Originally published 26 September 2008

Edited by Dr. Fred Dunbar, Dr. Elaine Buckberg, and Dr. Ronald I. Miller with the assistance of Dr. Denise Martin, Dr. John Montgomery, Dr. David Tabak, and other NERA economists. This report presents a summary of current thinking by academic economists and does not necessarily represent the views of NERA or any NERA economist.

During the past week, many economists have commented on the proposed Paulson Plan and alternatives intended to stabilize the financial system. Under the assumption that our clients have had more pressing demands on their time than to follow closely the responses of academic economists, we have distilled below, without attribution, some of their more interesting observations.

How did we get here?

Mortgages began to be securitized in the 1970s, creating a national market for housing finance in a pre-interstate banking era, thereby freeing up capital for lenders and adding to their liquidity and, consequently, making more funds available for borrowers. In recent years, on the implicit assumption that housing prices would continue to rise, mortgage originators were able to sell increasing numbers of subprime mortgages to households with poor credit.1 This growth in mortgages was due both to innovations in mortgage design, such as more deeply discounted teaser rate loans with affordable fixed rates for an initial period, and an abundant supply of investment funds in search of higher yields. Financial institutions carried mortgage-backed securities inventories with money provided by short-term debt.2 The securitization market also innovated by resecuritizing

mortgage-backed securities into collateralized debt obligations, providing additional investment opportunities. Further, some financial institutions, notably AIG, wrote credit default swap contracts that effectively provided insurance against default to some holders of mortgage-backed securities. The value of many of these derivative contracts, largely unregulated and unreported, has dropped precipitously and diverged from valuations in the cash (securities) market as the performance and value of the underlying mortgaged-backed securities have declined.

In hindsight, economists find that the expansion in subprime lending was based on a housing price bubble (i.e., unsustainably high prices, possibly amplified by inaccurate appraisals); an oversupply of investment funds in search of higher yields; and by changes in securitization itself, which, for some mortgage originators, may have reduced incentives for careful lending.

Housing prices started to fall in August 2006. The models used for determining credit ratings and valuing mortgage-backed securities—subprime or otherwise—were based on assumptions that, also in hindsight, proved to be optimistic. Historically, delayed mortgage payments, defaults, and foreclosures would not be highly correlated across all regions of the country. This time, however, they all increased almost everywhere—and prepayments fell. Major financial players found themselves concentrated in these securities and the associated mortgage-related writedowns left them with less capital and a reduced ability to extend credit. The market for mortgage-backed securities of all forms dried up, in part because few institutions were positioned to buy more of them and in part because their complexity made them difficult to value.

In one of those coincidences that contributes to the perfect storm, the Financial Accounting Standards Board (FASB) in 2006 clarified the definition of accounting "fair value" to be an "exit price." In cases in which an asset must be reported at fair value (marked-to-market), the FASB opined that the best evidence of fair value is a market transaction for an identical instrument. Without such transactions, fair value must be estimated by reference to market transactions for similar instruments or by using models. Without a functioning market, the market value of mortgage-backed securities was highly uncertain—a major problem for those who had to report these securities at fair value. The stocks of those banks and insurance companies that took repeated subprime-related writedowns were severely punished. With the potential for yet-further writedowns, investors began to doubt whether some financial institutions with large holdings of mortgage-related assets were solvent. Creditors stopped lending because of changed perceptions of, or increased aversion to, risk.

Policymakers believed the economy was being drawn into a black hole. They saw the potential for a worsening downward spiral that was already claiming large mortgage and investment banks. If institutions sold assets to raise cash, then prices would decline further and the carrying value

of assets on the books of other financial institutions would thereby be further depressed. This would further dry up their sources of funding from depositors, counterparties, and investors. Banks would continue to fail when they could not repay loans or satisfy calls for more collateral. The credit that financial institutions normally provide to the real economy would dry up. "Main Street" could not be insulated from a widening and deepening credit crisis.

Will the Paulson Plan help?

Not necessarily. Whether it helps depends, first, on whether current prices of mortgage-backed securities are too high or too low relative to their value based on realistic expectations of the cashflows from the underlying mortgages. If prices are too high, then the concern is about what will happen when those prices fall, and what, if anything, should be done in advance of that decline. If prices are too low, the concern is whether and when the prices will return to their proper levels, and whether and how the government should intervene in that process.

A great deal of uncertainty exists about the true value of mortgage-backed securities because of the unpredictability of future housing prices and the complexity of the securities involved. Below, we consider the impact of the Paulson Plan under each scenario, considering whether the problem would resolve without immediate, drastic intervention.

Scenario 1: Assuming Current Prices of Mortgage-Backed Assets Are Too Low

The Administration's view of the current problem, as articulated by President George W. Bush and Federal Reserve Chairman Ben S. Bernanke, is that the current prices of mortgage-backed assets are too low. In other words, the present value of the expected cash flows from the securities exceeds their current marks. A market failure of this sort can occur in several circumstances:

  • Temporarily heightened uncertainty or risk aversion, with investors discounting expected future cash flows more steeply than they would be expected to do in the future, combined with an inability to recognize or adjust for this phenomenon. This could be caused by the simultaneous effect of many financial firms selling assets to raise capital.
  • The market is caught in an information cascade. That is, an informed market participant, who would otherwise have an unbiased sense of the value of these assets, is now seeing everybody else running for the exits. The knowledge of the other investors' actions overrides the judgment of this individual who decides, rationally, to join the crowd. In this case, prices may be irrationally below their true values.3

In either setting, further price decline can become a self-fulfilling prophecy: because the market believes the economy is heading for the abyss, a severe contraction will occur.

Does the Paulson Plan solve the problem?

Such an intervention would be expected to calm the markets, regardless of whether the underpricing was caused by risk aversion or an information cascade. Indeed, intervention of this type is a long-established role for government policy. Last week, we essentially had a series of bank runs with Morgan Stanley and Goldman Sachs looking like they might be the next to fall. With such runs creating the risk of major macroeconomic dislocation, particularly if this was due solely to market participants anticipating a bad future outcome, there was a clear rationale for the government to intervene. The Paulson Plan was designed to change expectations: assure the market that balance sheets would be shored up, financial institutions would survive, credit would flow, counterparty risk would be low, and a severe contraction would be averted. If the market believed the Paulson Plan would work—as it appeared to believe on 19 September—it would work by restoring confidence even if it were not an ideal solution.

If a market failure has caused prices to be below their true value, then the Paulson Plan should work if implemented correctly. In such a setting, an unbiased estimate of the discounted present value of the future stream of cash flows (DCF) from the mortgage-backed securities is higher than their current market price. Fed Chairman Bernanke's reference to "hold-to-maturity prices" likely refers to the DCF values of the securities at some "normal" or expected future discount rate. If true, and if the government buys these at prices less than or equal to their "normalized" DCF, the long-term cost of the plan to taxpayers will be limited to its administration and transactions costs—much less than the current $700 billion headline cost in initial outlays. In principle, the US Treasury could even make money if the ultimate cash flows justify higher values than the prices paid.

Would the problem be solved without immediate, drastic intervention?

Economists are divided on this issue. They note that politicians often cry "wolf" needlessly, leading to an overreaction that causes as much harm as good. Assuming this is a problem where the market is temporarily undervaluing these assets, there should be global capital available to acquire these assets directly or indirectly, without going through liquidation, thereby staunching the downward spiral in prices. This process has already begun with the direct investments in Morgan Stanley by Mitsubishi-UFJ and Goldman Sachs by Berkshire Hathaway, although Berkshire Hathaway has said that its investment was made with the expectation that the Paulson Plan would be approved. To the extent that there are a limited number of banks that are actually insolvent, they could seek bankruptcy protection.

Some economists believe that a less drastic measure to help resolve the crisis would be to change the mark-to-market accounting rules. Some banks may be insolvent per the books but would be able to survive and meet their financial obligations if they did not have to raise the funds necessary to satisfy capital requirements that have been breached by mark-to-market revaluations. If this were the case, a plausible intervention would be to give such a regulatory change a chance to work. If the crisis continues, the government could then make investments in troubled but intrinsically solvent institutions, as happened with AIG.

Scenario 2: Assuming Current Prices or Marks for Mortgage-Backed Securities Are Correct or Too High

Some economists have argued that current marks or prices are still too high, i.e., above the long-run value of these assets. This is consistent with a view that financial institutions still have not adequately written down their mortgage-backed assets and that there are more writedowns to come. If true, it may be that a number of financial institutions are actually insolvent or very poorly capitalized—even if their current financial statements report otherwise. Some markets may have frozen up before prices had a chance to adjust to and reflect lower values.

Does the Paulson Plan solve the problem?

If the problem is that current prices are still above their discounted cash flow value, then a number of financial institutions are in long-run trouble, and the Plan is probably not the optimum solution. In this case, the fundamental problem is undercapitalization of financial institutions. Purchasing at "hold-to-maturity" prices, then, involves forcing the banks to recognize as-yet unrecognized losses. Doing so might accelerate the process of getting mortgage-backed assets off the books of financial institutions, but it would not solve their undercapitalization. If the government instead purchased mortgage-backed securities at their current, possibly inflated values—in excess of DCF values—the government would be effectively giving a capital injection to the banks equal to the difference between the purchase price and the DCF value.

If the goal is to recapitalize financial institutions, most economists would recommend instead making direct investments in the institutions, in return for an equity stake as compensation for taxpayer capital, as was done with AIG.

Would the problem be solved without immediate, drastic intervention?

If markets are frozen because of uncertainty concerning the solvency of financial institutions, preventing banks from getting short-term liquidity and creating perceived counterparty risk, then there may be a need for immediate, dramatic intervention to restore confidence in the financial sector.

Even if credit resumed flowing in the near-term, if overstated values are concealing the fact that a number of major financial institutions are insolvent, inaction would only delay the problem. A well-capitalized financial system is critical to the health of a highly developed economy. It is not clear how many more financial institution failures the economy could withstand without a severe recession.

On the other hand, opponents of intervention point out that the regional banking system is weathering the crisis just fine. In fact, there is some evidence that customer deposits are flowing into community banks from interstate banks. If so, then these banks are capable of extending credit to small and even mid-sized businesses, thereby mitigating the impact on Main Street were additional money market firms to fail. More speculatively, other opponents of the Paulson Plan point to large pools of capital in other parts of the globe, such as Asia, that could potentially relieve the crisis.

How should auctions to purchase troubled assets be structured?

See our forthcoming note on reverse auctions.

Should there be more oversight in the Paulson Plan?

Here, economists are generally in agreement. There needs to be a mechanism design to prevent self-dealing and other abuses. Allowing aggrieved parties to sue the government would be one such mechanism.

Is homeowner protection also needed?

Although there is a great deal of sympathy for struggling homeowners, there is only a limited economic policy rationale for bailing them out. To the extent that income redistribution is a desired goal, subsidies for certain items, such as owner-occupied housing, are not the best way to achieve this objective.4 A generally preferred approach is through a negative income tax, much the way the Earned Income Tax Credit works today. Taking the same amount of money that would be given to struggling families and funneling it to those who have borrowed on the mistaken belief that their house price was going to continue to increase creates a moral hazard of the same type as bailing out financial institutions without making the shareholders pay.

In contrast, some economists feel that since the entire crisis started in the mortgage market, any comprehensive solution is going to have to address that market directly. They nonetheless recognize the problems that such intervention may have in encouraging future borrowers to engage in riskier behavior in the expectation of a government bailout. One solution that has been offered is to give homeowners an option to refinance their mortgage at a lower rate, but in return having to put up their non-housing assets as collateral. The extra collateral would make the mortgages less likely to default and costs to the lending institutions from the lower rates would be offset by increased recoveries in many default situations. However, it is unclear whether many homeowners would have substantial additional collateral.

Is the Congressional Republicans' plan better than the Paulson Plan?

An alternative plan has been recently proposed by a group of Congressional Republicans unhappy with the Paulson Plan. The central feature of this plan is that it would provide federal insurance for mortgage-backed securities held by financial institutions. The insurance would be risk-rated in the sense that riskier assets would require higher premia. A key difficulty in implementing this plan would be establishing appropriate premia, either at the financial institution (or portfolio) level or the individual asset level. It would seemingly require the Treasury to establish the riskiness of each firm's individual portfolio. The non-standardized nature and complexity of these securities will make this an extremely difficult task—a task that has apparently proved beyond the abilities of the banks themselves.

If premia are somehow chosen so that the insurance is provided at actuarially fair rates, this will transfer risk from financial institutions to the federal government, but will not address issues of undercapitalization.5 If insurance were provided at the portfolio level, it would impede trading as the insurance would not be attached to individual assets. If insurance were instead provided at the individual asset level, setting appropriate premia would be a complex, massive undertaking, at least equal in scope to the Paulson Plan. The companies that have in the past provided such insurance in the form of credit default swaps, notably including AIG, were themselves unable to set appropriate premia. However, there may be auction mechanisms that could provide market-based pricing for the government guarantees. Auctions of this sort are being prepared to deal with credit default swaps held by Lehman, Fannie Mae, and Freddie Mac.

One of the main arguments put forward for this alternate plan is that it will not require any upfront expenditure of taxpayers' money. But no money upfront also means no immediate infusion of funds to affected firms and would instead require them to spend money for insurance against future defaults. As such, the alternative plan does not directly address the problem that credit markets are currently frozen and could even make things worse if portfolio-based insurance impeded trading. The plan might be able to unfreeze markets if the promise of eventually shifting risk to the federal government were sufficient to stabilize market expectations and restore short-term credit to financial institutions.

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1. If a subprime borrower could not make his or her mortgage payments, he or she was expected to be able to refinance, taking advantage of appreciation in the borrower's home value.

2. Here we use the term mortgage-backed securities to refer to any securities with mortgage collateral because the Paulson Plan defines Troubled Assets as "residential or commercial mortgages and any securities, obligations or other instruments that are based on or related to such mortgages." However, we note that in the financial markets, the term mortgage-backed security is typically used to refer specifically to mortgages that meet the standards for purchase by Fannie Mae and Freddie Mac. Other securities with mortgage collateral, such as subprime mortgage collateral or commercial mortgages, fall in the larger category of asset-backed securities.

3. This same herd behavior can lead to a pricing bubble—as may have occurred in the housing market leading up to 2006.

4. The federal government has a long history of subsidizing owner-occupied housing by allowing mortgage interest to be taken as a federal income tax deduction while not imputing income to the value of the housing services received.

5. The plan also proposes temporary tax relief and restrictions on dividend issues for affected firms, but these provisions will not provide any immediate sources of capital. As the worst affected firms are unlikely to have either substantial dividends or tax liabilities, these provisions will provide little relief to the crisis.

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