Lawbitrage

Focusing on Private Reverse Mortgages

A post yesterday by Reverse Mortgage Daily writer Elizabeth Ecker focused largely on my testimony before Congress a couple weeks ago about whether the reverse mortgage market could exist without insurance provided by the Federal Housing Administration. She writes, in relevant part:

Take the stress off of FHA and make way for private reverse mortgage products, was the message presented by two housing academics [the other being Anthony Saunders] in testimony presented before a Congressional panel earlier this month. The progression might not be such a long way off, they said....

“Conventional reverse mortgages will likely increase in market share as the economy recovers, housing prices stabilize, and credit conditions improve,” Houman Shadab, Associate Professor of Law at New York Law School told the panel.

“Currently, the most important obstacles to the development of private reverse mortgages seem to be continued uncertainties regarding housing prices and the willingness of lenders, insurers, and investors to assume housing price risk.”

The outlook is strong, he said. And insurers could become larger players as they are already equipped in actuarial-based products. It was rumored this year, for example, that New York Life was seeking entry into the reverse mortgage business, in addition to active insurers in the space such as Genworth Financial and, previously, MetLife.

“There now seems to be a market consensus developing around how to better underwrite and produce what could become a standardized privately insured reverse mortgage. For example, an underwriter of life insurance and similar products has recently argued that the reverse mortgage market could greatly expand if actuarial methods used in other industries were applied to reverse mortgages.”

Read the whole post here.

Recent Coverage of My Reverse Mortgage Testimony

The blog of Reverse Mortgage Calculator recently summarized last week's Congressional hearings on reverse mortgages that I participated in. A large part of the post focuses on my testimony:

While [Jeff Lewis', Chairman of the Coalition for Independent Seniors,] account of the hearing seems positive, Houman Shadab’s take on HECMs is less encouraging. In his written testimony prepared for the hearing, Shadab clearly opposed expanding the HECM program. Shadab believes that reverse mortgages can flourish without FHA insurance. Instead of HECM programs, the professor believes that the industry should place more emphasis on building stronger conventional reverse mortgage products.

If FHA does continue to insure HECMs, Shadab argues that the maximum claim amount should be reduced. The professor believes that this would lessen the risk of the loan product without posing a “long-term problem for borrowers seeking reasonably priced reverse mortgages.” Public opinion on the issue has yet to be heard.

That about summarizes it.

What Matt Taibbi Gets Wrong About Naked Short Selling

Matt Taibbi's recent column criticizing Goldman Sachs' supposed failure to comply with short sale regulation rests upon the erroneous premise that naked short selling artificially depresses stock prices and thereby robs companies of growth opportunities and shareholders of wealth.

A naked short sale takes place when the short seller "fails to deliver" the shorted stock to the buyer because the seller did not borrow the shares in the first place. From Taibbi's perspective,

naked short-selling [is] a kind of high-finance counterfeiting that, especially prior to the introduction of new regulations in 2008, short-sellers could use to artificially depress the value of the stocks they’ve bet against. 

Contrary to Taibbi's claim, however, there is virtually no evidence that naked short selling depresses stock prices, "artificially" or otherwise. Academic studies find that naked short sales do not cause price reductions and in fact are made in response to overvalued stocks.

Below are snippets from the abstracts of some recent academic studies:

• a 2009 study by Veljko Fotak, Vikas Raman, and Pradeep K. Yadav:

We empirically investigate the impact of naked short-selling on market quality, and find that naked shorting leads to significant reduction in positive pricing errors, the volatility of stock price returns, bid-ask spreads, and pricing error volatility. We study naked shorting surrounding the demise of financial institutions hardest hit by the financial crisis in 2008 and find no evidence that stock price declines were caused by naked shorting. We also find that naked short-selling intensifies after rather than before credit downgrade announcements during the 2008 financial crisis. In general, we find that naked short sellers respond to public news and intensify their activity after price declines rather than triggering these price declines.

• a 2010 dissertation chapter by Stanford's Elizabeth Stone (page 88):

This paper evaluates the validity of the claim that naked shorting leads to negative excess returns by creating additional selling pressure. ... I find no evidence that stocks subject to naked short selling experience negative excess returns. Rather, I find evidence that these stocks outperform on the day the trades occur. Naked short sellers appear to target stocks that outperform during the trading day and cover existing fails on days when the stocks underperform....The analysis presented in this paper finds that naked short selling is not systematically associated with negative excess returns.

• a 2011 study by Warren Bailey and Lin Zheng:

Using NYSE transactions records, we study short selling during the recent financial crisis....We conclude that short sales did not contribute substantially to stock price declines, and constraining short-selling is unwarranted.

•  a 2012 article by Thomas Boulton and Marcus V. Braga-Alves:

Contrary to recent claims that naked short sellers are momentum traders who drive down stock prices, we find that returns are typically positive just prior to periods of increased naked short selling that result in persistent fails and that returns generally remain positive for several weeks afterwards.

Taibbi's column certainly makes for some interesting reading. But when it comes to giving readers an accurate picture of the impact of naked shorting, it's what he's writing that fails to deliver.

The Volcker Rule's Hedging Exemption May Encourage JP Morgan-Style Risk Taking

Many details of the credit derivatives position that caused JP Morgan (JPM) to recently lose at least $2 billion are unknown. Yet based on the company's disclosures and media accounts of the trade, the Volcker Rule as proposed in October 2011 may end up encouraging the type of risk taking underlying JPM's losing position, if the Rule is implemented as proposed.

The Volcker Rule bans proprietary trading by banks and their holding companies, affiliates, and subsidiaries. As noted on page 67 of the proposal, the Rule's "hedging exemption" permits banks to engage in otherwise prohibited trading to hedge, but only if the hedging transaction does "not give rise, at the inception of the hedge, to significant exposures that are not themselves hedged in a [second] contemporaneous transaction."

The problem is that while entering into a secondary hedging transaction may initially reduce risk, it may also leave banks with even riskier positions that are difficult to manage in the long-run. Indeed, JPM's losing trade exemplifies just this sort of risky secondary hedging transaction.

To hedge its exposures from holding high-grade corporate bonds, JPM bought credit protection on a credit default swap (CDS) index referencing corporate bonds. However, this primary hedging transaction itself exposed JPM to at least two new risks. First, in accordance with accounting rules, JPM had to mark-to-market the value of its CDS index hedging transaction, which means that the primary hedge exposed JPM to market price risk. Second, the primary hedge also exposed JPM to the risk that the other side of the hedging transaction would be unable to pay, or counterparty risk.

To hedge these new risks, JPM also entered into another hedging transaction where it sold protection on a related CDS bond index. To borrow a metaphor from the New York Times, JPM put an umbrella on an umbrella. Importantly, not only was this sale of CDS protection the part of the transaction that ultimately led to JPM's $2 billion loss, but it was also the type of secondary hedging transaction that could be required by the Volcker Rule. When the secondary hedge was entered into 2011, it seems to have been an appropriate hedge for the primary hedging transaction.

None of the foregoing implies that JPM's loss was caused by anything other than its own mismanagement. However, given that secondary hedging transactions seem ripe for such mismanagement, the fact that the Volcker Rule seems to encourage them to qualify for one of its exemptions is troubling. It suggests attempts to micro-manage bank risk taking through regulation could seriously backfire, and that higher capital requirements or limiting the size of banks will be more effective in reducing systemic risk than the Volcker Rule.

My Congressional Testimony on Reverse Mortgages and Securitization

Earlier this week, I testified on reverse mortgages and securitization before the House Financial Services subcommittee on Insurance, Housing and Community Opportunity. It was the third time I testified before Congress, the prior two occasions being in hearings on hedge funds in 2008 and on executive compensation in 2007.

A reverse mortgage is a niche financial product that entails a borrower taking out a loan based upon their home equity and paying it back when they move or pass away. The "reverse" aspect comes from the fact that the lender makes payments to the borrower, and it is typically done through a line of credit. Pursuant the Federal Housing Administration's (FHA) Home Equity Conversion Mortgage (HECM) program, the FHA insures lenders (up to a certain amount) against losses that may result from the property value being less than the amount of the loan when payment is due. Ginnie Mae also fully guarantees HECM mortgage-backed securities.

My testimony focused on the extent to which markets can provide reverse mortgages without the HECM program or Ginnie Mae guarantees. This question is relevant to the extent one is concerned about taxpayers being exposed to losses from subsidizing the risk taking of financial institutions involved with reverse mortgages. My basic conclusion was that a sizable reverse mortgage market could probably exist without government involvement. This is due primarily to the appetite of institutional investors for a wide variety securitized debt products that do not come with a governmental guarantee. Of course, a remaining question beyond the scope of my testimony is how large or expensive a private reverse mortgage market would be.

My full written testimony is available here, and the video of my oral remarks is here.

Photo Credit: Jay Mallin

Why Warren Buffet's Hedge Fund Gamble is a Sucker's Bet

Katherine Burton of Bloomberg reports with an update on Warren Buffet's 2008 bet against a fund of hedge funds manager. The bet turns on which investment vehicle will produce higher returns over a decade: a fund of hedge funds index or mutual fund tracking the S&P 500 index. As of March 2012, the mutual fund was handily beating the hedge fund vehicle by returning 2.2 percent against the fund of hedge fund's negative 4.5 percent.

Leaving the peculiarties of the specific bet aside, only a sucker would bet that a diversified group of hedge funds would produce higher returns than the stock market over a decade. This does not reflect poorly on  hedge funds, however. In general, hedge funds aim to hedge--not to produce higher returns than the market, but rather to produce better returns on a risk-adjusted basis.

More precisely, as I wrote in 2008, hedge funds "must be evaluated in the context of their contribution to the overall risk of an investment portfolio." Hedge funds should not be evaluated as to whether they beat the market, but how they improve the risk and return profile of an already existing portfolio of stocks, bonds, and other traditional investments. On that approach, there is ample empircial evidence finding that hedge funds do indeed add value to traditional portfolios. For example, a 2007 study suggests that an optimal allocation to hedge funds is somewhere around 20 percent after taking into account the unique risk-return properties of the funds.

Warren Buffet surely knows that hedge fund returns will likely trail the market on a non-risk-adjusted basis, which only makes the willingness of anyone to take that bet against him all the more remarkable.

Banning Synthetic CDOs Could Increase Risk and Regulatory Arbitrage

Comments are due today to the Securities and Exchange Commission (SEC) regarding a rule that it proposed last year which prohibits sellers of risk in synthetic securitizations (underwriters, sponsors, etc.) from taking short positions in the securitization. I summarized the rule here.

If implemented as proposed, the rule may decrease the ability of banks to reduce risk. It may also increase regulatory arbitrage.

Prohibiting Risk-Reducing Securitizations

The proposed rule, mandated by the Dodd-Frank Act of 2010, targets the types of synthetic securitizations made infamous by an array of hedge funds and investment banks including John Paulson's fund, Magnetar, Goldman Sachs, JP Morgan, and Citigroup. The rule seeks to prohibit certain types of conflicts of interest in synthetic securitizations, including in those securitizations that are used by a firm

to reduce its long investment exposure to the relevant assets because it has come to believe that the assets will perform poorly. If the firm accomplishes this result by transferring the risk of its long positions to [asset-backed securities] ABS investors through a synthetic ABS—while marketing the ABS securities to investors as a good investment opportunity—it could be viewed as benefiting from a decline in the ABS at the expense of the ABS investors, who now have the exposure to the underlying assets. [proposed rule (page 60,338)]

Unfortuantely, this aspect of the proposal may have the effect of prohibiting synthetic securitizations that are used by banks reduce risk, so-called "balance sheet" transactions.

An example of such a transaction is the 2002 Deutsche Bank London Wall synthetic collateralized debt obligation (CLO). It transferred the risk of a "reference portfolio" of 264 corporate loans to investors, and is depicted in the following diagram from Standard and Poor's.

CLOs have in fact been effective in helping banks reduce their exposures to corporate loans. Investors have also benefited from their CLO investments by earning their expected returns and seeing minimal defaults, even for CLOs created before the 2008 financial crisis (see this Federal Reserve report, page 62). And contrary to what is implied by the proposed rule's discussion, investors have indeed found "good" investments in "poorly" performing assets. Due to pooling, tranching, and other credit risk transfer governance mechanisms, CLO investors experienced minimal losses even though corporate loan defaults spiked in early 2010.

It is unclear, therefore, where the actual conflict in these types of securitizations exist. True, all derivatives transactions are a zero-sum in the sense that one party's gain is the other's loss; and vice versa. Indeed, the very nature of a synthetic transaction is such that the risk transferring firm must "benefit[] from a decline in the ABS at the expense of the ABS investors."

But there is nothing inherently suspicious (or conflicted) about the balance sheet securtization the SEC describes, any more than there would be in a credit default swap purchased by a bank for hedging purposes. If adequate disclosures are made to investors about the underlying long positions whose risk is being transferred, and about the structure of the securitization itself, the transaction is no different from a conflicts perspective than a wide range of routine and healthy transactions that transfer risk, including a loan guaranty or loan participation agreement.

Increasing Regulatory Arbitrage

The potential for the proposed rule to limit the ability of firms to manage their credit risk exposures was also noted in a comment filed in response to the rule by a representative of banking institutions (the International Association of Credit Portfolio Managers).

That comment letter makes the additional point that the rule as proposed would nonetheless permit economically equivalent transactions:

[P]rohibiting synthetic securitizations that hedge balance sheet risk while permitting traditional securitizations that hedge balance sheet risk is not logically sustainable because it would have the consequence of treating economically identical transactions differently merely because of the means through which they are implemented. Notably, neither DFA § 621 nor the Proposal prohibits a financial institution that sells or grants participations in financial assets to an SPE in a traditional securitization from underwriting or having a subsidiary or affiliate underwrite the SPE’s ABS. Nor would DFA § 621 or the Proposal prohibit a lender from purchasing credit protection or insurance on corporate loans in bilateral transactions with counterparties other than securitization vehicles. All of these transactions – the traditional securitization of assets that are sold or participated to the SPE and the bilateral purchase of credit protection without an SPE – could have identical outcomes to the transactions that Example 3B identifies as involving a material conflict of interest.

A potential problem here is regulatory arbitrage. The proposed rule would incentivize parties to transfer risk through cash securitizations, participations, or bilateral credit default swaps; and it is not obvious that these transactions are any less "conflicted" or better promote investor protection than synthetic securitizations. Perhaps more importantly, because synthetic securitization is more efficient than other methods of transferring risk, it is unlikely that there will be any viable alternative available for banks to transfer certain loan exposures if the proposed rule is implemented.

Balance sheet securitizations should accordingly not be prohibited on the basis of being unduly conflicted. Full disclosure about the transaction's assets and structure is adequate to protect investors. This aspect of the SEC's proposed rule should not be adopted as proposed.

Mark-to-Fraud by Former Credit Suisse Traders Was Unique

Yesterday, two former traders at Credit Suisse pleaded guilty to criminal charges and, along with two former colleagues, were separately sued by the Securities and Exchange Commission (SEC) for "stunning" fraud. The wrongdoing stemmed from failing in the fourth quarter of 2007 to write down the value of AAA-rated subprime mortgage-related securities as the market value of the instruments collapsed.

It is unlikely, however, that the traders' conduct is indicative of widespread pre-crisis fraud at other banks or across Wall Street. This is because by the end of 2007, the major underwriters of mortgage-related securities actually took the massive writedowns that the former Credit Suisse traders tried to avoid. This includes in the fourth quarter, which probably deprived traders of much coveted bonuses for that year.

For example, by October 2007 UBS had already taken a $3.4 billion writedown, and by December of 2007 announced another $10 billion in writedowns for the fourth quarter. And UBS was no exception. In just the third quarter of 2007 alone, Wall Street wrote down over $25 billion in subprime and related debt. In the fourth quarter of 2007, while the fraud at Credit Suisse was taking place, Citigroup took a record $18 billion writedown on its mortgage-related exposures, and Merrill Lynch was not far behind with a fourth quarter writedown of over $14 billion (on top of a nearly $8 billion third quarter writedown). As the graph below from this Bloomberg story indicates, Citi and Merrill reported massive losses for 2007, making the likelihood their financials being inflated through fraud highly unlikely.

So there's good reason to believe that the Credit Suisse defendants were merely bad apples whose conduct was not representative of their peers, and that similiar suits or guilty pleas will not be forthcoming in significant numbers, if at all. Even within Credit Suisse, the SEC stated that it considers the fraud isolated enough not to charge the company.

It is also worth noting that the traders' wrongdoing is primarly about the fraud that they committed against their own company which, as a result, ended up defrauding investors in Credit Suisse that may have relied on the company's resulting inflated income. Unlike the supposed wrongdoing in suits brought by the SEC against Goldman Sachs and others arising out of their synthetic mortgage-related securitizations, the former Credit Suisse traders' fraud was not committed against any mortgage-bond investors.

The former Credit Suisse traders' fraud underscores the basic structural problem with the subprime mortgage securitization market: it failed to transfer risk and instead saddled banks and underwriting firms with mortgage-related risk as the housing market imploded.

The Bright Side of Hedge Fund Returns

The benefit of investing in hedge funds is rightly being questioned after delivering lack-luster performance in 2011. According to Hedge Fund Research, global hedge fund returns in 2011 were -8.87%, nearly a double-digit loss relative to the return of the S&P 500, which was flat for the year.

What should not be overlooked, however, is that in 2011, despite the ongoing turmoil in global credit markets, hedge funds continued to deliver on one of their core strengths: returns that are less volatile than the stock market. Comparing monthly returns of the Hedge Fund Research Global Hedge Fund Index (HFR) to those of the S&P 500 makes this clear:

The big story in 2011 is that while hedge funds guarded investors against September lows, they missed out on the rally in October. One way to look at hedge funds' low volatility is to view the funds as being--contrary to popular wisdom--generally cautious, as they continue to be in the first month of 2012. 

And 2011 was not a fluke. Any broader time period makes it even more clear that hedge funds are less volatile than stock markets, as the following graph demonstrates for 2009 to 2011:

Low volatility is generally good because volatility reduces returns in the long run. But low volatility is not an end-in-itself since investors ultimately care about risk-adjusted returns. Low volatility means little if returns turn out to be negative, as they were in 2011.

So perhaps a bit less caution is in order.

CDOs: Designed for Fees, Not to Fail

An important new study on collateralized debt obligations (CDOs) finds that the assets used to make CDOs just prior to the financial crisis consistently performed much worse than comparable non-CDO assets. The authors suggest that banks used CDOs to transfer low quality assets to CDO investors as part of a plan to unload financial "lemons."

A Bloomberg story on the paper notes that it supports the narrative that prior to the financial crisis bank issued CDOs that were "designed to fail" and stuffed with toxic mortgage-related risk. Dealbreaker's Matt Levine also argues that, in any case, such activities may reflect well on banks' risk management to the extent CDOs were intended to transfer mispriced assets to investors.

However, while the paper does indeed bolster the case that CDOs were used to transfer risk, it is actually more likely that structuring and issuing CDOs was motivated primarily to generate fees for underwriters (and ratings firms). This is because underwriters continued to create CDOs even when outside investors stopped buying them.

As noted by the Financial Crisis Inquiry Commission report (p. 188), despite a lack of outside investor interest in buying CDOs, by 2006

The CDO machine had become self-fueling. Senior executives—particularly at three of the leading promoters of CDOs, Citigroup, Merrill Lynch, and UBS— apparently did not accept or perhaps even understand the risks inherent in the products they were creating. More and more, the senior tranches were retained by the arranging securities firms, the mezzanine tranches were bought by other CDOs...

Importantly, the "other CDOs" were also created by CDO issuers to purchase mortgage-related securities that outside investors did not want to buy. As the IMF explained in a 2008 report (p. 59):

These CDOs-squared and structured-finance CDOs were created almost solely to resecuritize MBS and CDO mezzanine tranches, for which there was not sufficient demand from investors. Therefore their value added in transferring risk is questionable.

While the "designed to fail" motivation may explain some CDOs, the fee-generation explanation seems superior and indeed underlies perhaps most important result of pre-crisis CDOs: they did not transfer risk but rather caused billions of dollars in write-downs at the financial institutions that created them.