paper about MBS

5 in sub-prime and similarly high-risk mortgages and

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Unformatted text preview: 5% in sub-prime and similarly high-risk mortgages and 15.2% in interest-only loans. It is certainly true that the majority of GSE losses derived from these vintages. But the losses were confined to 2006 and 2007 vintages not because of prudent lending in prior years but instead because weaker loans in earlier years were masked by the continued rising in housing prices through mid 2006. Mortgages issued in 2003 and 2004 may have been just as shoddy, but homeowners had built substantial equity in their homes by 2006 because of the large house price increases, which protected them (and Fannie and Freddie) against the subsequent price decreases. In other words, the GSEs had crossed their own Rubicon in the mid 1990s after the passage of FHEFSSA. The moment that the GSEs lowered their underwriting standards, there was no turning back, and as soon as housing prices started falling, their fate was sealed. A final observation is that the GSE Affordable Housing Goals were all stipulated as a percentage of their mortgage share. There were no growth targets. In fact, as Figure 1-1 showed their mortgage portfolios remained steady in size during 2003-2007. It was the MBS guarantee business that truly took off. The government push for affordable housing does not explain why the GSEs chose to grow the MBS guarantee business so dramatically. While their first master, HUD, might have been unhappy with a lack of growth, their second master, the GSEs’ shareholders, would have been even unhappier since investment banks had started generating substantial returns in lines of business that the GSEs could do. This is the issue that we turn to next. 33 Chapter 3: Race to the Bottom “You’re becoming irrelevant,” Mr. Mozilo, CEO of Countrywide told Mr. Mudd, CEO of Fannie Mae, “You need us more than we need you, and if you don’t take these loans, you’ll find you can lose much more.” - Charles Duhigg, New York Times , October 5, 2008 In their important 1932 book on the American corporation, The Modern Corporation and Private Property , Adolf Berle and Gardiner Means introduce the concept “race to the bottom”: the idea that competition can lead to a reduction of standards. While Berle and Means were referring to regulatory standards and competition among the (then) 48 states, it is not difficult to see how the same arguments could be applied to government-sponsored enterprises and likewise financial institutions. Figure 3-1 graphs the tremendous growth in the mortgage market (solid line, plotted against the right axis), and the fraction of residential mortgage originations each year that were securitized by the GSEs or private-label firms, as well as the amount not securitized (dashed lines plotted against the left axis). As can be seen from Figure 3-1, the mortgage market increased dramatically in size, especially in the latter period with the emergence of the riskier mortgage lending. It also shows that mortgage securitization generally increased every year from 1995 onwards, albeit for different reasons. In the period up to 2003, the GSEs dominated the 1995 onwards, albeit for different reasons....
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5 in sub-prime and similarly high-risk mortgages and 15.2...

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