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The Role of Investment Banks in the Housing Prices Collapse

Levitin and Wachter wrote a terrific paper on the role of investment banks in the housing collapse and the shift from regulated to unregulated securitization:
 “…it was the result a fundamental shift in the structure of the mortgage finance market from regulated to unregulated securitization…..  Prior to 2003-2004, most mortgage-backed securities (MBS) were issued by regulated government-sponsored entities (GSEs), Fannie Mae and Freddie Mac and the federal agency Ginnie Mae (collectively with the GSEs, the “Agencies”). In 2003-2004, the market shifted radically toward MBS issued by unregulated private-label securitization conduits, typically operated by investment banks. The shift occurred as financial institutions sought to maintain earnings levels that had been elevated during 2001-2003 by an unprecedented refinancing boom due to historically low interest rates…..Thus, the shift from Agency securitization to private-label securitization also corresponded with a shift in mortgage product type, from traditional, amortizing, fixed-rate mortgages (FRMs) to nontraditional, structurally riskier, non-amortizing, adjustable-rate mortgages (ARMs), and in the start of a sharp  deterioration in mortgage underwriting standards.”

According to Mortgage Finance’s Statistical Annual Report, fixed-rate mortgages made up over 75% of conventional loans in 2002-2003. In 2004, fixed-rate mortgages dropped to a 66% market share.

Levitin & Wachter point out that the growth of privately labeled mortgage-backed securities (PLS), forced the GSEs to lower their underwriting standards in an attempt to reclaim lost market share. The GSEs private shareholders insisted that the GSEs reclaim market share. Shareholder pressure pushed the GSEs into competition with PLS for market share, and the GSEs loosened their guarantee business underwriting standards in order to compete. In contrast, the wholly public FHA/Ginnie Mae maintained their underwriting standards and ceded market share.
Federal Reserve Board data show that:
  • More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.
  • Private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year.
What I like about Levitin & Wachter is the focus on investment banks in the housing prices collapse rather than the Morgenson’s trashing of Fannie Mae and Freddie Mac that was only part of the problem.


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