so integral to the lives of so many people, across all social, economic and political boundaries has made narrowing in on key issues, at best, very difficult. As multiple perspectives compete for attention, reform becomes as daunting as ‘boiling the ocean,’ so to speak. However, since real reform will benefit all, there is an incentive to finding where these perspectives overlap and focusing efforts to address obsolescence within that overlap.
Pre-depression housing finance
Before the Great Depression, the federal government did not have a direct involvement in housing finance. When left to their own devices, lenders, e.g. banks, insurance companies, etc., would offer mortgage loans exhibiting what might seem draconian by today’s residential financing standards. Loan-to-value (LTV) ratios of 50 percent, variable interest rates and five- to 10-year maturities requiring large ‘balloon’ or ‘bullet’ repayments at maturity were typical. These terms, however conservative they sound, do actually have contemporary analogies which may hint at the mindset of pre-1930s lenders.
In modern commercial real estate finance, five- to 10-year balloon mortgage loans are made available by those same types of lenders subject to the strength of the borrower and the demonstrable historical cash flow of the property. When a borrower is not able to present evidence of stable cash flows, from either the property or a corporate sponsor, first mortgage lenders will usually place a 50 percent LTV cap on the amount lent. While this is often the case when financing raw land, or the conversion of an existing structure to perform a new purpose, plenty of hotels and single-tenant office buildings receive this treatment as well.
With respect to the residential lending market, within a couple of years of the 2008 financial crisis, lenders and investors were offering 55 percent LTV jumbo first mortgage loans to customers who were borrowing more than what conformed to standards set by the government sponsored enterprises (GSEs).
What motivates certain lenders, both now and then, to avoid speculating on collateral value by limiting their LTVs? Liquidity. Lenders that are not in the business of owning real estate outright are most concerned with their ability to seize and sell the collateral backing their loans quickly. A bank which ceases to receive interest income from a borrower must replace that borrower as quickly as possible, thus its ability to foreclose on and sell that house is greatly improved if it may do so at 50 percent of the borrower’s purchase price or the loan amount. The notion that some types of lenders are designed to provide liquidity in return for stable interest income as opposed to speculating on the value potential of the collateral will be relevant to understanding GSE reform.
The 1929 financial market crisis
In late 1929, the U.S. stock market suffered a series of collapses that would begin a cascading failure of financial market liquidity providers, e.g. brokerages, banks, insurance companies, etc., which would ultimately strain and break the historically conservative housing finance market. This would not be dissimilar to how the U.S. residential housing market crash in 2008 affected the stock market and relatively conservative commercial real estate market.
Beginning on March 2, 1932, the U.S. Senate passed a series of resolutions authorizing the Committee on Banking and Currency (Pecora Committee) to investigate, amongst other things, practices related to: The buying, selling, borrowing and lending of securities; the general industrial and commercial credit structure of the U.S.; and the operation of the national banking and Federal Reserve systems. The broad scope of this Committee highlighted what was the growing concerns regarding fundamental financial risk management in the U.S., as what had begun as the collapse of an unstable stock market expansion in 1929 had spiraled into a stable economic depression. In other words, the goal was to find and address obsolescence in the U.S. system of financial liquidity providers.
On June 16, 1933, the Banking Act of 1933 (Glass-Steagall Act) was enacted. This law was, by design, to “Prevent the undue diversion of funds into speculative operations” by separating commercial and investment banking activities and by requiring the Federal Reserve bank to keep itself informed of whether “undue use is being made of bank credit for the speculative carrying or trading in securities, real estate …” While Congress again enlisted the Federal Reserve as an agent capable of managing the degree to which commercial banks speculate, it was deemed too difficult for this regulator to otherwise manage the conflict arising from a single financial services holding company attempting to manage businesses having inconsistent objectives. Therefore, Congress hoped to cure the Federal Reserve’s particular obsolescence through the Glass-Steagall Act while letting the Federal Reserve choose how to address any residual obsolescence related to commercial banks failing to perform their liquidity function due to their direct and indirect exposure to the practice of speculating on asset value appreciation (a function better suited to investment banks and brokerages).
One year later, the Securities Exchange Act of 1934 is passed. To prevent excessive speculation and the resulting “unreasonable fluctuations in the prices of securities,” the law sought to create more transparency around the trading of securities while also acknowledging the pro-cyclicality of lenders. Pro-cyclicality describes the tendency of lenders to offer more loans and higher leverage when collateral prices are rising, while also tending to restrict lending, offering lower leverage, when collateral prices are dropping. This tendency creates a self-reinforcing cycle which, if left unchecked, will lead to financial bubbles and depressions. To address how pro-cyclicality can cause “alternately unreasonable expansion and unreasonable contraction of the volume of credit” and the prevention of “fair valuation of collateral for bank loans,” Congress saw fit to suggest limits on LTVs related to securities lending. While the Federal Reserve was made responsible for reviewing the suitability of such limits over time, LTVs were initially set at the higher rate of 55 percent of the current market price or 100 percent of the lowest market price during the preceding three years, subject to an overall lending cap at 75 percent of the current market price. This was a good example of a counter-cyclical capital reserving scheme, where within a defined stable market, a reserve level is set lower to maintain that stable market while another level is set higher to help a market in crisis recover.
Ten days later, on June 16, 1934, the Pecora Committee released its final report. Though initially tasked with doing so, the report stops short of making legislative recommendations as Congress had already passed major legislative responses between 1932 and 1934. While acknowledging how these new laws would positively affect reform of important issues highlighted within the report, it is also emphasized that certain immediately “vital matters” remained to be addressed, such as “the nature and diversification of loans and security” and “proper banking reserves.”
The term “reserves” is related to the amount of cash a lender holds, rather than lending, which serves as a form of buffer for the benefit of depositors, in the case of a bank, just as a homebuyer’s downpayment acts as a buffer for the benefit of a bank. As all professional financiers understood, and as the Pecora Committee suggested, the diversity of an institution’s loan portfolio is of both critical concern and directly related to the level of cushion those loans have to the value of the collateral securing them, i.e. LTV. If this is not immediately intuitive, consider how LTV affects liquidity as discussed earlier. A bank has more comfort providing 50 percent LTV loans versus 100 percent LTV loans because as the price of a property drops, holding all else equal, more people would be willing to purchase it. Put another way, every home is unique, hence the price paid by the buyer must contain some purely subjective component that is justified only to them, i.e. beauty is in the eye of the beholder. As the bank’s valuation of that home, for lending purposes, drops below the sale price there is less reliance on the subjective components to that price. Therefore a lower LTV results in the bank’s ability to foreclose and own that home at a value which is supported by more objective factors, i.e. factors that a broader selection of potential buyers agree upon. Broader agreement is, by definition, a more diversified agreement. In essence, lower LTV equals higher diversity and greater liquidity. The attempt to manage diversity without managing LTV will prove to be a point of failure for many financial risk managers in the years to follow.
Another topic that the Pecora Committee focused heavily on was the proper role of the investment trust, where an entire chapter within their report was dedicated to the nature and abuses of these trusts. The investment trust, being a company organized to acquire and hold financial assets, is a tool that while historically beneficial to financial markets was found to have been abused in the years running up to the 1929 crash. The general consensus was that, through false claim of diversification and safety, investment trusts were used by American financiers to consolidate greater control of the “public’s money” such that it could be diverted into concentrated risks for purely speculative purposes and private gain. The report concluded that “Investment trusts conducted in accordance with the underlying principles responsible for their creation, diversification of investments with the view to investment return rather than capital appreciation, may have a place in our investment system” and subsequently challenged Congress and the private financial market participants to work together to insure future trusts be structured as such.
Government-sponsored housing finance
Less than two weeks after the Pecora Committee report was released, the National Housing Act is created “to encourage improvement in housing standards and conditions” and “to provide a system of mutual mortgage insurance.” The Act creates the Federal Housing Administration (FHA) and gives it the mandate and authority to begin writing housing finance related insurance to approved institutions. It was anticipated that with a relatively small upfront capital investment from the government and an implied backstop from the U.S. Treasury for losses larger than reserved for that the FHA would be able to administer a fund facilitating the sharing of housing finance risk amongst policy holders, i.e. lenders, for the mutual benefit of those policy holders. FHA’s mandate to promote new housing construction, renovation and general affordability was, in aggregate, an attempt to affect a counter-cyclical macroeconomic strategy. Not only would this construction related subsidy promote jobs, hence wealth creation, Congress hoped that an 80 percent LTV limit for FHA would help side-step what would be an otherwise longer process of recovery in the banking sector. The failure to maintain the strength of liquidity providers was a hard lesson learned after the crash. Hopefully, higher LTVs would increase demand for housing and lead to greater transaction volume and banking revenues. However, unlike the new regulations specific to the stock market, no mechanism was put into place to recognize the existence of a stabilized housing market or establish an appropriate LTV limit for such a market.
Recognizing that to insure an asset is to invest in that asset, it can be instructive to evaluate FHA as an investment trust from the perspective of the then contemporaneous Pecora Committee. Does the FHA seek to consolidate control of public money so that it can be diverted into concentrated risks allowing for private gain from capital appreciation? FHA does possess potential access to a considerable amount of government funding and was obviously intended to consolidate certain lending standards for the housing market. Would increasing LTV limits beyond private market norms for an indefinite timeframe for the benefit of existing private homeowners and private lending institutions be considered speculative? At what point could FHA’s efforts go beyond recovery and begin facilitating an unstable expansion? Taking a cue from the Pecora Committee report, instability arises from making concentrated investments under the guise of diversification, which means FHA’s lending and insurance activities would have to be deemed concentrated to suggest being speculative. Given the limits placed on the size of the loans to be insured relative to the size of its fund, it is fair to say that FHA would not be allowed to be over-exposed to any single borrower, but what about its exposure to a singular market (or corporate entities within that market)?
Having a portfolio of loans or investments, entirely within any one particular market is not concentrated as a rule, but one needs to understand what factors tie the risks of those individual loans together within that market. Such factors are otherwise known as the market’s systemic risks. If a lender is able to successfully isolate those systemic risk factors and either reduce, avoid or effectively transfer them to another entity, then their portfolio of loans could be considered diversified. In the FHA’s case, Congress recognized two primary risk factors to manage: The borrower’s ability to pay and the value of the home securing the loan. While Congress left it up to the FHA to determine how to reasonably assess the first risk, it made explicit the limitation on exposure to housing prices in the form of a cap on LTVs. As explicit was the recognition that housing value risk could not be diversified in the same way that borrower credit risk could be, for example, by demanding the insured loan portfolio always exhibited a high number of borrowers, or homes in this case. So, with the mandate to affect a counter-cyclical response to the depression of the entire housing market and the knowledge that LTV was the key to diversifying collateral value risk, Congress chose to structure FHA initially with that 80 percent LTV limit for the loans it insured. This limit falls somewhere in the middle of a range bounded by a non-speculative, liquid financing level of 50 percent, relied upon by private financiers in multiple markets (and Congress) and the purely speculative 100 percent LTV, by definition the least diversified, i.e. you own the properties securing the loans. This standard is definitely not analogous to the concentrated pyramiding of singular corporate risks described in the Pecora Committee report, but it is definitely designed to put a positive pressure on housing values. In a depressed market, the FHA was Congress’s hedged-bet on housing.
The National Mortgage Association
In addition to creating the FHA, the National Housing Act also established the framework for national mortgage associations (NMIs) which were to serve as investment trusts in support of FHA by drawing private investment capital into the housing market. NMIs would be authorized to raise equity and borrow money such that they could purchase and sell first mortgages subject to the same 80 percent LTV constraint as FHA. However, they were restricted from borrowing money unless the mortgages purchased were insured by FHA. Why? If any private equity investor was going to be allowed to use an investment trust to make leveraged bets into one market, in a post-1929 environment, it was going to have to do so for the public benefit in a fashion consistent with Congress’s own hedged macroeconomic bet. Incenting private investors into FHA insured mortgages allowed for maintaining public control of the degree of speculation into capital appreciation.
Though the government was engineering what it hoped to be a compelling set of investment options for the private investor markets, exactly zero NMIs were created in the four years following FHA’s creation. Private capital tends to be more opportunistic and less innovative after a financial crisis and, as a rule, generally not motivated by social welfare, as such, in order to fully affect its counter-cyclical strategy the government was forced to take additional proactive measures in 1938 by amending the National Housing Act.
FHA’s authority to write insurance was expanded to allow for tiered LTVs beyond the standard 80 percent, based on housing price. While borrowers would continue to have access to an 80 percent LTV FHA mortgage for a home up to $20,000 in value, newly constructed homes worth $10,000 or less would be eligible for up to 86 percent LTV. Even 90 percent LTV was available should the new home be valued below $6,000. Though this option was designed primarily to encourage the development of low cost homes, it also acknowledges mortgage risk changes relative to overall housing prices and suggests a path the government might take to help it manage overall housing finance risk.
As additional motivation for raising private capital, non-government owned NMIs would be allowed to buy and sell non-FHA insured first mortgages, yet, in keeping with the need to en-sure that private capital could not be used to drive asset prices beyond FHA’s controlled limits, those loans could not be in excess of 60 percent LTV.
Ultimately, the first and what would be only NMI for the next 30 years had to be created by the government. So, in 1938, FHA authorized the Reconstruction Finance Corporation, FHA’s original funding source and itself an independent agency of the U.S. government, to create the National Mortgage Association of Washington. This investment trust would be re-chartered as Fannie Mae 10 years later.
Distilling the legacy of 1930s housing finance is relatively straightforward. In the wake of a market crisis, the government must be in a position to facilitate a counter-cyclical economic strategy. In its experiment to do so through FHA and Fannie Mae, the government was successful in creating what was a hedged-bet on housing prices. The public, i.e. homeowners and the government itself, would benefit from any capital appreciation through their equity ownership of either the homes being financed or the investment trusts providing the liquidity. Private debt investors, or lenders, would benefit only by gaining access to bonds and loans that were structured to safely return their capital via highly diversified and/or insured collateral. Notwithstanding the soundness of this strategy at the time, without having established a mechanism to recognize the transition from recession to recovery then recovery to expansion, the continued existence of FHA and Fannie Mae would inevitably become a pro-cyclical influence in the housing market.
Ryan W. Birtel is founder and managing director of Eolith Advisory Ltd., an independent consulting firm that provides economic and financial advisory services related to the real estate and structured finance markets. He may be reached by phone at (646) 707-1502 or e-mail
[email protected].
