Systemic Risk Immunization and Contract Design in the US and Canadian Mortgage Funding Systems

Geoffrey PoitrasSimon Fraser University

Vancouver, BC CANADA

Current State of US Mortgage Mkt.

• August 7, 2013 USA TODAY reports:

Almost five years after taxpayers bailed out mortgage giants Fannie Mae and Freddie Mac, President Obama said it's time for private investors to take a bigger role in the mortgage market.

"For too long, these companies were allowed to make big profits buying mortgages, knowing that if their bets went bad, taxpayers would be left holding the bag," Obama said. "It was heads we win, tails you lose. And it was wrong."

America in Denial

The number of ‘explanations’, ‘causes’, of the mortgage market collapse include: ‘perverse features of the loan origination and securitization process’; moral hazard in mortgage appraisal; inaccurate pricing of default risk, etc. etc. Subprime lending is to blame, that is why the collapse is referred to as the ‘subprime mortgage crisis’

Subprime is Over, Problem Solved

CommonMisperceptions

• Subprime loans were the last stage in a process that Subprime loans were the last stage in a process that commenced with the ‘Greenspan put’ – not the ‘cause’commenced with the ‘Greenspan put’ – not the ‘cause’

• Perverse feature of US mortgage contract design (prepayment Perverse feature of US mortgage contract design (prepayment option exercise): significant interest rate decrease generated a option exercise): significant interest rate decrease generated a wave of ‘refinancing’ that resulted in losses on the mortgage wave of ‘refinancing’ that resulted in losses on the mortgage portfolios creating demand for higher return assets to close the portfolios creating demand for higher return assets to close the implicit funding gapimplicit funding gap

• Similar to previous collapse of S&L where dramatic rises in Similar to previous collapse of S&L where dramatic rises in interest rates also generated mortgage losses interest rates also generated mortgage losses LBO lending LBO lending by S&L’s by S&L’s

Basic Results of this Paper

• Mortgage contracts with yield maintenance prepayment penalties and term to maturity that is significantly less than the amortization period reduce systemic risk

• This paper is about the impact of mortgage contract design on REDUCING SYSTEMIC RISK (the connection to the subprime crisis is illustrative)

Canada vs. US Mortgage Markets

• Prior to the recent market failure, criticism of the US mortgage system was muted and claims for innovation and superiority over mortgage financing methods used in other countries were common.

• Canadian mortgage system was criticized for “lack of access to mortgages with fixed rates, penalty-free prepayment and high loan-to-value ratios” (Green and Wachter 2005, p.102). Yield maintenance penalties and relatively low levels of mortgage securitization also singled out for criticism.

• Despite considerable economic integration of the Canadian and US economies and financial markets, the Canadian mortgage funding system has been comparatively unscathed by the crises that have emerged in the US and other countries.

Mortgage Contract Characteristics

• The conventional U.S. mortgage contract: – low or no prepayment penalties– limited or no recourse in the event of default

combined with inaccurate pricing by mortgage lenders of the implicit mortgage default premium

– contracts with a long amortization period that is equal to the term to maturity of the mortgage

Mortgage Contract Characteristics

• The conventional Canadian mortgage contract– term to maturity of the mortgage that is significantly

less than the amortization period– full recourse in the event of default– ‘yield maintenance’ prepayment penalties

Defining Systemic Risk

• What is systemic risk?– A bewildering number of definitions and descriptions– Greenspan (1995) remains: “the very definition [of systemic risk] is still somewhat

unsettled”.– FRBNY (2007, p.7) observes: “Systemic risk in the financial system is difficult to

define precisely

• Official Definitions:– Bullard et al. (2009): “Systemic risk refers to the possibility of a

triggering event, such as the failure of an individual firm, will seriously impair other firms or markets and harm the broader economy.”

– Kupiec and Nickerson (2004) define systemic risk as: “the potential for a modest economic shock to induce substantial volatility in asset prices, significant reductions in corporate liquidity, potential bankruptcies and efficiency losses.”

Academic Definitions of Systemic Risk

• Saunders and Walters (2012, p39): “financial firms that are ‘systemic’ in nature ... firms judged too big or too interconnected to be allowed to fail”. – In this case, systemic risk is associated with “what is gained and what is

lost as a result of the available policy options” to deal with “the dominant role of systemically important financial institutions in the financial architecture.”

• Kane (2010, p.253) identifies: “The primary characteristic of systemic risk is the emergence of widespread concerns about the potential for substantial ‘spillovers’ of contagious defaults across counterparties in the financial sector and from these defaults to breakdowns in the real economy.”

Systemic Risk in Mortgage Funding

• Conventional view is to take an insurance perspective on ‘risk’ where outcomes involve either loss or no loss.

• Risk in financial markets is two-sided.– Versus insurance perspective on ‘risk’ where outcomes only

involve either loss or no loss

• Systemic risk from the mortgage funding system originates when the transfer of mortgage risks between households and mortgage lenders results in equity losses that exceed system equity available. To cover such losses, the mortgage funding system then needs to draw capital from elsewhere in the financial system

Systemic Risk Definition

• Systemic risk needs to be precisely defined by the context

• ‘Systemic risk’– the risk that equity losses from the (mortgage) funding

system will spill over into the greater financial system with potentially catastrophic consequences

• Possible to refer to systemic risk of government funding, external market funding, pension funding, etc.

Contribution of this Paper

• This paper extends results from fixed income portfolio immunization theory to demonstrate:

1) systemic risk of long amortization period mortgages is substantively reduced by shortening mortgage term to maturity

2) reducing mortgage term to maturity will reduce the value of the prepayment and default options.

3) including a yield maintenance prepayment penalty in the mortgage contract is a systemic risk reducing method of pricing the value of the prepayment contingency

Fixed Income Portfolio Immunization Theory

• Classical fixed income interest rate immunization model uses a univariate Taylor series expansion to derive two rules for immunizing a zero surplus fixed income portfolio against a change in the level of interest rates: – 1) match the duration of cash inflows (assets) and

outflows (liabilities)– 2) set the asset cash flows to have more dispersion

(convexity) than the liability cash flows around that duration

Extending the Classical Model

• This paper is a substantive extension of the classical fixed income portfolio immunization model

• The concept of zero duration of ‘system surplus’ is defined:– Incorporating house prices and time value to produce a

multivariate Taylor series expansion that is then used to solve for the zero change in the duration of surplus condition for both mortgage lenders and borrowers these conditions are used to solve for the zero change in the duration of SYSTEM SURPLUS

– NEED TO READ THE PAPER

Conclusions

• Basic Intuition of the theoretical results I– Without prepayment options, a thirty year fixed rate

mortgage contract poses significantly more systemic risk than a contract where mortgage contract term to maturity is less than the thirty amortization period

– The systemic impact of + (-) interest rate changes on the unpaid balance of the mortgage contract where term to maturity is less than the amortization period offsets the - (+) impact on the value of the mortgage cash flows over the term of the mortgage.

Conclusions (Cont’d)

• Basic Intuition of the theoretical results I I– Without prepayment penalty, losses (gains) by mortgage lenders

(borrowers) on the market value of mortgage contracts when interest rates increase is offset by gains (losses) when interest rates decrease

• From a mortgage funding system perspective, as long as there is sufficient surplus (equity) on the balance sheets of lenders and borrowers, there will be no demand for equity funding from outside the system

– The inclusion of a prepayment penalty in the mortgage contract makes this funding system unstable