on tarp and its impact on the mortgages acquired by fannie mae

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

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.

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.

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

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.


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



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



2. Portfolio Investment

- Acquiring assets on their own balance sheets

• Mortgages

• MBS (Agency and non-Agency)

• Fixed Income Securities


Single-Family Residential Mortgage Holdings

Source: Flow of Funds Accounts of the United States


Source: Financial Statements of 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

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


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.



- 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.



- 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.



- Specifically, it’s been found that TARP banks increased

their market power and gained a competitive advantage

soon after receiving the government capital transfers.



- 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.

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.

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

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.

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

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

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

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)


Event study

Short-run reductions and Longer-run

increases in the systematic risk of the

supported banks increased.

Elyasiani, Mester &

Pagano (2014)


Event study

Literature Review


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.

Literature Review


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.

Literature Review


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

Literature Review


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

Literature Review


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

Literature Review


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.

Literature Review


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.

Literature Review


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.

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

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

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

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.

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

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

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

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.

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).


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


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

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

Appendix – Lerner Index (1/5)

𝑙𝑛 𝐶𝑜𝑠𝑡𝑖𝑡 = 𝛽0 + 𝛽1 ln𝑄𝑖𝑡 + 𝛽2 ln𝑄𝑖𝑡2 + 𝛾𝑘 ln𝑊𝑘,𝑖𝑡

3

𝑘=1

+⋯

…+ ∅𝑘 ln 𝑄𝑖𝑡

3

𝑘=1

ln𝑊𝑘,𝑖𝑡 + 𝛿𝑘𝑗ln𝑊𝑘,𝑖𝑡 ln𝑊𝑗,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)


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:


𝛽3 + 𝛽4 + 𝛽5 = 1 𝛽6 + 𝛽7 + 𝛽8 = 0 𝛽9 + 𝛽12 + 𝛽13 = 0 𝛽10 + 𝛽12 + 𝛽14 = 0 𝛽11 + 𝛽13 + 𝛽14 = 0


Marginal cost is then computed as:

𝑀𝐶𝑇𝐴𝑖𝑡 =𝐶𝑜𝑠𝑡𝑖𝑡𝑄𝑖𝑡𝛽1 + 2𝛽2 ln 𝑄𝑖𝑡 + ∅𝑘

3

𝑘=1

ln𝑊𝑘,𝑖𝑡



𝑃𝑇𝐴𝑖𝑡 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.



𝐿𝑒𝑟𝑛𝑒𝑟𝑖𝑡 = 𝑃𝑇𝐴𝑖𝑡 − 𝑀𝐶𝑇𝐴𝑖𝑡𝑃𝑇𝐴𝑖𝑡

Where 𝑃𝑇𝐴𝑖𝑡 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 𝑀𝐶𝑇𝐴𝑖𝑡 is the marginal cost

of total assets for bank 𝑖 at time 𝑡.


Empirical Results

𝑀𝐶𝑖,𝑡 is defined as the marginal cost of bank 𝑖 at time t.

𝐷𝑖,𝑡𝑇𝐴𝑅𝑃 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 = 𝜆1𝐷𝑖,𝑡𝑇𝐴𝑅𝑃 + 𝝀𝟐𝑩𝑖,𝑡−1 + 𝝁𝑖 + 𝜌𝑡 + 𝜐𝑖,𝑡

H1: TARP >> Competitive Distortions

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)

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)***

Empirical Results TARP >> Competitive Distortions

Empirical Results

𝑟𝑖,𝑙,𝑡 = 𝛽1𝐷𝑖,𝑡𝑇𝐴𝑅𝑃 + 𝜷2𝑴𝑙 + 𝜷3𝑪𝑡 + 𝜷4𝑩𝑖,𝑡−1 + 𝜶𝑖 + 𝛿𝑡 + 휀𝑖,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 𝑪𝑡 is a set of time-variant aggregate-economy level controls

H2: TARP >> More favorable contract terms

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

Empirical Results TARP >> More favorable contract terms

Empirical Results TARP >> More favorable contract terms

(even more so for “safer” borrowers)

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,𝑡𝑇𝐴𝑅𝑃,𝑴, 𝑪,𝑩, 𝜽, 𝜓

= Φ 𝛾1𝐷𝑖,𝑡𝑇𝐴𝑅𝑃 + 𝛾2𝑴𝑙 + 𝛾3𝑪𝑡 + 𝛾4𝑩𝑖,𝑡−1 + 𝜽𝑖 + 𝜓𝑡 + 𝑢𝑖,𝑙,𝑡

H3: TARP >> Better Performing Loans

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

Empirical Results TARP >> Better Performing Loans

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,𝑡𝑇𝐴𝑅𝑃 ,𝑴, 𝑪,𝑩,𝝓, 𝜚)

= Φ 𝜑1𝐷𝑖,𝑡𝑇𝐴𝑅𝑃 + 𝜑2𝑴𝑙 + 𝜑3𝑪𝑡 + 𝜑4𝑩𝑖,𝑡−1 +𝝓𝑖 + 𝜚𝑡 + 𝑒𝑖,𝑙,𝑡

H4: Better loans >> Higher likelihood to hold on to

loans thru servicing (In Progress)

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)***

Empirical Results Better Loans >> Seller=Servicer

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.

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.

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

on tarp and its impact on the mortgages acquired by fannie mae

Economy & Finance