Topic: Finance, Banking & Monetary Policy

FHA: On Mortgage Insurance and Adverse Selection

According to a White House release, the Federal Housing Administration (FHA), which insures lenders’ against borrower default, will be lowering its annual premiums. While I believe this to be a reckless move in the wrong direction, I am the first to say that setting the appropriate premium is a lot harder than it looks.

The fundamental problem facing any insurer, like the FHA, is that the risk profile of borrowers is influenced by the premium rates they are charged. Obviously a rate that is set too low will not cover losses and the insurance fund will lose money. But a rate set too high will drive away low-risk borrowers and leave the insurer covering only high risk borrowers (and likely also losing money). An insurance fund can easily find itself in a position where it needs to raise rates to cover losses from risky borrowers, but each rate increase only drives out the good borrowers, making the risk composition of the pool ever worse. If you want to see this spelled out with a lot of fancy math, I refer you to Joe Stiglitz and Andrew Weiss’s classic paper on the topic (which builds upon earlier work by Dwight Jaffee).

Figure 3 from Stiglitz and Weiss (below the jump) illustrates this tension. If you want to attract both low- and high-risk borrowers, you need to have a much lower rate than if you only want to attract high-risk borrowers. In fact, one of the rationales I often hear from advocates of expanding the FHA is that doing so will improve the health of the fund by attracting better quality borrowers.

The problem with this is that President Obama is quite explicit that his desire is to lower the credit quality of FHA borrowers. From the White House fact sheet: “FHA premium reduction will help hundreds of thousands of additional families own a home for the first time.” This initiative is targeted at first-time buyers, those who have not been able to get a loan previously. First-time buyers who have been previously “waiting on the sidelines” are likely to be younger and hence have lower credit scores on average, or else be older buyers who have had trouble finding credit because they are high-risk.

Such is also borne out in the FHA’s most recent origination report, which shows average FICO scores (a measure of creditworthiness) declining over recent years. Almost 60 percent of recent FHA borrowers have FICOs below 680. Almost 75 percent made a down-payment of less than 5 percent. If they would need to sell their homes within a few years of purchase, then given the transactions costs they’d need to bring cash to the table. This is not a high-quality book of business. 

As I wrote almost three years ago, if the FHA is serious about rebuilding its financial health and protecting the taxpayer, it needs to move in the direction of reducing its lending to higher-risk borrowers. If the agency is unwilling to do so, which appears to be the case, then any change in premiums should be up not down.

EU Demand for US Subprime: the Case of Germany

The growth of the U.S. subprime mortgage market was made possible only by the willingness of investors to fund that market.  The largest single investors in the market for private label subprime securities appears to have been Fannie Mae and Freddie Mac, whose market share reached almost 40% of private label subprime mortgage-backed securties (MBS) in 2004.  A less recognized driver was investment demand coming from the European Union.  Perhaps the role of EU has been less appreciated due to data limitations, which will soon become apparent.

What we do know is that as of June 30, 2008, just before the crisis hit, almost $460 billion in non-agency residential mortgage-backed securities (RMBS) was held outside the US (see table 24 here). This represented almost a fourth of total US-issued RMBS at that time.  Of course not all non-agency MBS is subprime.  For instance a significant share are jumbo prime mortgages.  Estimates suggest subprime were a little more than half of outstanding non-agency MBS.  This breakdown does not appear to be available for EU holdings, which were almost half of non-US holdings.  More than $30 billion was held by German institutions.

One reason Germany merits special discussion is that some research has been done on who exactly these institutions were.  Germany is also interesting because of the diversity of its financial system and the special role of state-owned banks.  Almost half of banking in Germany is conducted by the public sector.  The most prominent of this being the Landesbanken, which are owned by the German regional governments.  One study found losses from US subprime MBS to be “on average three times as large for state-owned banks compared to privately owned banks.” Overall about two-thirds of losses in Germany on US subprime MBS were from holdings by state owned banks.

Bitcoin Might Not Be Money, but Cryptocurrencies are the Way of the Future

Kevin Dowd, a long-time friend and eminent free-banking authority, set his sights on Bitcoin in the book he published this summer: New Private Monies: A Bit Part Player?.  His work delivers a refreshingly accurate and straightforward assessment of Bitcoin, ignoring the hype which surrounds it.

Both Kevin and I appreciate the importance of cryptocurrencies: in his own words, “The broader implications of cryptocurrency are extremely profound.”  The peer-to-peer exchange structure common to cryptocurrencies like Bitcoin cuts the intermediary out of transactions.  This eliminates the need for a third party in exchanges and protects wealth against exchange controls or capital controls.  Because Bitcoin and other cryptocurrencies are entirely digital, the location of the two parties of a transaction is irrelevant: transactions can be carried out anywhere.  This also makes transactions highly anonymous, a feature appealing to consumers who cherish privacy.

The intermediary-free, digital transactions characteristic of cryptocurrencies such as Bitcoin are an important step towards exchanges free of regulatory meddling.  In addition, this technology should enable low-cost banking accessible to anyone with a cellphone.  Indeed, cryptocurrencies should improve access to financial services in developing countries and elsewhere because they will complement existing services that now rely on standard currencies (see the M-Pesa in Kenya).

There is, however, an important line to be drawn between the future of the technology behind Bitcoin and the future of Bitcoin itself, thanks to its notorious volatility.  Kevin is crystal clear on the distinction:

“Though the supply of Bitcoin is limited, the demand is very variable; this variability has made its price very uncertain and created a bubble-bust cycle in the Bitcoin market.  Perhaps the safest prediction is that Bitcoin will eventually be displaced by alternative cryptocurrencies with superior features.” 

Will the Third Time Be the Charm as the Supreme Court Again Takes Up a Controversial Theory of Racial “Discrimination”?

Title VIII of the Civil Rights Act, also known as the Fair Housing Act (FHA), makes it illegal to deny someone housing on the basis of race and other protected characteristics. Applicable to governments, private entities, and individuals, the FHA prohibits racially discriminatory practices in most if not all transactions relating to housing.

For example, a landlord can’t refuse to rent an apartment to an otherwise qualified tenant, solely on the basis of race. Similarly, banks and credit unions can’t take a borrower’s race into account when deciding whether and on what terms to extend credit for the purpose of buying a home.

While it’s clear that the FHA bars such discriminatory intent, it remains an open question whether it covers claims of “disparate impact,” where a neutral policy disproportionately harms members of the protected class. Under this theory, a landlord insisting that all applicants pass a credit check could be held liable if it turns out that applicants from one protected group are disproportionately unlikely to have a sufficiently high credit score. That landlord would be held liable even though a satisfactory credit score is required of all potential tenants, regardless of race, and the landlord’s only intent was the (perfectly legal) desire to avoid tenants who would get behind on their rent—not to deny housing to any particular group.

In the decades since the FHA was passed, disparate impact has been used by the government and private litigants to exact tens of millions of dollars in fines and settlements from banks and developers whose facially neutral policies were alleged to have excluded members of a protected class from the housing market. The problem is that unlike with other anti-discrimination laws, such as the Americans with Disabilities Act—which expressly prohibits policies that have a disparate impact—the text of the FHA explicitly forbids only intentional discrimination.

Krugman vs. Krugman on Statutory Interpretation

To follow-up on my colleague Walter Olson’s earlier post on the Paul Krugman piece on King v. Burwell, what struck me was Krugman’s flexible approach to statutory interpretation.

Here he is in today’s piece:

Last week the court shocked many observers by saying that it was willing to hear a case claiming that the wording of one clause in the Affordable Care Act sets drastic limits on subsidies to Americans who buy health insurance. It’s a ridiculous claim; not only is it clear from everything else in the act that there was no intention to set such limits, you can ask the people who drafted the law what they intended, and it wasn’t what the plaintiffs claim. …

 if you look at the specific language authorizing those subsidies, it could be taken — by an incredibly hostile reader — to say that they’re available only to Americans using state-run exchanges, not to those using the federal exchanges.

As I said, everything else in the act makes it clear that this was not the drafters’ intention, and in any case you can ask them directly, and they’ll tell you that this was nothing but sloppy language. …

So, don’t worry so much about the specific language; instead, look at the drafters’ intent and the surrounding context. Got it.

On the other hand, here’s Krugman from January of 2013, writing about the idea of a platinum coin:

Enter the platinum coin. There’s a legal loophole allowing the Treasury to mint platinum coins in any denomination the secretary chooses. Yes, it was intended to allow commemorative collector’s items — but that’s not what the letter of the law says. And by minting a $1 trillion coin, then depositing it at the Fed, the Treasury could acquire enough cash to sidestep the debt ceiling — while doing no economic harm at all.

So in this situation, you should stick to the “letter of the law,” and not worry so much about the drafters’ intent.

Hmm, how to reconcile those two Krugman assertions about the proper approach to statutory interpretation?  That’s a tough one.  Wait, I got it!  We’ll call this the Krugman canon of construction: “Interpret statutes in whatever way makes them consistent with your policy preferences.”

Midterm Impact on Financial Regulation

With Republicans taking the majority (but far short of control at 60) in the Senate and increasing their majority in the House, the regulation of our financial markets may see renewed attention, with particular focus on reforming Dodd-Frank. My former employer Senator Richard Shelby takes the Chair on the Senate Banking Committee, while Congressman Jeb Hensarling retains his leadership role on House Financial Services.

In my nearly twenty years following financial services, we have not had two chairmen more skeptical of government oversight of our financial markets. While neither could be called “libertarian,” both are suspicious of big government as well as big finance.  Both agree that “Too Big To Fail” is a real issue and one created by the actions of government, not the market.

Sen. Shelby, for instance, has repeatedly said “no one is too big to fail” - what he means here is that no company should be getting a bailout.  It was for that reason he led the charge in the Senate against the TARP, and also for that reason he voted against the Chrysler Bailout in 1979.  Shelby also led the efforts to reform Fannie Mae and Freddie Mac, warning years before their failure of the various flaws inherent in a mortgage model of privatized gains and socialized losses.  Shelby also tried to bring more competition to the credit rating agencies, passing legislation in 2006 to reduce barriers to entry in that market.

The above, however, should not be read to overstate the case.  Both Rep. Hensarling (who apparently had a subscription to the Cato Journal in college) and Sen. Shelby would like to see the federal safety net behind our financial markets reduced, allowing a greater role for market discipline.  Perhaps even more rare in D.C., they both believe their chairmanships come not just with privilege but great responsibility.  If it were simply up to these two to agree, I have confidence that our system of financial regulation would be greatly improved, reducing bailouts and increasing stability.  

But it isn’t up to these two. There are numerous protectors of the status quo in both major political parties.  Both would also have to reach agreement with the Obama Administration, which seems quite comfortable with bailouts and regulatory discretion.  Ultimately, the many obstacles our Founding Fathers wisely put in place for legislation will prove too high for Shelby and Hensarling to implement all but modest reform.  

But at least financial regulation is unlikely to get any worse.

A Few Words on ‘Gainful Employment’

The big higher education news this week is that the Obama administration released its “gainful employment” rules aimed squarely at beleaguered for-profit colleges, which are the schools most likely to offer programs that are explicitly about supplying job skills. This attack does not seem to come because for-profits are objectively worse performers than the rest of the decrepit Ivory Tower, but because it is easy to demonize institutions that—unlike much of higher ed—are honest about trying to make a profit. Oh, and because going after the real culprit—an aid system that gives almost any person almost any amount of money to go to college—would require federal politicians to take on a system they created, and that makes them look ever-so-caring.

Perhaps the only unexpected thing about the regulations is that they do not include cohort default rates—the percentage of an institution’s borrowers defaulting on their loans within two or three years of entering repayment—among the assessments of aid worthiness. Instead, they just use debt-to-earnings ratios. The American Association of Private Sector Colleges and Universities—proprietary colleges’ advocacy arm—suspects this was done because including the default rate was projected to ensnare some community colleges, and the administration wanted this to be all about for-profit institutions.

There is reason to believe this may be true. The administration has lauded community colleges as the Little Schools That Could for a long time, and, indeed, directly compared them to for-profit schools in its press release for the new regulations. “The situation for students at for-profit institutions is particularly troubling,” they wrote. “On average, attending a two-year for-profit institution costs a student four times as much as attending a community college.” What didn’t they mention? According to federal data, completion rates at community colleges are around 20 percent, versus 63 percent at two-year for-profits. The data aren’t perfect—they capture only first-time, full-time students who finish at the institution where they started—but it is a yawning gap that illustrates a crucial point not just about gainful employment, but overall higher education policy: emotions and political concerns, not objective analysis, seem to drive it.

And speaking of objective analysis: We will be hosting what should be a great, diverse panel discussion on Wednesday, November 5, that will look at the changing face of higher education—including, no doubt, gainful employment—as well as offer predictions about what the previous night’s election results might mean for higher education. Hope to see you there!