About


Real Estate Research provides analysis of topical research and current issues in the fields of housing and real estate economics. Authors for the blog include the Atlanta Fed's Kristopher Gerardi, Carl Hudson, and analysts, as well as the Boston Fed's Christopher Foote and Paul Willen.

Comment Standards:
Comments are moderated and will not appear until the moderator has approved them.

Please submit appropriate comments. Inappropriate comments include content that is abusive, harassing, or threatening; obscene, vulgar, or profane; an attack of a personal nature; or overtly political.

In addition, no off-topic remarks or spam is permitted.

April 25, 2014

Two Views of the Involvement of Credit Rating Agencies in the Mortgage Crisis

A lot of people have blamed credit rating agencies (CRAs) for helping to cause the mortgage crisis. The report of the Financial Crisis Inquiry Commission (FCIC) labelled CRAs as "key enablers of the crisis," because the exploding mortgage-backed bonds that caused so much trouble could not have been sold without stamps of approval from the CRAs. Commentators often link CRA failings to the fact that they are paid by the issuers of the securities they rate, with the implication that CRAs are thus given incentive to award good ratings to securities that do not deserve them. Indeed, two recent articles by academic economists on this topic come to the same conclusion: financial markets would work better if we scrapped the issuer-pays model in favor of some other way to pay CRAs for their evaluations. But the two articles disagree on why this is so, and understanding the source of this disagreement sheds some harsh light on claims that CRAs should be even partly blamed for the financial crisis in the first place.

Grade inflation in the student-pays model
The first article is a Wall Street Journal op-ed piece by Princeton economist Alan Blinder. Blinder likens the awarding of credit ratings to mortgage-backed securities to his own awarding of letter grades to his Princeton students. "Suppose I proposed to grade my students by a 'student pays' model," Blinder suggests. Such a setup would encourage him to give easy As in hopes of attracting more students and higher pay, and the information in the grades would suffer as a result. "Yet that description comes pretty close to mimicking the way we pay rating agencies," Blinder writes. "Looking back, is it any wonder that so many securities were blessed with undeserved triple-A ratings?"

One interpretation of Blinder's analogy is that college grading works better than securities rating because universities have not adopted the student-pays model. That argument will seem curious to many college instructors, because this model approximates their own compensation arrangements pretty well. Students may not write checks to professors, but they (or their parents) write checks to colleges, who then pay the professors. Instructors whose grades are overly harsh in relation to other courses are likely to see their class sizes dwindle, to the dismay of department chairs facing hard budget constraints. Even if an instructor has no problem attracting students, she may not want grading disparities among courses to distort student decisions on what to study, so she might ease up in her own grading as well. Given the incentives of professors, it is not surprising that grade inflation is debated at many universities, even the very best ones. A December 2013 article in Harvard University's student newspaper, the Crimson, described a faculty meeting at which a professor bemoaned the fact that the most frequently awarded grade at Harvard College is an A-minus. A university dean corrected him: "The median grade in Harvard College is indeed an A-minus," the dean is quoted as saying. "The most frequently awarded grade in Harvard College is actually a straight A." (Disclosure: Harvard's grading policy is of personal interest to two authors of this blog post, who teach intermediate macroeconomics courses there in their spare time.)

Rational employers, rational investors
If the student-pays model leads to grade inflation, then don't we have even more ammunition that the bad incentives inherent in the investor-pays model for CRAs is partly responsible for the mortgage crisis? Not necessarily. For bad CRA incentives to have caused the crisis, two things must be true: one, the incentives must have caused inflated ratings, and two, the investors had to believe the inflated ratings. The second step in this causal chain is open to question. If the investors knew that the issuer-pays model gave incent to the rating agencies to inflate ratings, then rational investors would have taken that information into account when making investment decisions.

The college-grading analogy is again useful here. Consider an employer who is thinking about hiring a recent graduate who received a B-minus in a course that is highly relevant to what the firm does. How should the employer use this information? One option would be for the employer to look up how the student's official university documents define a B-minus—the documents are likely to define a grade in the B range as indicating a better-than-average understanding of the material. But a rational employer who knows the incentives facing American professors would also know that instructors are given cause to inflate grades. The firm could thus surmise that an applicant on the border between a B and a C may actually have a lower-than-average mastery of the subject. In the same way, rational mortgage investors who knew that CRAs had incentive to inflate ratings would have taken those ratings with a grain of salt when evaluating mortgage-backed investments.

Investor rationality plays a prominent role in a second recent piece on CRA incentives, a formal paper by the economists Anil Kashyap and Natalia Kovrijnykh (KK). Because this article is part of the academic economics literature, the authors adopt the fundamental assumption that all actors in the model are rational. As we might expect from our analogy of the job applicant, the rationality assumption makes a big difference when analyzing CRA payment regimes. Consider a situation in which CRAs are paid by the issues of securities, as they are today. Further assume that CRAs receive more money for good ratings than for bad ones. Rational investors in the KK model would realize the ratings are likely to be inflated under this set of incentives and would deflate the ratings accordingly. But if the CRAs are unable to fool investors who know both the CRAs' preferences and their opportunities, then the CRAs might as well tell the truth. KK therefore constrain their attention to equilibria where rating agencies are always truthful.

The revelation principle
In assuming truth-telling, KK are following a long tradition in the modeling of imperfect information. In fact, the assumption that actors with private information tell the truth shows up so often in models of imperfect information that it has a special name: the revelation principle. This principle is useful for modelers because it allows them to focus on equilibria in which the agent with private information has no reason to lie. To be clear, in this situation, the revelation principle does not mean that rating agencies never lie. Rather, it states that any equilibrium in which rating agencies lie is equivalent to one in which they tell the truth. The lying doesn't affect the actions of investors who know the incentives and opportunities of the CRAs, just as inflation of our B-minus student's grade does not lead the employer into an inappropriate hire. Because lying does not encourage agents to take inappropriate actions, it can safely be ignored when thinking through the fundamental aspects of the problem.

The appropriateness of the revelation principle in this context hinges on the ability of mortgage investors to analyze CRA incentives and opportunities and thereby back out the truth. Is this realistic? Ironically, the critics of CRAs provide evidence in support of this view. When Barney Frank alleged that CRA incentives led them to inflate ratings, he was doing exactly the sort of reverse engineering that lies behind the revelation principle. And if legislators could figure out that rating agencies had distorted incentives, why couldn't investors, who were putting up their own money? Indeed, investors should have had much better information about agency incentives than Barney Frank. It turns out that financial intermediaries lost enormous sums on the mortgage-related securities that they purchased and held on their balance sheets (more details on this in the next post). At the same time, they were also large issuers of these securities. Who would know better about the potential for corruption of rating agencies than the financial intermediaries that supposedly corrupted them?

Of course, if the KK model holds that rating agencies always tell the truth, then the model cannot rationalize arguments that CRAs helped cause the crisis by misleading investors. Indeed, the revelation principle makes it hard to rescue any story about untruthful CRAs. What if credit rating agencies had private information about their incentives, in addition to private information about their effort and the quality of the securities that they rated? Setting aside the fact that the issuer-pays model of credit ratings was common knowledge in the market, this change to the model has no effect on its outcome. Here again, the revelation principle would imply that CRAs truthfully reveal the private information about their incentives. For investors to be misled, they cannot simply be confused about incentives. Rather, they must believe that the CRAs' incentives were better aligned than they actually were. In our view, that is unlikely.

CRA payment arrangements
We began this post by noting that both of the recent articles on CRA incentives argued against the issuer-pays model. How can KK make this argument if investors in their model are not fooled? The reason involves some subtle implications of exactly how CRAs are paid in different states of the world. In all contracts in KK's issuer-pays regime, CRA pay is contingent on the outcome of the security. That means that if an AAA-rated security defaults, the CRA gets paid less than if the security pays off. To induce effort by the CRA, the spread between the payoffs must be large (that is, the CRA must be paid a lot more when the AAA security is successful compared to when it defaults). Because of limited liability, the CRA's compensation is bounded below by zero when a bond defaults—that is, investors can't demand payment from the CRAs in the default state—so high-powered incentives, which require high average pay, imply that compensation to the CRA in the good state has to be very high. As a result, paying the CRA for high effort can be prohibitively expensive for the issuer, causing the issuer to settle for low-powered incentives instead and thus receiving low effort from the CRA. Even in the low-effort equilibrium, however, CRAs increase the information set of investors and are socially useful.

Going farther, KK show that having the investor rather than the issuer pay the CRA solves the limited-liability problem and thereby raises social welfare. Particularly surprising about this finding is that the investor-pays model is not only good for society, but it is also good for the CRAs! The reason once again involves the revelation principle. In equilibrium, everyone knows both the amount and usefulness of the effort expended by the CRAs in evaluating securities. The larger the CRA's social benefit, the more the CRA gets paid. If KK's model is accurate, then CRAs themselves may lead the way to a better social outcome by encouraging the adoption of the investor-pays model.

While KK's paper includes many specific lessons about potential CRA payment arrangements, the bottom line to emerge from a comparison of the Blinder op-ed and the KK model involves their differing assumptions regarding investor rationality. The KK model illustrates how the revelation principle, which follows from investor rationality, works against the argument that CRAs helped cause the crisis by misleading investors. As long as investors understand the basic structure of the market, then standard models of asymmetric information—of which the KK model is an example— do not predict that investors will experience large and unexpected losses.

You can read the Harvard Crimson article on the magazine's website.

Photo of Chris FooteChris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston,

 

Photo of Kris GerardiKris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta, and

 

Photo of Paul WillenBy Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston

February 19, 2014

Asymmetric Information and the Financial Crisis

In describing the $13 billion settlement reached between JPMorgan and the Department of Justice last November, Attorney General Eric Holder said,

Without a doubt, the conduct uncovered in this investigation helped sow the seeds of the mortgage meltdown. JPMorgan was not the only financial institution during this period to knowingly bundle toxic loans and sell them to unsuspecting investors, but that is no excuse for the firm's behavior.

What Holder describes sounds like a textbook example of what economists call asymmetric information: JPMorgan knew something about the loans it was selling (that they were toxic) that they didn't reveal to investors. Specifically, the government alleged that JPMorgan reported facts to the investors that turned out to be wrong. For example, JPMorgan may have said that it made only 10 percent of the loans in a pool to investors (as opposed to owner-occupants) when the actual percentage was 20 percent. So it would seem as if economic theory, which has a lot to say about asymmetric information, should help us understand the crisis. Indeed, to many, asymmetric information and "bad incentives" are the leading explanations of the financial crisis. For example, a Reuters article that described the settlement made the following claim:

The behavior that the largest U.S. bank admitted to, authorities said, is at the heart of what inflated the housing bubble: lenders making bad mortgages and selling them to investors who thought they were relatively safe. When the loans started turning bad, investors lost faith in the banking system, and a housing crisis turned into a financial crisis.

In future posts, we will consider this seemingly intuitive idea, and argue that the economic theory of asymmetric information, in fact, provides very little aid in understanding the central questions of the crisis.

Let's focus on Holder's quote. The standard theory of asymmetric information implies that JPMorgan's misrepresentations could not cause significant losses to investors. That may seem surprising. Many may think that either we don't understand the economics of asymmetric information or it's just another example of the naïveté of economists regarding how the real world actually works. While there is certainly no shortage of examples of economists holding naïve opinions about the real world, in this case, we will argue that we are correctly characterizing the economist's view and that it is based on a common-sense argument.

Let's start with the economics. Let's assume that JPMorgan is selling a pool of loans, about which it knows the true quality, to a group of buyers who can't observe the true quality. What does economic theory say will happen?

A. Investors will overpay for the assets and lose money.
B. Investors will underpay for the assets and make money.
C. Investors will infer the true quality of the loans and pay accordingly.

The answer is C. To many, that may sound shocking, but the basic logic is simple: investors know that they cannot observe the true quality of the loans and they know that JPMorgan has an incentive to dump bad loans in the pool. Thus, they correctly infer that JPMorgan will dump bad loans in the pool. In other words, investors form correct beliefs about the quality of a loan,1 despite not being able to observe quality directly.2

"Knowingly bundl[ing] toxic loans" may be unethical or even illegal, but according to the economic theory of asymmetric information, it shouldn't cause unexpected financial losses to investors. The key to understanding the gap between Holder and economics is the word "unsuspecting." Economists assume that all market participants are inherently suspicious. Market participants understand that the people with whom they are doing business have an incentive to cheat them if those people know more about the products that they are selling.

Are economists naïve to think that market participants can figure out the incentives of their adversaries? We would argue that common sense says people are pretty suspicious. Take, for example, real estate agents. A cursory search on the internet yields the following table of "translations" of real estate listings:

Loaded with Potential: means loaded with problems the seller didn't want to tackle.
Cute: means they couldn't think of any other possible way to describe it.
Great Bones: means you're going to have to gut it and rebuild.
Wooded/Shaded Lot: means surrounded by trees and leaves on the ground.
Charming: means they couldn't think of a more appropriate word.
Needs a Little TLC: means it needs about $45,000 dollars or more in renovations and repairs.
Won't Last Long at This Price: means the price is so low it will compel you to see it but it will take a miracle for you to want to buy it.
No Disclosures: means you're going to have to find out all the problems with the home on your own.

Most people read this and chuckle, but no one is surprised that real estate agents stretch the truth. After all, it's their job to convince you to buy. And, in general, people view salespeople as among the least ethical of all occupations, only slightly above members of Congress. Perhaps the most egregious example of this, and in fact the example that motivated the seminal paper on the economics of asymmetric information, is used-car salespeople. Do used-car salespeople try to misrepresent the quality of the cars that they are trying to sell? Most people would likely answer this question with a resounding "Yes, of course." Does this cause injury to most used-car buyers? Not so much. Since the general public recognizes that "used-car salesman" is basically American slang for a fraudster, nobody really believes what they say.

In subsequent posts, we will answer questions about the crisis that turn on asymmetric information problems:

  1. Theory says investors should have guessed the quality of the loans. Did they?
  2. If investors knew the quality of the loans they were buying, why did JPMorgan pay $13 billion to settle accusations that it misrepresented the quality of the loans it was selling?
  3. Can't policymakers fix some of these incentive problems? Doesn't forcing issuers such as JPMorgan to retain a portion of the securities they issue align incentives and mitigate the asymmetric information problem?
  4. If asymmetric information didn't cause investor losses, does that mean it doesn't affect economic outcomes? (Spoiler: The answer is an emphatic no.)
  5. What about rating agencies? Didn't they know that deals were bad but lie to investors and say they were good?

Photo of Paul WillenBy Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston, and

 

Photo of Kris GerardiKris Gerardi, associate economist and policy adviser at the Federal Reserve Bank of Atlanta.



1 In some situations, investors will hold beliefs that may be wrong on an individual asset-by-asset basis, but that are right on average. For example, they might not know which loans are the most likely to default, but their beliefs about the performance of the pool of loans will be, on average, right.

2 More generally, the revelation principle says that in any equilibrium of an asymmetric information game, we can confine our attention to equilibria in which all private information is fully revealed. For example, in Akerlof's (1970) example of equilibrium in the used car market, the seller knows whether the car is a peach or a lemon but only the lemons trade. Everyone knows which car is good (the one that the dealer doesn't sell), but the buyer doesn't buy it because he knows that the dealer would have an incentive to substitute a bad car.

January 22, 2014

Wall Street and the Housing Bubble

The conventional wisdom on the 2008 financial crisis is that finance industry insiders on Wall Street deceived naïve, uninformed mortgage borrowers into taking out unaffordable mortgages and mortgage-backed security (MBS) investors into purchasing securities backed by bad loans—mortgages and securities that had not been properly vetted and that would eventually default. This theory is on display front and center in the Academy Award-winning documentary Inside Job, and it has motivated new regulations aimed at realigning incentives among Wall Street insiders and their customers. (One such rule is the risk retention requirement in the Dodd-Frank Act, which we will discuss in some detail in a future post.)

We've written in support of an alternative hypothesis for the financial crisis—specifically, that overly optimistic views about house prices, not poorly designed incentives on Wall Street, are the better explanation for the crisis (for an example, see this 2012 paper). This alternative theory holds that investors lost money not because they were deceived by financial market insiders, but because they were instead misled by their own belief that housing-related investments could not lose money because house prices were sure to keep rising.

A new paper makes an important empirical contribution to this debate by inferring the beliefs of Wall Street insiders during the height of the bubble. The paper, titled "Wall Street and the Housing Bubble," performs a clever analysis of personal housing-related transactions (like home purchases) made by individuals who worked in the mortgage securitization business during the peak of the housing boom. The behavior of these mortgage insiders is compared with that of a control group of people who worked for similar institutions in the finance industry but did not have any obvious connection to the mortgage market. What the analysis finds should be an eye-opener for believers in the inside-job explanation of the crisis. There is no evidence that mortgage insiders believed there was a housing bubble in the 2004–06 period. In fact, mortgage insiders were actually more aggressive in increasing their personal exposure to housing at the peak of the boom. The increase in insider exposure contradicts the claim that insiders sold securities backed by loans that they knew would eventually go bad when the housing bubble burst.

The authors construct a random sample from the list of attendees of the 2006 American Securitization Forum, which is a large industry conference featuring employees of most of the major U.S. investment and commercial banks (as well as hedge funds and other boutique firms). The sample is mainly comprised of vice presidents, managing directors, and other nonexecutives in mid-managerial positions whose jobs focused on the structuring and trading of MBS. The authors refer to this group as "securitization agents." As a comparison group, they use a random sample of Wall Street equity analysts who covered firms that were in the S&P 500 in 2006 but did not have a strong connection to the housing market (in other words, the sample includes no homebuilders). These equity analysts worked for similar financial institutions, had similar skill sets, and likely experienced similar income shocks (in the form of bonuses during the boom) but did not have any experience in the securitization business and thus did not have access to any insider information. (As a second control group, the authors use a random sample of lawyers who did not specialize in real estate law.) The names of the securitization agents and the equity analysts are then matched to a database of publicly available information on property transactions. The final data set contains information on the number of housing transactions, the sale price of each transaction, some mortgage characteristics, and income at the time of origination for each individual in the sample spanning the period 2000–10.

Armed with this unique data set, the authors then implement a number of empirical tests to determine whether the securitization agents' beliefs about the likelihood of a housing crash differed from the beliefs of the control groups. The first test considers whether the securitization agents timed the housing market cycle better than the comparison groups by reducing their exposure to the market at the peak of the bubble (2004–06) by either selling their homes outright or downsizing. The second test is slightly weaker in that it simply tests whether the securitization agents were more cautious in their housing transactions by avoiding home purchases at the peak of the bubble to a greater extent than the control groups. The third test looks at whether the average return on housing transactions during the entire sample period was higher for the securitization agents. The final test considers a prediction of the permanent income hypothesis: if securitization agents were armed with superior knowledge of the impending collapse of the housing bubble, then through reductions in their expectations of permanent income, they should have decreased the size of their housing purchases relative to their current incomes by a greater amount than the comparison groups.

The results of these empirical tests show very little evidence to support the inside-job theory of the financial crisis. The authors conclude that there is "little systematic evidence that the average securitization exhibited awareness through their home transactions of problems in overall house markets and anticipated a broad-based crash earlier than others." If anything, the authors are being a little timid in their interpretation as the empirical results clearly show that securitization agents were significantly more aggressive in their housing transactions during the bubble period, which suggests that they held even more optimistic expectations of housing prices dynamics than did the control groups.

This is an important paper because it sheds light on one of the most striking aspects of the financial crisis, which the inside-job theory is unable to reconcile: the financial institutions involved in the creation of the subprime MBS and collateralized debt obligations (CDO)—the true "insiders," if you will—lost enormous amounts of money on those securities. The table clearly supports this observation. The firms that lost the most money from mortgage-related credit losses were the same investment and commercial banks that are being accused of profiting off of naïve investors by selling securities comprised of loans that they knew would eventually go bad. The table shows that these firms lost enormous sums of money, and the paper provides a simple answer to explain why: like the rest of the market, agents working at those firms believed that housing prices would continue to rise so that even the riskiest mortgages would continue to perform well.

Mortgage-Related Losses to Financial Institutions from the Subprime Crisis, as of June 18, 2008

Photo of Kris GerardiKris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta, with

 

Photo of Chris FooteChris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston.

August 1, 2013

Government Policy and the Crisis: The Case of the Community Reinvestment Act

Commentators on both the right and left seem to agree on one aspect of the recent mortgage crisis: government policy was at the heart of it. But they disagree on which particular government policy is at fault. The theory from the left is that financial deregulation allowed mortgage lenders and securitizers to exploit both mortgage borrowers and the investors in mortgage-backed securities. On the right, the thinking is that the government instituted policies and programs that were designed to increase credit availability and expand homeownership—policies that induced lenders to make massively risky loans.

To test these theories, researchers must identify a specific change in government policy and then explain the effects this policy change should have. They must then turn to the data to show that the predicted effects occurred soon after the government policy was instituted. A new paper by Sumit Agarwal, Efraim Benmelech, Nittai Bergman, and Amit Seru weighs some evidence related to one government policy that has long been controversial in conservative policy circles: the Community Reinvestment Act (CRA). In particular, the authors claim that the CRA played a role in the mortgage crisis by encouraging banks to make risky loans. How does this research project hold up?

History of the CRA
Before we discuss the details, here is some background on the CRA, which was enacted in 1977. In a 2003 retrospective on the law, William C. Apgar and Mark Duda noted that the CRA "was built on the simple proposition that deposit-taking banking organizations have a special obligation to serve the credit needs of the communities in which they maintain branches" (Apgar and Duda 2003, 169). The act instructed regulators to conduct periodic CRA examinations to make sure that banks were meeting the credit needs of their deposit bases. To enforce compliance, regulators had to take a banking institution's CRA record into account whenever the institution applied to consolidate with some other institution or to expand its operations with new branches (Apgar and Duda 2003, 172).

What economic effect should we expect the CRA to have? For banks, the act changes the economics of mortgage lending. In effect, it adds an extra "shadow return" to each CRA-eligible loan, over and above the loan's usual financial return. For example, the risk-adjusted return on a particular mortgage loan may be 5 percent without the CRA, but this return could rise to 6 percent after the bank factors in the benefit of the loan to its CRA compliance—and by extension, to its ability to perform a profitable merger or open a profitable branch. Simple economic theory implies that after the CRA, banks should make more and riskier loans in CRA-eligible locations, all else being equal.

The Agarwal et al. paper provides evidence that the CRA did indeed lead to more lending and also to riskier lending. The authors argue that in the three quarters before and the three quarters following a CRA examination, the average lender would make more loans and riskier loans in CRA-eligible areas.

In principle, the evidence in the paper seems consistent with the theory: government policy to encourage more lending encouraged more lending. However, other researchers have raised strong objections to the paper's empirical design. Most notably, the University of North Carolina Center (UNC) for Community Capital published a paper that claims to rebut the evidence put forth in the Agarwal et al. study, asserting that the study's entire identification strategy is invalid and therefore the results are spurious. In our reading of the paper, we found three significant issues that make us skeptical of the authors' interpretation that the CRA played a significant role in the crisis by increasing the amount of risky lending during the housing boom.

First issue: Time periods do not correspond
As the authors of the UNC paper note, the six-quarter window that Agarwal et al. use to identify the causal impact of CRA examinations "rarely corresponds to the actual period that is covered by the CRA exam." Instead, the CRA examiners typically analyze loans originated well before the actual exam date. To illustrate the issue, the UNC paper looks at a CRA exam of JPMorgan Chase that occurred in June 2011. The authors, who obtained their information from the public record of the exam (the CRA Performance Evaluation), find that the exam covered mortgage originations from January 2007 through December 2010. In contrast, the Agarwal et al. six-quarter window would have run from October 2010 to March 2012, implying an overlap of only one quarter. And even that one quarter of overlap is unlikely—the authors point out that the CRA examiner evaluated only JPMorgan's market share of lending through 2009, as the 2010 data generated to comply with the Home Mortgage Disclosure Act (HMDA) were unavailable at the time of the exam. The implication is that JPMorgan would have had no incentive to increase CRA-eligible mortgage originations in the three quarters before the examination period, since the CRA examiner was not going to consider those loans anyway.

Another relevant example (obtained from correspondence with economists from the Federal Reserve Board of Governors) is the June 2006 exam of Citibank. That exam used 2004 HMDA data for the market share analysis and used data through 2005 to compute the bank's distribution of loans to low- and moderate-income borrowers or neighborhoods. Thus, there is almost no overlap between the data used by the CRA examiners and the window employed by Agarwal et al. If the UNC paper is correct in its assertion that CRA examiners often consider loans that are outside of the six-quarter window used by Agarwal et al., then their claim that institutions were ramping up their CRA-eligible lending in order to pass their CRA examinations is flawed.

Second issue: CRA treatment effects possibly overestimated
Agarwal et al. find an increase in lending resulting from the CRA in non-CRA-eligible census tracts for both high- and low-income households. Specifically, they stratify their sample based on income terciles and find that origination rates to borrowers in the bottom-income tercile in non-CRA-eligible tracts increased by 6 percentage points around the initiation of CRA exams. This result supports their interpretation because banks would obtain CRA credit for loans to these borrowers. However, the results also show that origination rates for borrowers in the highest-income tercile in the non-CRA-eligible tracts increased by almost 4 percentage points around the initiation of CRA exams. Since these loans did not count toward fulfilling CRA obligations, the effect cannot be interpreted as a CRA treatment effect. Rather, a reasonable interpretation of this estimate is that it is picking up an unobserved factor that happens to be correlated with the timing of the CRA examinations (that is, a spurious correlation). If this is the case, then the true CRA treatment effect in CRA-ineligible tracts is really the difference between the increase in origination rates for the borrowers in the bottom income tercile and the borrowers in the top income tercile, which is an economically small 2 percentage points. Furthermore, by lending to high-income borrowers in non-CRA-eligible tracts, banks would tilt the distribution of their lending away from areas targeted by the CRA, which would end up hurting them in a CRA exam. Thus, it's difficult to imagine a scenario in which banks would target these borrowers for CRA-related purposes.

Issue 3: Securitization an unlikely explanation for effects
Agarwal et al. argue that they find significant CRA effects on lending in the 2004–06 and 2007–09 periods but not during the 1999–2003 period, and they find significant CRA effects on default rates only in the 2004–06 period. The authors' explanation for this pattern is that 2004–06 was the period in which the securitization of mortgage loans peaked, and "banks are more likely to originate loans to risky borrowers around CRA examinations when they have an avenue to securitize and pass these loans to private investors after the exam" (p. 21).

There are at least three problems with this line of reasoning. First, private securitization markets shut down in the 2007–09 period, so they couldn't possibly explain the increase in lending in CRA-eligible tracts during that period. The GSEs were very active in securitizing mortgages during this period—but they were also very active in the early 2000s, so agency securitization doesn't seem like an adequate explanation either.

Second, while it is true that securitization could alter the risk-return tradeoff for mortgage lending—it does so by allowing mortgage originators to offload their credit risk by selling their loans into mortgage-backed securities—securitization would make this offloading possible and appealing to many mortgage originators, not just CRA lenders. The result could easily be a decline in mortgage lending by depository institutions in CRA-eligible areas rather than an increase, thanks to increased competition from nondepository institutions. In fact, we would argue that the empirical evidence supports this interpretation more than Agarwal et al.'s interpretation. The late 1990s and early 2000s saw the emergence of nondepository institutions that specialized in originating subprime mortgages and selling them to securitizers. These aggressive subprime lenders were typically not subject to CRA requirements, a fact that is consistent with the shrinking footprint of CRA institutions, which we discuss in more detail below. According to Bhutta and Canner (2009), only about 6 percent of subprime loans made in 2005 and 2006 were made to CRA-targeted populations by CRA-regulated lenders. In effect, one of the consequences of the dramatic rise in private-label securitization volume was that it created lots of competition among the riskier segments of the mortgage market. This situation likely resulted in less lending by banks in CRA-eligible areas rather than more.

Finally, perhaps a more fundamental reason to doubt that securitization explains the timing of the paper's effects is that securitization has been around a long time. Laws needed to be changed before securitization could take off, but these legal changes occurred in the 1980s. So if the CRA and securitization together formed a lethal combination for the mortgage market, then why did the crisis occur in the late 2000s rather than the late 1980s?

Even if CRA encouraged risk, would it really say much about government policy?
With these caveats in mind, what would a finding that the CRA encouraged risky lending really tell us? In our opinion, a finding that the CRA encouraged risky lending would probably tell us little about the role of government in the financial crisis.

The focus needs to be on quantitative magnitudes. The question of whether or not the CRA led to an increase in risky lending of any size may not be that interesting because it is hard to imagine a world in which the CRA would not have done so. Economists begin with the premise that banks are profit-maximizing entities, so they should make all the loans that increase their expected profits. If a loan is not made, then that is because the bank must have judged the loan to reduce expected profits rather than raise them. As we described above, the CRA increases the risk-adjusted return for certain loans, so that some of the loans a bank deems unprofitable in the absence of the CRA (because of risk-adjusted returns that were too low) become profitable with CRA. Because these are marginal loans in risk-adjusted returns, then risk must be increasing.

If we start with the assumption that the CRA leads to more risky lending, the more interesting question is how much risky lending is encouraged. As it happens, the quantitative magnitudes of the estimates in the Agarwal et al. study are quite small. For example, if we assume that the appropriate CRA treatment effect should only be measured using the difference in the increase in lending between CRA-eligible census tracts and CRA-ineligible tracts, then magnitudes are trivial. Specifically, the paper finds that the CRA increased origination rates in CRA-eligible census tracts relative to CRA-ineligible census tracts by somewhere between 1 and 3 percentage points, depending on the specific quarter around the initiation of the CRA exam. When one considers that the average origination rate in the Agarwal et al. sample is 72 percent, and only 15 percent of loan originations in the sample came from CRA-eligible tracts, this is an extremely small effect. The effect becomes even smaller if you adjust the baseline estimates to take into account the likely simultaneity bias that we discussed above in the subsection titled "Issue 2."

The CRA passed long before the crisis
In concluding, we should point out that the CRA went into effect in 1977, 30 years before the financial crisis. If the CRA did shift the risk-return tradeoff for mortgage lending, then why didn't risky lending take off in 1978 rather than 2003? Moreover, the footprint of CRA-regulated institutions in the mortgage market has shrunk dramatically since the law passed. Figure 1 (taken from Foote, Gerardi, and Willen [2012]) shows that nondepository mortgage companies—which generally are not covered by the CRA—accounted for only 15 percent of mortgage lending when the CRA was passed in 1977. By the late 1990s, however, these non-CRA entities had grown to nearly 60 percent of the mortgage market. If the CRA is so toxic to the mortgage market, then it is puzzling why the act had no effect soon after its enactment, when it covered 85 percent of the mortgage market, yet led to an explosion of risky lending 25 years later, when it covered only 40 percent of the market.

Figure 1: The growth of non-depository mortgage companies

Indeed, any attempt to link the recent crisis to government policies aimed at expanding mortgage credit and homeownership faces an uphill struggle. The basic problem is that the federal government has been deeply involved in housing and mortgage markets since at least the end of World War II. In particular, the Federal Housing Authority (FHA) and Veterans Administration (VA) loan programs began at about that time and were explicitly designed to extend homeownership to underserved populations. As figure 2 (also from Foote, Gerardi, and Willen, 2012) shows, the FHA and VA pioneered no and low down payment loans in the 1950s and 1960s. And as figure 3 shows, FHA loans accounted for 40 percent of loans outstanding in the 1970s and had default rates that were an economically massive 100 percent higher than non-FHA loans. In their size and their effect on housing markets, the FHA and VA were literally orders of magnitude more important than the CRA. Did government lead to risky lending? Yes! But it did so 30 years before CRA and 60 years before the recent financial crisis.

Figure 2: The role of the Federal government in the mortgage market

Rer-03

Photo of Chris FooteChris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston,

 

Photo of Kris GerardiKris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta, and

 

Photo of Paul WillenBy Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston

April 25, 2014

Two Views of the Involvement of Credit Rating Agencies in the Mortgage Crisis

A lot of people have blamed credit rating agencies (CRAs) for helping to cause the mortgage crisis. The report of the Financial Crisis Inquiry Commission (FCIC) labelled CRAs as "key enablers of the crisis," because the exploding mortgage-backed bonds that caused so much trouble could not have been sold without stamps of approval from the CRAs. Commentators often link CRA failings to the fact that they are paid by the issuers of the securities they rate, with the implication that CRAs are thus given incentive to award good ratings to securities that do not deserve them. Indeed, two recent articles by academic economists on this topic come to the same conclusion: financial markets would work better if we scrapped the issuer-pays model in favor of some other way to pay CRAs for their evaluations. But the two articles disagree on why this is so, and understanding the source of this disagreement sheds some harsh light on claims that CRAs should be even partly blamed for the financial crisis in the first place.

Grade inflation in the student-pays model
The first article is a Wall Street Journal op-ed piece by Princeton economist Alan Blinder. Blinder likens the awarding of credit ratings to mortgage-backed securities to his own awarding of letter grades to his Princeton students. "Suppose I proposed to grade my students by a 'student pays' model," Blinder suggests. Such a setup would encourage him to give easy As in hopes of attracting more students and higher pay, and the information in the grades would suffer as a result. "Yet that description comes pretty close to mimicking the way we pay rating agencies," Blinder writes. "Looking back, is it any wonder that so many securities were blessed with undeserved triple-A ratings?"

One interpretation of Blinder's analogy is that college grading works better than securities rating because universities have not adopted the student-pays model. That argument will seem curious to many college instructors, because this model approximates their own compensation arrangements pretty well. Students may not write checks to professors, but they (or their parents) write checks to colleges, who then pay the professors. Instructors whose grades are overly harsh in relation to other courses are likely to see their class sizes dwindle, to the dismay of department chairs facing hard budget constraints. Even if an instructor has no problem attracting students, she may not want grading disparities among courses to distort student decisions on what to study, so she might ease up in her own grading as well. Given the incentives of professors, it is not surprising that grade inflation is debated at many universities, even the very best ones. A December 2013 article in Harvard University's student newspaper, the Crimson, described a faculty meeting at which a professor bemoaned the fact that the most frequently awarded grade at Harvard College is an A-minus. A university dean corrected him: "The median grade in Harvard College is indeed an A-minus," the dean is quoted as saying. "The most frequently awarded grade in Harvard College is actually a straight A." (Disclosure: Harvard's grading policy is of personal interest to two authors of this blog post, who teach intermediate macroeconomics courses there in their spare time.)

Rational employers, rational investors
If the student-pays model leads to grade inflation, then don't we have even more ammunition that the bad incentives inherent in the investor-pays model for CRAs is partly responsible for the mortgage crisis? Not necessarily. For bad CRA incentives to have caused the crisis, two things must be true: one, the incentives must have caused inflated ratings, and two, the investors had to believe the inflated ratings. The second step in this causal chain is open to question. If the investors knew that the issuer-pays model gave incent to the rating agencies to inflate ratings, then rational investors would have taken that information into account when making investment decisions.

The college-grading analogy is again useful here. Consider an employer who is thinking about hiring a recent graduate who received a B-minus in a course that is highly relevant to what the firm does. How should the employer use this information? One option would be for the employer to look up how the student's official university documents define a B-minus—the documents are likely to define a grade in the B range as indicating a better-than-average understanding of the material. But a rational employer who knows the incentives facing American professors would also know that instructors are given cause to inflate grades. The firm could thus surmise that an applicant on the border between a B and a C may actually have a lower-than-average mastery of the subject. In the same way, rational mortgage investors who knew that CRAs had incentive to inflate ratings would have taken those ratings with a grain of salt when evaluating mortgage-backed investments.

Investor rationality plays a prominent role in a second recent piece on CRA incentives, a formal paper by the economists Anil Kashyap and Natalia Kovrijnykh (KK). Because this article is part of the academic economics literature, the authors adopt the fundamental assumption that all actors in the model are rational. As we might expect from our analogy of the job applicant, the rationality assumption makes a big difference when analyzing CRA payment regimes. Consider a situation in which CRAs are paid by the issues of securities, as they are today. Further assume that CRAs receive more money for good ratings than for bad ones. Rational investors in the KK model would realize the ratings are likely to be inflated under this set of incentives and would deflate the ratings accordingly. But if the CRAs are unable to fool investors who know both the CRAs' preferences and their opportunities, then the CRAs might as well tell the truth. KK therefore constrain their attention to equilibria where rating agencies are always truthful.

The revelation principle
In assuming truth-telling, KK are following a long tradition in the modeling of imperfect information. In fact, the assumption that actors with private information tell the truth shows up so often in models of imperfect information that it has a special name: the revelation principle. This principle is useful for modelers because it allows them to focus on equilibria in which the agent with private information has no reason to lie. To be clear, in this situation, the revelation principle does not mean that rating agencies never lie. Rather, it states that any equilibrium in which rating agencies lie is equivalent to one in which they tell the truth. The lying doesn't affect the actions of investors who know the incentives and opportunities of the CRAs, just as inflation of our B-minus student's grade does not lead the employer into an inappropriate hire. Because lying does not encourage agents to take inappropriate actions, it can safely be ignored when thinking through the fundamental aspects of the problem.

The appropriateness of the revelation principle in this context hinges on the ability of mortgage investors to analyze CRA incentives and opportunities and thereby back out the truth. Is this realistic? Ironically, the critics of CRAs provide evidence in support of this view. When Barney Frank alleged that CRA incentives led them to inflate ratings, he was doing exactly the sort of reverse engineering that lies behind the revelation principle. And if legislators could figure out that rating agencies had distorted incentives, why couldn't investors, who were putting up their own money? Indeed, investors should have had much better information about agency incentives than Barney Frank. It turns out that financial intermediaries lost enormous sums on the mortgage-related securities that they purchased and held on their balance sheets (more details on this in the next post). At the same time, they were also large issuers of these securities. Who would know better about the potential for corruption of rating agencies than the financial intermediaries that supposedly corrupted them?

Of course, if the KK model holds that rating agencies always tell the truth, then the model cannot rationalize arguments that CRAs helped cause the crisis by misleading investors. Indeed, the revelation principle makes it hard to rescue any story about untruthful CRAs. What if credit rating agencies had private information about their incentives, in addition to private information about their effort and the quality of the securities that they rated? Setting aside the fact that the issuer-pays model of credit ratings was common knowledge in the market, this change to the model has no effect on its outcome. Here again, the revelation principle would imply that CRAs truthfully reveal the private information about their incentives. For investors to be misled, they cannot simply be confused about incentives. Rather, they must believe that the CRAs' incentives were better aligned than they actually were. In our view, that is unlikely.

CRA payment arrangements
We began this post by noting that both of the recent articles on CRA incentives argued against the issuer-pays model. How can KK make this argument if investors in their model are not fooled? The reason involves some subtle implications of exactly how CRAs are paid in different states of the world. In all contracts in KK's issuer-pays regime, CRA pay is contingent on the outcome of the security. That means that if an AAA-rated security defaults, the CRA gets paid less than if the security pays off. To induce effort by the CRA, the spread between the payoffs must be large (that is, the CRA must be paid a lot more when the AAA security is successful compared to when it defaults). Because of limited liability, the CRA's compensation is bounded below by zero when a bond defaults—that is, investors can't demand payment from the CRAs in the default state—so high-powered incentives, which require high average pay, imply that compensation to the CRA in the good state has to be very high. As a result, paying the CRA for high effort can be prohibitively expensive for the issuer, causing the issuer to settle for low-powered incentives instead and thus receiving low effort from the CRA. Even in the low-effort equilibrium, however, CRAs increase the information set of investors and are socially useful.

Going farther, KK show that having the investor rather than the issuer pay the CRA solves the limited-liability problem and thereby raises social welfare. Particularly surprising about this finding is that the investor-pays model is not only good for society, but it is also good for the CRAs! The reason once again involves the revelation principle. In equilibrium, everyone knows both the amount and usefulness of the effort expended by the CRAs in evaluating securities. The larger the CRA's social benefit, the more the CRA gets paid. If KK's model is accurate, then CRAs themselves may lead the way to a better social outcome by encouraging the adoption of the investor-pays model.

While KK's paper includes many specific lessons about potential CRA payment arrangements, the bottom line to emerge from a comparison of the Blinder op-ed and the KK model involves their differing assumptions regarding investor rationality. The KK model illustrates how the revelation principle, which follows from investor rationality, works against the argument that CRAs helped cause the crisis by misleading investors. As long as investors understand the basic structure of the market, then standard models of asymmetric information—of which the KK model is an example— do not predict that investors will experience large and unexpected losses.

You can read the Harvard Crimson article on the magazine's website.

Photo of Chris FooteChris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston,

 

Photo of Kris GerardiKris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta, and

 

Photo of Paul WillenBy Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston

February 19, 2014

Asymmetric Information and the Financial Crisis

In describing the $13 billion settlement reached between JPMorgan and the Department of Justice last November, Attorney General Eric Holder said,

Without a doubt, the conduct uncovered in this investigation helped sow the seeds of the mortgage meltdown. JPMorgan was not the only financial institution during this period to knowingly bundle toxic loans and sell them to unsuspecting investors, but that is no excuse for the firm's behavior.

What Holder describes sounds like a textbook example of what economists call asymmetric information: JPMorgan knew something about the loans it was selling (that they were toxic) that they didn't reveal to investors. Specifically, the government alleged that JPMorgan reported facts to the investors that turned out to be wrong. For example, JPMorgan may have said that it made only 10 percent of the loans in a pool to investors (as opposed to owner-occupants) when the actual percentage was 20 percent. So it would seem as if economic theory, which has a lot to say about asymmetric information, should help us understand the crisis. Indeed, to many, asymmetric information and "bad incentives" are the leading explanations of the financial crisis. For example, a Reuters article that described the settlement made the following claim:

The behavior that the largest U.S. bank admitted to, authorities said, is at the heart of what inflated the housing bubble: lenders making bad mortgages and selling them to investors who thought they were relatively safe. When the loans started turning bad, investors lost faith in the banking system, and a housing crisis turned into a financial crisis.

In future posts, we will consider this seemingly intuitive idea, and argue that the economic theory of asymmetric information, in fact, provides very little aid in understanding the central questions of the crisis.

Let's focus on Holder's quote. The standard theory of asymmetric information implies that JPMorgan's misrepresentations could not cause significant losses to investors. That may seem surprising. Many may think that either we don't understand the economics of asymmetric information or it's just another example of the naïveté of economists regarding how the real world actually works. While there is certainly no shortage of examples of economists holding naïve opinions about the real world, in this case, we will argue that we are correctly characterizing the economist's view and that it is based on a common-sense argument.

Let's start with the economics. Let's assume that JPMorgan is selling a pool of loans, about which it knows the true quality, to a group of buyers who can't observe the true quality. What does economic theory say will happen?

A. Investors will overpay for the assets and lose money.
B. Investors will underpay for the assets and make money.
C. Investors will infer the true quality of the loans and pay accordingly.

The answer is C. To many, that may sound shocking, but the basic logic is simple: investors know that they cannot observe the true quality of the loans and they know that JPMorgan has an incentive to dump bad loans in the pool. Thus, they correctly infer that JPMorgan will dump bad loans in the pool. In other words, investors form correct beliefs about the quality of a loan,1 despite not being able to observe quality directly.2

"Knowingly bundl[ing] toxic loans" may be unethical or even illegal, but according to the economic theory of asymmetric information, it shouldn't cause unexpected financial losses to investors. The key to understanding the gap between Holder and economics is the word "unsuspecting." Economists assume that all market participants are inherently suspicious. Market participants understand that the people with whom they are doing business have an incentive to cheat them if those people know more about the products that they are selling.

Are economists naïve to think that market participants can figure out the incentives of their adversaries? We would argue that common sense says people are pretty suspicious. Take, for example, real estate agents. A cursory search on the internet yields the following table of "translations" of real estate listings:

Loaded with Potential: means loaded with problems the seller didn't want to tackle.
Cute: means they couldn't think of any other possible way to describe it.
Great Bones: means you're going to have to gut it and rebuild.
Wooded/Shaded Lot: means surrounded by trees and leaves on the ground.
Charming: means they couldn't think of a more appropriate word.
Needs a Little TLC: means it needs about $45,000 dollars or more in renovations and repairs.
Won't Last Long at This Price: means the price is so low it will compel you to see it but it will take a miracle for you to want to buy it.
No Disclosures: means you're going to have to find out all the problems with the home on your own.

Most people read this and chuckle, but no one is surprised that real estate agents stretch the truth. After all, it's their job to convince you to buy. And, in general, people view salespeople as among the least ethical of all occupations, only slightly above members of Congress. Perhaps the most egregious example of this, and in fact the example that motivated the seminal paper on the economics of asymmetric information, is used-car salespeople. Do used-car salespeople try to misrepresent the quality of the cars that they are trying to sell? Most people would likely answer this question with a resounding "Yes, of course." Does this cause injury to most used-car buyers? Not so much. Since the general public recognizes that "used-car salesman" is basically American slang for a fraudster, nobody really believes what they say.

In subsequent posts, we will answer questions about the crisis that turn on asymmetric information problems:

  1. Theory says investors should have guessed the quality of the loans. Did they?
  2. If investors knew the quality of the loans they were buying, why did JPMorgan pay $13 billion to settle accusations that it misrepresented the quality of the loans it was selling?
  3. Can't policymakers fix some of these incentive problems? Doesn't forcing issuers such as JPMorgan to retain a portion of the securities they issue align incentives and mitigate the asymmetric information problem?
  4. If asymmetric information didn't cause investor losses, does that mean it doesn't affect economic outcomes? (Spoiler: The answer is an emphatic no.)
  5. What about rating agencies? Didn't they know that deals were bad but lie to investors and say they were good?

Photo of Paul WillenBy Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston, and

 

Photo of Kris GerardiKris Gerardi, associate economist and policy adviser at the Federal Reserve Bank of Atlanta.



1 In some situations, investors will hold beliefs that may be wrong on an individual asset-by-asset basis, but that are right on average. For example, they might not know which loans are the most likely to default, but their beliefs about the performance of the pool of loans will be, on average, right.

2 More generally, the revelation principle says that in any equilibrium of an asymmetric information game, we can confine our attention to equilibria in which all private information is fully revealed. For example, in Akerlof's (1970) example of equilibrium in the used car market, the seller knows whether the car is a peach or a lemon but only the lemons trade. Everyone knows which car is good (the one that the dealer doesn't sell), but the buyer doesn't buy it because he knows that the dealer would have an incentive to substitute a bad car.

January 22, 2014

Wall Street and the Housing Bubble

The conventional wisdom on the 2008 financial crisis is that finance industry insiders on Wall Street deceived naïve, uninformed mortgage borrowers into taking out unaffordable mortgages and mortgage-backed security (MBS) investors into purchasing securities backed by bad loans—mortgages and securities that had not been properly vetted and that would eventually default. This theory is on display front and center in the Academy Award-winning documentary Inside Job, and it has motivated new regulations aimed at realigning incentives among Wall Street insiders and their customers. (One such rule is the risk retention requirement in the Dodd-Frank Act, which we will discuss in some detail in a future post.)

We've written in support of an alternative hypothesis for the financial crisis—specifically, that overly optimistic views about house prices, not poorly designed incentives on Wall Street, are the better explanation for the crisis (for an example, see this 2012 paper). This alternative theory holds that investors lost money not because they were deceived by financial market insiders, but because they were instead misled by their own belief that housing-related investments could not lose money because house prices were sure to keep rising.

A new paper makes an important empirical contribution to this debate by inferring the beliefs of Wall Street insiders during the height of the bubble. The paper, titled "Wall Street and the Housing Bubble," performs a clever analysis of personal housing-related transactions (like home purchases) made by individuals who worked in the mortgage securitization business during the peak of the housing boom. The behavior of these mortgage insiders is compared with that of a control group of people who worked for similar institutions in the finance industry but did not have any obvious connection to the mortgage market. What the analysis finds should be an eye-opener for believers in the inside-job explanation of the crisis. There is no evidence that mortgage insiders believed there was a housing bubble in the 2004–06 period. In fact, mortgage insiders were actually more aggressive in increasing their personal exposure to housing at the peak of the boom. The increase in insider exposure contradicts the claim that insiders sold securities backed by loans that they knew would eventually go bad when the housing bubble burst.

The authors construct a random sample from the list of attendees of the 2006 American Securitization Forum, which is a large industry conference featuring employees of most of the major U.S. investment and commercial banks (as well as hedge funds and other boutique firms). The sample is mainly comprised of vice presidents, managing directors, and other nonexecutives in mid-managerial positions whose jobs focused on the structuring and trading of MBS. The authors refer to this group as "securitization agents." As a comparison group, they use a random sample of Wall Street equity analysts who covered firms that were in the S&P 500 in 2006 but did not have a strong connection to the housing market (in other words, the sample includes no homebuilders). These equity analysts worked for similar financial institutions, had similar skill sets, and likely experienced similar income shocks (in the form of bonuses during the boom) but did not have any experience in the securitization business and thus did not have access to any insider information. (As a second control group, the authors use a random sample of lawyers who did not specialize in real estate law.) The names of the securitization agents and the equity analysts are then matched to a database of publicly available information on property transactions. The final data set contains information on the number of housing transactions, the sale price of each transaction, some mortgage characteristics, and income at the time of origination for each individual in the sample spanning the period 2000–10.

Armed with this unique data set, the authors then implement a number of empirical tests to determine whether the securitization agents' beliefs about the likelihood of a housing crash differed from the beliefs of the control groups. The first test considers whether the securitization agents timed the housing market cycle better than the comparison groups by reducing their exposure to the market at the peak of the bubble (2004–06) by either selling their homes outright or downsizing. The second test is slightly weaker in that it simply tests whether the securitization agents were more cautious in their housing transactions by avoiding home purchases at the peak of the bubble to a greater extent than the control groups. The third test looks at whether the average return on housing transactions during the entire sample period was higher for the securitization agents. The final test considers a prediction of the permanent income hypothesis: if securitization agents were armed with superior knowledge of the impending collapse of the housing bubble, then through reductions in their expectations of permanent income, they should have decreased the size of their housing purchases relative to their current incomes by a greater amount than the comparison groups.

The results of these empirical tests show very little evidence to support the inside-job theory of the financial crisis. The authors conclude that there is "little systematic evidence that the average securitization exhibited awareness through their home transactions of problems in overall house markets and anticipated a broad-based crash earlier than others." If anything, the authors are being a little timid in their interpretation as the empirical results clearly show that securitization agents were significantly more aggressive in their housing transactions during the bubble period, which suggests that they held even more optimistic expectations of housing prices dynamics than did the control groups.

This is an important paper because it sheds light on one of the most striking aspects of the financial crisis, which the inside-job theory is unable to reconcile: the financial institutions involved in the creation of the subprime MBS and collateralized debt obligations (CDO)—the true "insiders," if you will—lost enormous amounts of money on those securities. The table clearly supports this observation. The firms that lost the most money from mortgage-related credit losses were the same investment and commercial banks that are being accused of profiting off of naïve investors by selling securities comprised of loans that they knew would eventually go bad. The table shows that these firms lost enormous sums of money, and the paper provides a simple answer to explain why: like the rest of the market, agents working at those firms believed that housing prices would continue to rise so that even the riskiest mortgages would continue to perform well.

Mortgage-Related Losses to Financial Institutions from the Subprime Crisis, as of June 18, 2008

Photo of Kris GerardiKris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta, with

 

Photo of Chris FooteChris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston.

August 1, 2013

Government Policy and the Crisis: The Case of the Community Reinvestment Act

Commentators on both the right and left seem to agree on one aspect of the recent mortgage crisis: government policy was at the heart of it. But they disagree on which particular government policy is at fault. The theory from the left is that financial deregulation allowed mortgage lenders and securitizers to exploit both mortgage borrowers and the investors in mortgage-backed securities. On the right, the thinking is that the government instituted policies and programs that were designed to increase credit availability and expand homeownership—policies that induced lenders to make massively risky loans.

To test these theories, researchers must identify a specific change in government policy and then explain the effects this policy change should have. They must then turn to the data to show that the predicted effects occurred soon after the government policy was instituted. A new paper by Sumit Agarwal, Efraim Benmelech, Nittai Bergman, and Amit Seru weighs some evidence related to one government policy that has long been controversial in conservative policy circles: the Community Reinvestment Act (CRA). In particular, the authors claim that the CRA played a role in the mortgage crisis by encouraging banks to make risky loans. How does this research project hold up?

History of the CRA
Before we discuss the details, here is some background on the CRA, which was enacted in 1977. In a 2003 retrospective on the law, William C. Apgar and Mark Duda noted that the CRA "was built on the simple proposition that deposit-taking banking organizations have a special obligation to serve the credit needs of the communities in which they maintain branches" (Apgar and Duda 2003, 169). The act instructed regulators to conduct periodic CRA examinations to make sure that banks were meeting the credit needs of their deposit bases. To enforce compliance, regulators had to take a banking institution's CRA record into account whenever the institution applied to consolidate with some other institution or to expand its operations with new branches (Apgar and Duda 2003, 172).

What economic effect should we expect the CRA to have? For banks, the act changes the economics of mortgage lending. In effect, it adds an extra "shadow return" to each CRA-eligible loan, over and above the loan's usual financial return. For example, the risk-adjusted return on a particular mortgage loan may be 5 percent without the CRA, but this return could rise to 6 percent after the bank factors in the benefit of the loan to its CRA compliance—and by extension, to its ability to perform a profitable merger or open a profitable branch. Simple economic theory implies that after the CRA, banks should make more and riskier loans in CRA-eligible locations, all else being equal.

The Agarwal et al. paper provides evidence that the CRA did indeed lead to more lending and also to riskier lending. The authors argue that in the three quarters before and the three quarters following a CRA examination, the average lender would make more loans and riskier loans in CRA-eligible areas.

In principle, the evidence in the paper seems consistent with the theory: government policy to encourage more lending encouraged more lending. However, other researchers have raised strong objections to the paper's empirical design. Most notably, the University of North Carolina Center (UNC) for Community Capital published a paper that claims to rebut the evidence put forth in the Agarwal et al. study, asserting that the study's entire identification strategy is invalid and therefore the results are spurious. In our reading of the paper, we found three significant issues that make us skeptical of the authors' interpretation that the CRA played a significant role in the crisis by increasing the amount of risky lending during the housing boom.

First issue: Time periods do not correspond
As the authors of the UNC paper note, the six-quarter window that Agarwal et al. use to identify the causal impact of CRA examinations "rarely corresponds to the actual period that is covered by the CRA exam." Instead, the CRA examiners typically analyze loans originated well before the actual exam date. To illustrate the issue, the UNC paper looks at a CRA exam of JPMorgan Chase that occurred in June 2011. The authors, who obtained their information from the public record of the exam (the CRA Performance Evaluation), find that the exam covered mortgage originations from January 2007 through December 2010. In contrast, the Agarwal et al. six-quarter window would have run from October 2010 to March 2012, implying an overlap of only one quarter. And even that one quarter of overlap is unlikely—the authors point out that the CRA examiner evaluated only JPMorgan's market share of lending through 2009, as the 2010 data generated to comply with the Home Mortgage Disclosure Act (HMDA) were unavailable at the time of the exam. The implication is that JPMorgan would have had no incentive to increase CRA-eligible mortgage originations in the three quarters before the examination period, since the CRA examiner was not going to consider those loans anyway.

Another relevant example (obtained from correspondence with economists from the Federal Reserve Board of Governors) is the June 2006 exam of Citibank. That exam used 2004 HMDA data for the market share analysis and used data through 2005 to compute the bank's distribution of loans to low- and moderate-income borrowers or neighborhoods. Thus, there is almost no overlap between the data used by the CRA examiners and the window employed by Agarwal et al. If the UNC paper is correct in its assertion that CRA examiners often consider loans that are outside of the six-quarter window used by Agarwal et al., then their claim that institutions were ramping up their CRA-eligible lending in order to pass their CRA examinations is flawed.

Second issue: CRA treatment effects possibly overestimated
Agarwal et al. find an increase in lending resulting from the CRA in non-CRA-eligible census tracts for both high- and low-income households. Specifically, they stratify their sample based on income terciles and find that origination rates to borrowers in the bottom-income tercile in non-CRA-eligible tracts increased by 6 percentage points around the initiation of CRA exams. This result supports their interpretation because banks would obtain CRA credit for loans to these borrowers. However, the results also show that origination rates for borrowers in the highest-income tercile in the non-CRA-eligible tracts increased by almost 4 percentage points around the initiation of CRA exams. Since these loans did not count toward fulfilling CRA obligations, the effect cannot be interpreted as a CRA treatment effect. Rather, a reasonable interpretation of this estimate is that it is picking up an unobserved factor that happens to be correlated with the timing of the CRA examinations (that is, a spurious correlation). If this is the case, then the true CRA treatment effect in CRA-ineligible tracts is really the difference between the increase in origination rates for the borrowers in the bottom income tercile and the borrowers in the top income tercile, which is an economically small 2 percentage points. Furthermore, by lending to high-income borrowers in non-CRA-eligible tracts, banks would tilt the distribution of their lending away from areas targeted by the CRA, which would end up hurting them in a CRA exam. Thus, it's difficult to imagine a scenario in which banks would target these borrowers for CRA-related purposes.

Issue 3: Securitization an unlikely explanation for effects
Agarwal et al. argue that they find significant CRA effects on lending in the 2004–06 and 2007–09 periods but not during the 1999–2003 period, and they find significant CRA effects on default rates only in the 2004–06 period. The authors' explanation for this pattern is that 2004–06 was the period in which the securitization of mortgage loans peaked, and "banks are more likely to originate loans to risky borrowers around CRA examinations when they have an avenue to securitize and pass these loans to private investors after the exam" (p. 21).

There are at least three problems with this line of reasoning. First, private securitization markets shut down in the 2007–09 period, so they couldn't possibly explain the increase in lending in CRA-eligible tracts during that period. The GSEs were very active in securitizing mortgages during this period—but they were also very active in the early 2000s, so agency securitization doesn't seem like an adequate explanation either.

Second, while it is true that securitization could alter the risk-return tradeoff for mortgage lending—it does so by allowing mortgage originators to offload their credit risk by selling their loans into mortgage-backed securities—securitization would make this offloading possible and appealing to many mortgage originators, not just CRA lenders. The result could easily be a decline in mortgage lending by depository institutions in CRA-eligible areas rather than an increase, thanks to increased competition from nondepository institutions. In fact, we would argue that the empirical evidence supports this interpretation more than Agarwal et al.'s interpretation. The late 1990s and early 2000s saw the emergence of nondepository institutions that specialized in originating subprime mortgages and selling them to securitizers. These aggressive subprime lenders were typically not subject to CRA requirements, a fact that is consistent with the shrinking footprint of CRA institutions, which we discuss in more detail below. According to Bhutta and Canner (2009), only about 6 percent of subprime loans made in 2005 and 2006 were made to CRA-targeted populations by CRA-regulated lenders. In effect, one of the consequences of the dramatic rise in private-label securitization volume was that it created lots of competition among the riskier segments of the mortgage market. This situation likely resulted in less lending by banks in CRA-eligible areas rather than more.

Finally, perhaps a more fundamental reason to doubt that securitization explains the timing of the paper's effects is that securitization has been around a long time. Laws needed to be changed before securitization could take off, but these legal changes occurred in the 1980s. So if the CRA and securitization together formed a lethal combination for the mortgage market, then why did the crisis occur in the late 2000s rather than the late 1980s?

Even if CRA encouraged risk, would it really say much about government policy?
With these caveats in mind, what would a finding that the CRA encouraged risky lending really tell us? In our opinion, a finding that the CRA encouraged risky lending would probably tell us little about the role of government in the financial crisis.

The focus needs to be on quantitative magnitudes. The question of whether or not the CRA led to an increase in risky lending of any size may not be that interesting because it is hard to imagine a world in which the CRA would not have done so. Economists begin with the premise that banks are profit-maximizing entities, so they should make all the loans that increase their expected profits. If a loan is not made, then that is because the bank must have judged the loan to reduce expected profits rather than raise them. As we described above, the CRA increases the risk-adjusted return for certain loans, so that some of the loans a bank deems unprofitable in the absence of the CRA (because of risk-adjusted returns that were too low) become profitable with CRA. Because these are marginal loans in risk-adjusted returns, then risk must be increasing.

If we start with the assumption that the CRA leads to more risky lending, the more interesting question is how much risky lending is encouraged. As it happens, the quantitative magnitudes of the estimates in the Agarwal et al. study are quite small. For example, if we assume that the appropriate CRA treatment effect should only be measured using the difference in the increase in lending between CRA-eligible census tracts and CRA-ineligible tracts, then magnitudes are trivial. Specifically, the paper finds that the CRA increased origination rates in CRA-eligible census tracts relative to CRA-ineligible census tracts by somewhere between 1 and 3 percentage points, depending on the specific quarter around the initiation of the CRA exam. When one considers that the average origination rate in the Agarwal et al. sample is 72 percent, and only 15 percent of loan originations in the sample came from CRA-eligible tracts, this is an extremely small effect. The effect becomes even smaller if you adjust the baseline estimates to take into account the likely simultaneity bias that we discussed above in the subsection titled "Issue 2."

The CRA passed long before the crisis
In concluding, we should point out that the CRA went into effect in 1977, 30 years before the financial crisis. If the CRA did shift the risk-return tradeoff for mortgage lending, then why didn't risky lending take off in 1978 rather than 2003? Moreover, the footprint of CRA-regulated institutions in the mortgage market has shrunk dramatically since the law passed. Figure 1 (taken from Foote, Gerardi, and Willen [2012]) shows that nondepository mortgage companies—which generally are not covered by the CRA—accounted for only 15 percent of mortgage lending when the CRA was passed in 1977. By the late 1990s, however, these non-CRA entities had grown to nearly 60 percent of the mortgage market. If the CRA is so toxic to the mortgage market, then it is puzzling why the act had no effect soon after its enactment, when it covered 85 percent of the mortgage market, yet led to an explosion of risky lending 25 years later, when it covered only 40 percent of the market.

Figure 1: The growth of non-depository mortgage companies

Indeed, any attempt to link the recent crisis to government policies aimed at expanding mortgage credit and homeownership faces an uphill struggle. The basic problem is that the federal government has been deeply involved in housing and mortgage markets since at least the end of World War II. In particular, the Federal Housing Authority (FHA) and Veterans Administration (VA) loan programs began at about that time and were explicitly designed to extend homeownership to underserved populations. As figure 2 (also from Foote, Gerardi, and Willen, 2012) shows, the FHA and VA pioneered no and low down payment loans in the 1950s and 1960s. And as figure 3 shows, FHA loans accounted for 40 percent of loans outstanding in the 1970s and had default rates that were an economically massive 100 percent higher than non-FHA loans. In their size and their effect on housing markets, the FHA and VA were literally orders of magnitude more important than the CRA. Did government lead to risky lending? Yes! But it did so 30 years before CRA and 60 years before the recent financial crisis.

Figure 2: The role of the Federal government in the mortgage market

Rer-03

Photo of Chris FooteChris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston,

 

Photo of Kris GerardiKris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta, and

 

Photo of Paul WillenBy Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston