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On TARP and its Impact on the Mortgages Acquired by Fannie Mae

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José J. Cao-Alvira
Associate Professor, Lehman College at the City University of New York
Alexander Núnez
PhD Candidate, EGAE School of Business at the University of Puerto Rico

2016 Open Seminars of Eesti Pank

Published in: Economy & Finance
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On TARP and its Impact on the Mortgages Acquired by Fannie Mae

  1. 1. Bank of Estonia 2016 Open Seminars of Eesti Pank On TARP and its Impact on the Mortgages Acquired by Fannie Mae José J. Cao-Alvira Associate Professor, Lehman College at the City University of New York Alexander Núnez PhD Candidate, EGAE School of Business at the University of Puerto Rico
  2. 2. Abstract 1/2 We assess the consequences of the possible competitive distortions created by TARP on the sector of the banking system actively engaged in the mortgage swap-program with Fannie Mae. We do this by analyzing the mortgages acquired and securitized by the GSE from banks under the protection of TARP.
  3. 3. Abstract 2/2 Our results suggest that TARP funds effectively increased the cost competitiveness of the intervened banks receiving capital transfers and allowed them to offer more aggressive terms at the origination and procurement of mortgage credit. The aggressive behavior of TARP protected banks manifests in lower mortgage-loan rates, attracting safer borrowers and, in turn, decreasing the competitive margins for the banking system as a whole.
  4. 4. Outline of the Presentation Introduction: - Fannie Mae and Freddie Mac (or GSEs) - Recent U.S. Government Interventions Literature Review Data Description Empirical Results Concluding Remarks
  5. 5. Fannie Mae and Freddie Mac Government Sponsored Enterprises (or GSEs) - Public Corporations with a Social Mandate - Created in 1938 (FNM) y 1970 (FRE). - Mission: provide liquidity and stability to the secondary mortgage market and, this way, promote access to mortgage credit. - …While maximizing profit.
  6. 6. Fannie Mae and Freddie Mac TWO ways to fulfill the Social Mandate: 1. “Securitization” and credit guarantee - Acquiring mortgage pools from originators and issuing Mortgage-Backed Securities (MBS); - A GSE guarantees the principal and interest payments of the MBSs
  7. 7. Fannie Mae and Freddie Mac TWO ways to fulfill the Social Mandate: 1. “Securitization” and credit guarantee (cont.) - In exchage, sellers provide a “guarantee fee” or an insurance payment to the GSE - The seller has the option to continue servicing the mortgage or sell the servicing contract to another financial institution
  8. 8. Fannie Mae and Freddie Mac TWO ways to fulfill the Social Mandate: 2. Portfolio Investment - Acquiring assets on their own balance sheets • Mortgages • MBS (Agency and non-Agency) • Fixed Income Securities
  9. 9. Fannie Mae and Freddie Mac Single-Family Residential Mortgage Holdings Source: Flow of Funds Accounts of the United States
  10. 10. Fannie Mae and Freddie Mac Source: Financial Statements of Fannie Mae and Freddie Mac
  11. 11. Fannie Mae and Freddie Mac Many adverse consequences: - The “government sponsored” status of the GSEs offered an implicit government protection to both agencies which not explicitly determined. - The securitization process adds additional layers of moral hazard and adverse selection to a market already characterized by assymetric information. - Undiversified exposure to mortgage credit risk
  12. 12. U.S. Government Interventions Fannie Mae and Freddie Mac: - September 7 2008 – Conservatorship of FNM & FRE - Senior Preferred Stock Purchases – ensure solvency ~$190 billion USD - Purchase of the Agencies’ MBS ~$225 billion USD - Reduction of the investment portfolio ~10-15% per year
  13. 13. U.S. Government Interventions Troubled Asset Relief Program (or TARP): - October 2008 – Objective: Improve financial stability - Assigned up to $700 billion USD for the purchase of troubled assets. - Of which, $250b for the Capital Purchase Program: investment of the U.S. Treasury in the preferred equity of troubled financial institutions to improve their capital ratios.
  14. 14. U.S. Government Interventions Troubled Asset Relief Program (or TARP): - Scandals of executive’s bonuses payments (Mills, 2009), suspicion of credit rationing, and increased risk- taking (Black & Hazelwood, 2012) have questioned the effectiveness of the TARP implementation.
  15. 15. U.S. Government Interventions Troubled Asset Relief Program (or TARP): - Important works suggest that the TARP’s ability to restore the stability of the financial system was undermined by both the competitive distortions created in the banking system and the behavior of banking institutions reacting to these distortions.
  16. 16. U.S. Government Interventions Troubled Asset Relief Program (or TARP): - Specifically, it’s been found that TARP banks increased their market power and gained a competitive advantage soon after receiving the government capital transfers.
  17. 17. U.S. Government Interventions Troubled Asset Relief Program (or TARP): - And, albeit the Capital Purchase Program of TARP did not directly intervened with Fannie Mae and Freddie Mac… [So, our main hypothesis is:] repercussions are to be expected on the assets issued, insured and held by the GSEs if significant modifications occurred in the mortgage origination and resale practices of banks under TARP protection.
  18. 18. What we do? We analyze the mortgages acquired by Fannie Mae from U.S. banks during 2005:1-2011:12. Assess the consequences of the possible competitive distortions created by TARP on the sector of the banking system actively engaged in the mortgage swap-program with the GSE.
  19. 19. Intuition (1/2) TARP funds created Competitive Distortions in the mortgage origination/resale sector of the banking system TARP funds >> Decreased Marginal Costs of TARP Banks >> Increased Competitiveness and Market Power TARP banks are able to offer more attractive terms for its borrowing contracts >> attract better borrowers
  20. 20. Intuition (2/2) TARP banks >> attract better borrowers >> sell to Fannie Mae better mortgages (with lower Default probabilities) NOTE: Although Fannie Mae assumes all the credit risk of mortgages Incentives still exist for ALL banks to sell “good” mortgages to Fannie Mae because these increase a bank’s income from servicing fees.
  21. 21. Rest of the Presentation Literature Review Data Description Empirical Results - H1: Competitive Distortions and Market Power - H2: More favorable contract terms - H3: Better loans - H4: Income from loan servicing (In progress) Concluding Remarks
  22. 22. Literature Review Related literature: - On TARP and financial system stability - On TARP and credit risk - On TARP and market power - On Loan Performance and the Servicing of Mortgages
  23. 23. Literature Review - On TARP and financial system stability (brief) Systemic Risk TARP banks reduced their leverage decreasing their individual contributions to systemic risk Berger, Roman and Sedunov (2015) Diff-in-Diff method Although TARP banks reduced systematic risk (in the short-run), they found this was at the expense of increases in the systemic risk of the financial system as a whole. Farruggio, Michalak & Uhde (2013) Beta factor decomposition
  24. 24. Literature Review - On TARP and financial system stability (brief) Systematic Risk Immediate or Short-run reductions in the systematic risk of TARP banks Farruggio, Michalak & Uhde (2013) Beta factor decomposition Event study Short-run reductions and Longer-run increases in the systematic risk of the supported banks increased. Elyasiani, Mester & Pagano (2014) Beta factor decomposition Event study
  25. 25. Literature Review - On TARP and credit risk Black and Hazelwood (2013) Analyzing data on loan originations from the Survey of Terms of Business Lending and using a dichotomous measure of risk calculated internally by the Survey, the authors perform a difference-in-difference analysis on loan-level data and find that TARP banks increased significantly their risk taking behavior when issuing these loans.
  26. 26. Literature Review - On TARP and credit risk Duchin & Sosyura (2014) Find similar results performing a linear probability model where the dependent variable is the likelihood of bank approving a loan to a potential borrower and the primary control on borrower’s risk is the loan-to-debt ratio.
  27. 27. Literature Review - On TARP and credit risk Duchin & Sosyura (2014) Black and Hazelwood (2013) Both papers argue that TARP may have created incentives for excessive risk-taking through moral hazard, based on the likelihood of future government support if needed
  28. 28. Literature Review - On TARP and market power Berger and Roman (2015) Found evidence, using a difference-in-differences analysis, that banks receiving TARP funds increased their market power in the banking system over its unprotected competitors and, with it, their competitive advantage
  29. 29. Literature Review - On TARP and market power The authors used the Lerner Index as the main proxy of market power -constructed as the percentage difference between the bank’s pricing for its financial services and its marginal cost, i.e. (P-MC)/P. The authors additionally found that the main source of market power gains for TARP banks is the decreases in their marginal costs
  30. 30. Literature Review - On TARP and market power Hakenes & Schnabel (2010) develop a model showing that, because a government- protected bank has the capacity to refinance its capital in more favorable terms, these banks are induced to behave more aggressively; e.g. raising deposit rates or lowering loan rates.
  31. 31. Literature Review - On TARP and market power Further argue that the impact of the competitive distortion created by government interventions on troubled banks is not limited only to government-protected banks, but also to these banks’ unprotected competitors. The aggressive behavior of protected banks decreases the competitive margins in the banking system & hence drives their unprotected competitors to also assume higher risks.
  32. 32. Literature Review - On TARP and market power Berger, Makaew and Roman (2016) Find, using difference-in-differences, that TARP issued loan contracts offering better terms to all its borrowers and more so to its “safer” borrowers. Suggest the market power gained by TARP banks is the reason for the capacity of these offering better loan terms. Data source: Dealscan corporate debt contracts.
  33. 33. Literature Review - On Loan Performance and the Servicing of Loans Frame and White (2012) The servicing of mortgage loans is usually a routine electronic process with substantial economies of scale, but these are significantly reduced if the servicer needs to deal with loan modifications and delinquencies. Servicing fees: 25 basis points on the principal
  34. 34. Data The collection of residential mortgages originated by banking institutions in the U.S. and acquired by Fannie Mae between January 2005 and December 2011. We exclusively consider single-family conventional fixed- rate 30-year mortgages Source: Fannie Mae Loan Performance Database
  35. 35. Data Data on the Terms of Loans: - interest rate, - principal, - Loan-To-Value, - date of loan origination, and - date when Fannie Mae acquired loan Data on the Borrowers: - FICO score, and - Debt-To-Income ratio
  36. 36. Data Data on the Performance of Loans: - Monthly loan repayment Name of Seller bank Name of Servicer bank U.S. state where the residential property is located.
  37. 37. Data – Descriptive Statistics After intervention nonTARP banks TARP banks ↓ interest rate ↑ principal ↓ Loan-To-Value ↓ default rate ↑ FICO score ↓ Debt-To-Income ↓ interest rate ↑ principal ↓ Loan-To-Value ↓ default rate ↑ FICO score ↓ Debt-To-Income
  38. 38. Data – Descriptive Statistics: MORTGAGES Previous intervention: After intervention TARP banks > nonTARP banks interest rate principal default rate Loan-To-Value TARP banks < nonTARP banks FICO score Debt-To-Income Loan-To-Value FICO score Debt-To-Income interest rate principal default rate
  39. 39. Data Data on seller Banks: Source: U.S. Treasury - Participant of the TARP-CPP {yes, no} Source: FDIC Call Reports - CAMELS - Bank size - Deposit growth - Tier-1 to Total Assets ratio
  40. 40. Appendix – CAMELS (1/2) Capital adequacy is the ratio of total equity capital divided by gross total assets. Asset Quality is the ratio of nonperforming loans to total loans. Management Quality is the standard deviation of total assets in three consecutive quarters. Earnings ratio is the net income to gross total assets Liquidity is the ratio of cash to bank total deposits.
  41. 41. Appendix – CAMELS (2/2) Sensitivity to Market Risk is the ratio of the absolute difference between short-term assets and short-term liabilities to assets. Bank size is the natural log of the bank’s total assets, Deposit growth is the quarterly percentage change in deposits, and Tier-1 ratio is the value of Tier-1 capital to total assets Source: Duchin and Sosyura (2014), Berger and Roman (2016), and Liu et al (2013).
  42. 42. Data – Descriptive Statistics After intervention nonTARP banks TARP banks ↑ Asset Quality ↑ Liquidity ↑ Sensitivity to Risk ↑ Size ↑ Tier-1 Ratio ↑ Capital Adequacy ↑ Asset Quality ↓ Earnings ↑ Liquidity ↑ Sensitivity to Risk ↑ Size ↑ Tier-1 Ratio
  43. 43. Data – Descriptive Statistics BANKS Previous intervention: After intervention TARP banks > nonTARP banks Earnings Size Capital Adequacy Asset Quality Earnings Size TARP banks < nonTARP banks Asset Quality Tier-1 ratio Asset Volatility Tier-1 ratio
  44. 44. Empirical Results - H1: TARP>>Competitive Distortions & Market Power - H2: TARP>>More favorable contract terms - H3: TARP>>Better performing loans - H4: Better loans>>Higher likelihood to remain related to loans thru servicing In progress
  45. 45. Appendix – Lerner Index (1/5) 𝑙𝑛 𝐶𝑜𝑠𝑡𝑖𝑡 = 𝛽0 + 𝛽1 ln 𝑄𝑖𝑡 + 𝛽2 ln 𝑄𝑖𝑡 2 + 𝛾 𝑘 ln 𝑊𝑘,𝑖𝑡 3 𝑘=1 + ⋯ … + ∅ 𝑘 ln 𝑄𝑖𝑡 3 𝑘=1 ln 𝑊𝑘,𝑖𝑡 + 𝛿 𝑘𝑗ln 𝑊𝑘,𝑖𝑡 ln 𝑊𝑗,𝑖𝑡 3 𝑗=1 3 𝑘=1 + 𝜇𝑖 + 𝜌𝑡 + 𝜖𝑖𝑡 Where 𝑄𝑖𝑡 represents a proxy for bank output or total assets for bank 𝑖 at time 𝑡, and 𝑊𝑘,𝑖𝑡 are three input prices. 𝑊1,𝑖𝑡, 𝑊2,𝑖𝑡, 𝑊3,𝑖𝑡 indicate the input prices of labor, funds, and fixed capital, respectively, and are calculated as the ratios of personnel expenses to total assets, interest expenses to total deposits and other operating and administrative expenses to total assets respectively. Source: Anginer, Demirgüç-Kunt & Zhu (2013)
  46. 46. Appendix – Lerner Index (2/5) 𝑙𝑛 𝐶𝑜𝑠𝑡𝑖𝑡 is estimated using panel data analysis for each bank 𝑘 in the sample. Time effects are also introduced with robust standard errors by bank to capture the specificities of each one. Ensure the cost function in HOD 1 in input prices: Source: Anginer, Demirgüç-Kunt & Zhu (2013) 𝛽3 + 𝛽4 + 𝛽5 = 1 𝛽6 + 𝛽7 + 𝛽8 = 0 𝛽9 + 𝛽12 + 𝛽13 = 0 𝛽10 + 𝛽12 + 𝛽14 = 0 𝛽11 + 𝛽13 + 𝛽14 = 0
  47. 47. Appendix – Lerner Index (3/5) Marginal cost is then computed as: 𝑀𝐶 𝑇𝐴 𝑖𝑡 = 𝐶𝑜𝑠𝑡𝑖𝑡 𝑄𝑖𝑡 𝛽1 + 2𝛽2 ln 𝑄𝑖𝑡 + ∅ 𝑘 3 𝑘=1 ln 𝑊𝑘,𝑖𝑡 Source: Anginer, Demirgüç-Kunt & Zhu (2013)
  48. 48. Appendix – Lerner Index (4/5) 𝑃 𝑇𝐴 𝑖𝑡 is the price of assets and is equal to the ratio of total revenue (sum of interest income, commission and fee income, trading income, and other operating income) to total assets. Source: Anginer, Demirgüç-Kunt & Zhu (2013)
  49. 49. Appendix – Lerner Index (5/5) 𝐿𝑒𝑟𝑛𝑒𝑟𝑖𝑡 = 𝑃 𝑇𝐴 𝑖𝑡 − 𝑀𝐶 𝑇𝐴 𝑖𝑡 𝑃 𝑇𝐴 𝑖𝑡 Where 𝑃 𝑇𝐴 𝑖𝑡 is the price of total assets proxied by the ratio of total revenues (interest and noninterest income) to total assets for bank 𝑖 at time 𝑡, and 𝑀𝐶 𝑇𝐴 𝑖𝑡 is the marginal cost of total assets for bank 𝑖 at time 𝑡. Source: Anginer, Demirgüç-Kunt & Zhu (2013)
  50. 50. Empirical Results 𝑀𝐶𝑖,𝑡 is defined as the marginal cost of bank 𝑖 at time t. 𝐷𝑖,𝑡 𝑇𝐴𝑅𝑃 is a dummy variable assuming a value of one at time t and afterwards if bank i received TARP funds at time t & zero otherwise. 𝑩𝑖,𝑡−1 is a set of lagged bank-level controls 𝑀𝐶𝑖,𝑡 = 𝜆1 𝐷𝑖,𝑡 𝑇𝐴𝑅𝑃 + 𝝀 𝟐 𝑩𝑖,𝑡−1 + 𝝁𝑖 + 𝜌𝑡 + 𝜐𝑖,𝑡 H1: TARP >> Competitive Distortions
  51. 51. Empirical Results 𝜆1 measures changes in the marginal cost of TARP banks following the capital transfers, with respect to banks that did not receive TARP funds. Including fixed effects identifying the seller bank makes the identification to be from a within-bank change in the interest rate of loan originations. The inclusion of time effects produces a difference-in-differences estimate of mortgage interest rate from TARP banks relative to non-TARP banks, controlling for pre-existing differences across banks ref: Black and Hazelwood (2013)
  52. 52. Empirical Results Evidence is found indicating that Competitive Distortions were created in the form of cost-advantages for TARP banks, increasing their market power. TARP >> ↓ Marginal Cost (lower costs for funding opportunities) *** TARP >> ↓ Price (lower interest rates and fees on loans) TARP >> ↑ Lerner Index (higher market power)***
  53. 53. Empirical Results TARP >> Competitive Distortions
  54. 54. Empirical Results 𝑟𝑖,𝑙,𝑡 = 𝛽1 𝐷𝑖,𝑡 𝑇𝐴𝑅𝑃 + 𝜷2 𝑴𝑙 + 𝜷3 𝑪 𝑡 + 𝜷4 𝑩𝑖,𝑡−1 + 𝜶𝑖 + 𝛿𝑡 + 𝜀𝑖,𝑙,𝑡 𝑟𝑖,𝑙,𝑡 is defined as the percentage interest rate of loan l, acquired by Fannie Mae by bank 𝑖 at time t. 𝑴𝑙 is a set of time-invariant loan-level controls 𝑪 𝑡 is a set of time-variant aggregate-economy level controls H2: TARP >> More favorable contract terms
  55. 55. Empirical Results Evidence is found indicating that the loans acquired by Fannie Mae from TARP banks offered better terms to their borrowers, and specially to the “safest” borrowers. TARP >> ↓ Interest Rate on Loans Acquired *** All loans TARP >> ↓ Interest Rate on Loans Acquired *** Even more so for highest 75% FICO score TARP >> ↓ Interest Rate on Loans Acquired *** Even more so for lowest 25% DTI ratio
  56. 56. Empirical Results TARP >> More favorable contract terms
  57. 57. Empirical Results TARP >> More favorable contract terms (even more so for “safer” borrowers)
  58. 58. Empirical Results 𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑖,𝑙,𝑡 is a binomial variable denoting the mortgage loan repayment performance during the first year and the first two years since origination Two measures of loan delinquency are considered, e.g. a loan is considered delinquent when is past due >60 days or, a less stringent measure, when is past due >90 days. 𝑃(𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑖,𝑙,𝑡 = 1 𝐷𝑖,𝑡 𝑇𝐴𝑅𝑃 , 𝑴, 𝑪, 𝑩, 𝜽, 𝜓 = Φ 𝛾1 𝐷𝑖,𝑡 𝑇𝐴𝑅𝑃 + 𝛾2 𝑴𝑙 + 𝛾3 𝑪 𝑡 + 𝛾4 𝑩𝑖,𝑡−1 + 𝜽𝑖 + 𝜓 𝑡 + 𝑢𝑖,𝑙,𝑡 H3: TARP >> Better Performing Loans
  59. 59. Empirical Results Evidence is found that the loans sold to Fannie Mae by TARP banks performed better (lower default rate). TARP >> ↓ Default rate *** Failure of Payments at 60days and 90 days, during the first year after origination TARP >> ↓ Default rate *** Failure of Payments at 60days and 90 days, during the first two years after origination
  60. 60. Empirical Results TARP >> Better Performing Loans
  61. 61. Empirical Results 𝑆𝑒𝑙𝑙𝑒𝑟𝑖.𝑙,𝑡 = 𝑆𝑒𝑟𝑣𝑖𝑐𝑒𝑟𝑖,𝑙,𝑡 is a binomial variable denoting that the seller bank i of the mortgage l acquired by Fannie Mae remained as its servicer during the first year since its origination at t. 𝑃( 𝑆𝑒𝑙𝑙𝑒𝑟𝑖.𝑙,𝑡 = 𝑆𝑒𝑟𝑣𝑖𝑐𝑒𝑟𝑖,𝑙,𝑡 = 1|𝐷𝑖,𝑡 𝑇𝐴𝑅𝑃 , 𝑴, 𝑪, 𝑩, 𝝓, 𝜚) = Φ 𝜑1 𝐷𝑖,𝑡 𝑇𝐴𝑅𝑃 + 𝜑2 𝑴𝑙 + 𝜑3 𝑪 𝑡 + 𝜑4 𝑩𝑖,𝑡−1 + 𝝓𝑖 + 𝜚 𝑡 + 𝑒𝑖,𝑙,𝑡 H4: Better loans >> Higher likelihood to hold on to loans thru servicing (In Progress)
  62. 62. Empirical Results Evidence exists that seller banks are inclined to hold-on to the servicing of “better” loans and sell the servicing rights of “worst” loans. ↑ Interest Rate >> ↓ Prob(seller=servicer)*** ↑ Default Probe >> ↓ Prob(seller=servicer)***
  63. 63. Empirical Results Better Loans >> Seller=Servicer
  64. 64. Concluding Remarks (1/2) Focusing on the mortgages acquired by Fannie Mae from U.S. banks during 2005:1-2011:12 and the U.S. banks which sold the mortgages to Fannie Mae, we found that …the mortgages sold to Fannie Mae from TARP banks offered more beneficial terms and lower default ratios that those acquired from non-TARP banks.
  65. 65. Concluding Remarks (2/2) …TARP banks were able to offer the most beneficial terms and attract the safer borrowers due to a cost competitiveness advantage gained from the capital infusion from TARP funds. …The incentive for a bank from originating and/or procuring a “safe” mortgage that is later sold to Fannie Mae comes derives from the income from future servicing the mortgage. As banks are more inclined to continue servicing “safer” mortgages after their sale to the GSE.
  66. 66. Bank of Estonia 2016 Open Seminars of Eesti Pank Thank you for your invitation and kind attention José J. Cao-Alvira Associate Professor, Lehman College at the City University of New York Alexander Núnez PhD Candidate, EGAE School of Business at the University of Puerto Rico

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