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.
October 04, 2011
The uncertain case against mortgage securitization
The opinions, analysis, and conclusions set forth are those of the authors and do not indicate concurrence by members of the Board of Governors of the Federal Reserve System or by other members of the staff.
Did mortgage securitization cause the mortgage crisis? One popular story goes like this: banks that originated mortgage loans and then sold them to securitizers didn't care whether the loans would be repaid. After all, since they sold the loans, they weren't on the hook for the defaults. Without any "skin in the game," those banks felt free to make worse and worse loans until...kaboom! The story is an appealing one and, since the beginning of the crisis, it has gained popularity among academics, journalists, and policymakers. It has even influenced financial reform. The only problem? The story might be wrong.
In this post we report on the latest round in an ongoing academic debate over this issue. We recently released two papers, available here and here, in which we argue that the evidence against securitization that many have found most damning has in fact been misinterpreted. Rather than being a settled issue, we believe securitization's role in the crisis remains an open and pressing question.
The question is an empirical one
Before we dive into the weeds, let us point out why the logic of the above story need not hold. The problem posed by securitization—that selling risk leads to excessive risk-taking—is not new. It is an example of the age-old incentive problem of moral hazard. Economists usually believe that moral hazard causes otherwise-profitable trade to not occur, or that it leads to the development of monitoring and incentive mechanisms to overcome the problem.
In the case of mortgage securitization, such mechanisms had been in place, and a high level of trade had been achieved, for a long time. Mortgage securitization was not invented in 2004. To the contrary, it has been a feature of the housing finance landscape for decades, without apparent incident. As far back as 1993, nearly two-thirds (65.3 percent) of mortgage volume was securitized, about the same fraction as was securitized in
2006 (67.6 percent) on the eve of the crisis. In order to address potential moral hazard, securitizers such as Fannie Mae and Freddie Mac (the government sponsored enterprises, or GSEs) long ago instituted regular audits, "putback" clauses forcing lenders to repurchase nonperforming or improperly originated loans, and other procedures designed to force banks to lend responsibly. Were such mechanisms successful? Perhaps, perhaps not. It is an empirical question, and so our understanding will rest heavily on the evidence.
The case against securitization
Benjamin Keys, Tanmoy Mukherjee, Amit Seru, and Vikrant Vig released an empirical paper in 2008 (revised in 2010) titled "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans" (henceforth, KMSV) that pointed the finger squarely at securitization. The paper won several awards and, when it was published in the Quarterly Journal of Economics in 2010, it became that journal's most-cited paper that year by more than a factor of two. In other words, it was a very well-received and influential paper.
And for good reason. KMSV employs a clever method to try to answer the question of securitization's role in the crisis. Banks often rely on borrowers' credit (FICO) scores to make lending decisions, using particular score thresholds to make determinations. Below 620, for example, it is hard to get a loan. KMSV argues that securitizers also use FICO score thresholds when deciding which loans to buy from banks. Loan applicants just to the left of the threshold (FICO of 619) are very similar to those just to the right (FICO of 621), but they differ in the chance that their bank will be able to sell their loan to securitizers. Will the bank treat them differently as a result? This seems to have the makings of an excellent natural experiment.
Figures 1 and 2, taken from KMSV, illustrate the heart of their findings. Using a data set of only private-label securitized loans, the top panel plots the number of loans at each FICO score. There is a large jump at 620, which, KMSV argues, is evidence that it was easier to securitize loans above 620. The bottom panel shows default rates for each FICO score. Though we would expect default to smoothly decrease as FICO increases, there is a significant jump up in default at exactly the same 620 threshold. It appears that because securitization is easier to the right of the 620 cutoff, banks made worse loans. This seems prima facie evidence in favor of the theory that mortgage securitization led to moral hazard and bad loans.
Reexamining the evidence
But what is really going on here? In September 2009, the Boston Fed published a paper we wrote (original version here, updated version here) arguing for a very different interpretation of this evidence. In fact, we argue that this evidence actually supports the opposing hypothesis that securitizers were to some extent able to regulate originators' lending practices.
The data set used in KMSV only tells part of the story because it contains only privately securitized loans. We see a jump in the number of these loans at 620, but we know nothing about what is happening to the number of nonsecuritized loans at this cutoff. The relevant measure of ease of securitization is not the number of securitized loans, but the chance that a given loan is securitized—in other words, the securitization rate.
We used a different data set that includes both securitized and nonsecuritized loans, allowing us to calculate the securitization rate. Figures 3 and 4 come from the latest version of our paper.
Like KMSV, we find a clear jump up in the default rate at 620, as shown in the bottom panel. However, the chance a loan is securitized actually goes down slightly at 620, as shown in the top panel. How can this be? It turns out that above the 620 cutoff banks make more of all loans, securitized and nonsecuritized alike. This general increase in the lending rate drives the increase in the number of securitized loans that was found in KMSV, even though the securitization rate itself does not increase. With no increase in the probability of securitization, it is hard to argue that the jump in defaults at 620 is occurring because easier securitization motivates banks to lend more freely.
The real story behind the jumps in default
So why are banks changing their behavior around certain FICO cutoffs? To answer this question, we must go back to the mid-1990s and the introduction of FICO into mortgage underwriting. In 1995, Freddie Mac began to require mortgage lenders to use FICO scores and, in doing so, established a set of FICO tiers that persists to this day. Freddie directed lenders to give greater scrutiny to loan applicants with scores in the lower tiers. The threshold separating worse-quality applicants from better applicants was 620. The next threshold was 660. Fannie Mae followed suit with similar directives, and these rules of thumb quickly spread throughout the mortgage market, in part aided by their inclusion in automated underwriting software.
Importantly, the GSEs did not establish these FICO cutoffs as rules about what loans they would or would not securitize—they continued to securitize loans on either side of the thresholds, as before. These cutoffs were recommendations to lenders about how to improve underwriting quality by focusing their energy on vetting the most risky applicants, and they became de facto industry standards for underwriting all loans. Far from being evidence that securitization led to bad loans, the cutoffs are evidence of the success securitizers like Fannie and Freddie have had in directing lenders how to lend.
With this in mind, the data begin to make sense. Lenders, following the industry standard originally promulgated by the GSEs, take greater care extending credit to borrowers below 620 (and 660). They scrutinize applicants with scores below 620 more carefully and are less likely to approve them than applicants above 620, resulting in a jump-up in the total number of loans at the threshold. However, because of the greater scrutiny, the loans that are made below 620 are of higher average quality than the loans that are made above 620. This causes the jump-up in the default rate at the threshold.
Figures 5 and 6 show that this pattern also exists among loans that are kept in portfolio and never securitized. The change in lending standards causes these loans, as well as securitized loans, to jump in number and drop in quality at 620 (and 660). However, as figure 3 shows, the securitization rate doesn't change because securitized and nonsecuritized loans increase proportionately. The FICO cutoffs are used by lenders because they are general industry standards, not because the securitization rate changes. This means the cutoffs cannot provide evidence that securitization led to loose lending.
But the debate does not end there. In April 2010, Keys, Mukherjee, Seru, and Vig released a working paper (KMSV2), currently forthcoming in the Review of Financial Studies, that responded to the issues we raised. According to the paper, the mortgage market is segmented into two completely separate markets: 1) a "prime" market, in which only the GSEs buy loans, and 2) a "subprime" market, in which only private-label securitizers buy loans. KMSV2 argues that only private-label securitizers follow the 620 rule and, by pooling these two types of loans in our analysis, we obscured the jump in the securitization rate in that market.
The latest round in the debate
We went back to the drawing board to investigate these claims. We detail our findings in a new paper, available here. In the paper, we demonstrate that the pattern of jumps in default—without jumps in securitization—is not simply an artifact of pooling, but rather exists for many subsamples that do not pool GSE and private-label securitized loans. For example, we find the pattern among jumbo loans (by law an exclusively private-label market), among loans bought by the GSEs, and among loans originated in the period 2008–9 after the private-label market shut down. Furthermore, as figure 7 shows, the private-label market boomed in 2004 and disappeared around 2008, while the size of the jump in the number of loans at 620 continued to grow through 2010, demonstrating that use of the threshold was not tied to the private market.
What's more, KMSV's response fails to address the fundamental problem we identified with their research design: following the mandate of the GSEs, lenders independently use a 620 FICO rule of thumb in screening borrowers. Even if some subset of securitizers had used 620 as a securitization cutoff, one would not be able to tell what part of the jump in defaults is caused by an increase in securitization, and what part is simply due to the lender rule of thumb. Consequently, the jump in defaults at 620 cannot tell us whether securitization led to a moral hazard problem in screening.
To put this in more technical jargon, KMSV use the 620 cutoff as an instrument for securitization to investigate the effect of securitization on lender screening. But the guidance from the GSEs that caused lenders to adopt the 620 rule of thumb in the first place means that the exclusion restriction for the instrument is not satisfied—the 620 cutoff affects lender screening through a channel other than any change in securitization.
We also found that the GSE and private-label markets were not truly separate. In addition to qualitative sources describing them as actively competing for subprime loans, we find that 18 percent of the loans in our sample were at one time owned by a GSE and at another time owned by a private-label securitizer—a lower bound on the fraction of loans at risk of being sold to both. Because the markets were not separate, the data must be pooled.
Our findings, of course, do not settle the question of whether securitization caused the crisis. Rather, they show that the cutoff rule evidence does not resolve the question in the affirmative but instead points a bit in the opposite direction. Credit score cutoffs demonstrate that large securitizers like Fannie Mae and Freddie Mac were able to successfully impose their desired underwriting standards on banks. We hope our work causes researchers and policymakers to reevaluate their views on mortgage securitization and leads eventually to a conclusive answer.
By Ryan Bubb, assistant professor at the New York University School of Law, and Alex Kaufman, economist with the Board of Governors of the Federal Reserve System
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