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First Quarter 2015

Volume 98, Issue 1

Susquehanna River in Harrisburg, Pennsylvania

New Rules for Foreign Banks: What’s at Stake?
The Government-Sponsored Enterprises: Past and Future
Smart Money or Dumb Money: Investors’ Role in the Housing Bubble
Research Rap

INSIDE
ISSN: 0007-7011

FIRST QUARTER 2015

The Business Review is published four
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necessarily those of the Federal Reserve.
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New Rules for Foreign Banks: What’s at Stake?

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The Federal Reserve Bank of Philadelphia
helps formulate and implement monetary
policy, supervises banks and bank and
savings and loan holding companies, and
provides financial services to depository
institutions and the federal government. It
is one of 12 regional Reserve Banks that,
together with the U.S. Federal Reserve
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Charles I. Plosser
President and Chief Executive Officer
Michael Dotsey
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and Director of Research
Colleen Gallagher
Research Publications Manager
Dianne Hallowell
Art Director and Manager

1

In response to the financial crisis, stricter rules are being phased in for
foreign banks operating on U.S. soil. Mitchell Berlin explains how global
banking drives efficiency, how the new rules may impede that efficiency,
and why the rules may nevertheless be necessary.

The Government-Sponsored Enterprises: Past and Future

11

Fannie Mae and Freddie Mac’s role in the housing bubble and financial
crisis remains controversial. Did they precipitate or at least worsen the
crisis? How do their benefits compare against their losses? Ronel Elul
traces their evolution and actions and outlines reform proposals.

Smart Money or Dumb Money:
Investors’ Role in the Housing Bubble

21

To explain the historic housing boom and bust, most analysis has identified
easy credit in the form of low interest rates, subprime mortgages, and
relaxed qualifications for borrowers. But as Wenli Li explains, recent
research suggests an additional factor: real estate speculation.

Research Rap
Abstracts of the latest working papers produced by the Federal Reserve
Bank of Philadelphia.

27

New Rules for Foreign Banks: What’s at Stake?
BY MITCHELL BERLIN

T

he financial crisis has led economists and policymakers to
think more carefully about how global banks are regulated.
Before the crisis, foreign banks had operated their U.S.
branches and subsidiaries mainly under rules set by the
countries where they were based.1 But as the crisis made
clear, financial shocks are transmitted internationally. And efforts to
resolve them can be hampered when there are multiple regulators with
opposing interests and different resolution mechanisms. In response
to these concerns, the Federal Reserve Board, in accordance with the
Dodd-Frank Act, has approved rules to strengthen the regulation of
foreign banks operating on U.S. soil in coming years.

The new framework’s organizational restrictions and higher regulatory costs may reduce the efficient flow
of funds within global banks. These
costs and restrictions may also induce
global banks to shift activities to other
countries, switch from subsidiaries to
branches, or take other steps to avoid
the full impact of the regulations.
However, the new rules reflect heightened concerns about financial stability
that came into sharp relief during the
crisis. To understand the tradeoffs, this
article will examine: How did banking
become globally interconnected in the
years leading up to the financial crisis?
How does the presence of foreign
banks benefit a country, and what are

the costs? Why had foreign banks been
lightly regulated before the crisis? And
postcrisis, what are the new regulations’ likely costs and benefits?
THE RISE OF GLOBAL BANKING
Global banking expanded dramatically before the crisis. The two
decades preceding the financial crisis
of 2008-09 have been termed the
second age of globalization, a period
of rapid economic integration that included a dramatic expansion of international banking.2 International banks
have become truly global, in the sense
that they increasingly have branches
and subsidiaries physically located in
many countries performing a wide

1
I use the terms foreign and global bank more
or less interchangeably. See William Goulding
and Daniel Nolle for precise definitions of terms
used to describe foreign banks and foreign units
of global banks. Their article also contains a
description of U.S. foreign banking statistics.

2
Linda Goldberg uses the phrase “second age
of globalization” in her excellent account of the
growth of global banking in the period preceding the financial crisis. Maurice Obstfeld and
Alan Taylor, among others, date the first age of
globalization from 1870 to 1914.

Mitchell Berlin is a vice president and economist at the Federal
Reserve Bank of Philadelphia. The views expressed in this article
are not necessarily those of the Federal Reserve. This article and
other Philadelphia Fed reports and research are available at www.
philadelphiafed.org/research-and-data/publications.

www.philadelphiafed.org

range of funding, lending, and capital
market activities.
Figure 1 provides a glimpse of this
trend. The share of foreign banks operating subsidiaries in a sample of 137
countries increased by 14 percentage
points from 1995 to 2008. The rising
share was most dramatic in developing
countries. However, the trend may be
understated for developed countries, because banks often enter foreign markets
through branches rather than subsidiaries — more on this distinction later.
For just the U.S., we have data
extending further into the past and
that include both subsidiaries and
branches of foreign banks operating in
the U.S.3 These data reveal a rough
doubling of the share of all U.S. assets
of foreign banks among all banks doing business in the U.S. between 1980
and 1992 (Figure 2). After a modest
decline from 1992 to 2004, foreign
banks’ share of U.S. assets increased
again during the period of explosive
growth of U.S. banking assets through
2008. So the dollar amount of foreign
banking assets in the U.S. was increasing significantly even as the share increased modestly (Figure 3). Although
we observe a slowing and then a quickening of foreign banks’ asset growth in
the subsequent years, it is too soon to
predict future trends.
The modestly increasing share of
foreign banks in the U.S. and other
developed countries since the 1990s,

3
Comparable data for other nations are largely
confidential. The Fed, in conjunction with a
number of other central banks, the International
Monetary Fund, and the Bank for International
Settlements, has organized the International
Banking Research Network, which seeks to
expand researchers’ access to international banking data.

Business Review Q1 2015 1

evident in Figures 1 and 2, masks some
other important changes, notably in
the U.S. In the 15 years preceding the
crisis, the share of broker-dealer assets
of the 10 largest foreign banks operating in the U.S. increased from 15 percent to 50 percent, and 12 of the top
20 broker-dealers in the U.S. are now
owned by foreign banks.4 During this
period, global banks in both the U.S.
and the European Union relied increasingly on short-term funds to finance
capital market activities with funds
flowing freely across national borders.5
Why did banks become more
globalized? In a nutshell, the world
economy was becoming more integrated, and global banks promoted
both economic integration and a more
efficient financial system. How do
banks increase efficiency when they
locate abroad? For example, why would
a depositor in the U.S. place his funds
in, say, Santander Bank, a U.S. subsidiary of Santander Group of Spain?
And what can Deutsche Bank’s branch
office in the U.S. do that JP Morgan
can’t? More broadly, does an advanced
country like the U.S. or a less-developed country like Pakistan benefit
when global banks like Santander and
Deutsche Bank set up operations there?
Banks follow their customers abroad
and then compete for customers there.
G Corporation, a (fictional) German
automaker, has just opened a number

FIGURE 1
Globalization Most Evident in Developing World
Percent of foreign banks in different types of countries,
1995-2009.
Percent
80

All countries
Developed countries

70

Developing countries

60
50
40
30
20
10
0
1995

2000

2005

2009

Source: Claessens and Van Horen (2014).
Note: The data include foreign subsidiaries but not branches of foreign banks. The developed
countries are proxied by the 34 member nations of the Organization for Economic Cooperation
and Development.

FIGURE 2
Share of Foreign-Held Assets Resumed Rising
Before Crisis
Percent
30

Share of U.S. assets held by all foreign banking units
Share of U.S. assets held by foreign branches and agencies
Share of U.S. assets held by foreign banks

25

20

See Fed Governor Daniel Tarullo’s 2014
speech. Broker-dealers buy, sell, and trade a
wide range of capital market instruments such
as bonds, swaps, and futures contracts. As
brokers they seek to match buyers and sellers;
as dealers they take positions in — that is, have
their own stake in — the instruments they buy
and sell.
4

5
See Tarullo’s 2014 speech and Franklin Allen
and his coauthors’ article for accounts of these
trends. Former Fed Chairman Ben Bernanke
and his coauthors document the flow of shortterm funds from U.S. branches of European
banks, which were then used to purchase
mortgage-backed securities and other “safe” securities from U.S. banks in the years preceding
the financial crisis.

2 Q1 2015 Business Review

15

10

5

0
1981

1985

1989

1993

1997

2001

2005

2009

2013

Source: Federal Reserve Board, Share Data for U.S. Banking Offices of Foreign Entities, www.
federalreserve.gov/releases/iba/default.htm.
Note: Agencies include organizational forms grandfathered in under previous legislation to
ensure that foreign banks could compete on equal terms with U.S. banks.

www.philadelphiafed.org

of car dealerships in the U.S. The
company has a close relationship with
Götze Bank (also fictional), which
provides G Corporation with a range
of capital market services such as
financing dealers’ floor inventory and
customer purchases as well as packaging auto loans into asset-backed securities. Because Götze Bank has built up
an intimate knowledge of G Corporation’s business over time, it can provide
banking services to G Corporation
efficiently and therefore at a lower cost
than competing banks could. And, of
course, Götze Bank would prefer not
to lose G Corporation’s U.S. business
to a U.S. bank. So Götze Bank opens
a branch in the U.S. And since it has
world-class capital market expertise,
Götze Bank USA will also compete
for the banking business of other large
corporations operating in the U.S.6
Global banks can more readily tap
global capital. Once a bank has set up
shop in foreign markets, new oppor-

tunities open up for moving resources
across national borders to seize profitable opportunities. Following Russia’s
(nonfictional) default on its bonds in
1998, financial markets around the
world seized up, and firms far from
Russia had difficulty securing finance.
You might think that this would mean
global banks would make fewer loans
than would domestic lenders. But
when Philipp Schnabl compared the
lending behavior of Peruvian banks
owned by foreign parents with that of
domestically owned Peruvian banks
during this episode, he found that
foreign-owned banks reduced their

6
Claudia Buch summarizes the abundant
evidence for banks following their customers abroad. The desire to operate in a global
banking center such as New York or London is
also a major reason why banks locate abroad.
Also, international integration has spurred
the growth of foreign trade and, in turn, the
demand for trade finance from banks with a
global reach.

FIGURE 3
Growth of Foreign Assets Accelerated Before
Crisis
Trillions of U.S. dollars
18
16

Value of assets held by all banks in U.S.
Value of assets held by foreign banks in U.S.

14
12

lending less than did Peruvian-owned
banks. Moreover, Peruvian-owned
banks that relied solely on domestic funds reduced their lending less
than did Peruvian-owned banks that
had depended on international funds
before the Russian default. So the decline in lending was most extreme for
Peruvian-owned banks that relied on
funds from outside Peru.
What accounts for these different
lending patterns? As outside creditors pulled back from taking risks in a
stressed financial environment, domestically owned Peruvian banks dependent on foreign funds could not secure
funds.7 By contrast, foreign-owned Peruvian banks had access to funds from
around the world, routed through their
parent companies. Economists call
this an internal capital market: A global
bank collects funds where they can be
secured relatively cheaply and shifts
them to regions where lending is most
profitable. A bank may be able to shift
money from one region and put it to
work in another region more efficiently
through its own internal capital market
than financial markets can because
information about profitable opportunities flows more easily within organizations and because decisions about
allocating capital can be coordinated
through the bank’s headquarters.8
Meanwhile, the Peruvian economy benefited because global banks
insulated domestic borrowers from a

10
7
For a larger sample of countries over a longer
period, 1991 to 2004, Ralph de Haas and Iman
van Lelyveld similarly find that banks’ foreign
subsidiaries curtailed their lending less than
domestic banks did when the host country suffered a negative economic shock. They also find
that foreign banks were less likely than domestic
banks to keep lending when their own financial
health weakened.

8
6
4
2
0
1981

1985

1989

1993

1997

2001

2005

2009

2013

Source: Federal Reserve Board, Share Data for U.S. Banking Offices of Foreign Entities, www.
federalreserve.gov/releases/iba/default.htm.

www.philadelphiafed.org

8
There is a large, contentious body of economic
literature on the efficiency of internal capital
markets. Economists examining banking firms
have typically found evidence that they promote
efficiency at the firm level. See my Business
Review article for the pros and cons of internal
capital markets.

Business Review Q1 2015 3

foreign economic shock that would
have otherwise reduced bank lending more sharply. One reason foreign
banks can cushion an economy from
an outside shock is that they can diversify geographically.
Geographic diversification of banks
can promote economic stability. In an
ingenious study, Donald Morgan, Bertram Rime, and Philip Strahan provide
evidence of the benefits of geographic
diversification during a period in which
one could view the United States as
a mini-global economy. From 1977 to
1994, many states relaxed restrictions
on banks from other states operating
within their borders, while others continued to prohibit banking across state
lines. We can think of each state that
opened its borders as if it were a nation
welcoming foreign banks to enter. Morgan and his coauthors find that the interstate banking states suffered milder
economic fluctuations than states that
barred interstate banks. Their findings suggest that bank customers —
and residents within states that permit
interstate banking — benefit from
geographically diversified banks, which
can provide more stable funding in a
state that would otherwise be hit much
harder by a macroeconomic shock.9
Although Morgan and his coauthors
argue that geographically diversified
banks promoted stability in the U.S.,
they also provide evidence that a bank
operating in many states can transmit
economic shocks across state lines, an
issue that I discuss later.
Global banks compete in underserved markets. Economists have found
that when global banks enter less developed nations, they typically increase
competition without necessarily driving
out domestic lenders. For example,

9
In a related finding, in their article on monetary
transmission, Nicola Cetorelli and Linda Goldberg show that U.S. banks with global operations
are less sensitive to U.S. monetary policy shocks
than are U.S. banks without global operations.

4 Q1 2015 Business Review

Atif Mian shows that foreign banks
entering Pakistan primarily serve large
corporations, while Pakistani banks retain their local business customers.10 In
their review of the economic literature
on foreign banking, Stijn Claessens and
Neeltje Van Horen conclude that the
entry of a foreign bank into a country is
associated with greater efficiency in the
provision of banking services, especially
in developing markets.11 Researchers
have cited economies of scale for the
large global banks, access to diversified
sources of funds, diversified lending
opportunities, and the ability to apply
best practices to multiple markets as
sources of these efficiencies.
Despite a broad consensus among
economists that global banks enhance
economic efficiency, the basic question, “How should global banks be
regulated?” has always been controversial. Even as international integration
proceeded and banking became more
globalized, periodic crises provoked
concerns that unfettered capital flows
come at a cost. Indeed, in 2004, as
the pace of global banking quickened
by all measures, Maurice Obstfeld
and Alan Taylor wrote, “At the turn
of the twenty-first century, the merits
of international financial integration
are under more forceful attack than
at any time since the 1940s.” And as
we will see in the next section, some
national regulators permitted foreign
banks to enter freely but placed rela-

tively stringent controls over foreign
banks operating in their national
borders, even before the crisis.12 But
the financial crisis highlighted the
economic costs of global banking for
regulators in the U.S. and Europe, and
many economists and policymakers
have reevaluated how global banks
should be regulated. Before we can
see how policymakers’ answers to this
basic question have changed, we need
to briefly explain how banks organize
their foreign units.
HOW ARE FOREIGN UNITS
ORGANIZED?
As noted earlier, banks structure
their foreign units as either subsidiaries
or branches.13 Subsidiaries are owned
by the parent organization but are separate legal entities that are capitalized
separately from the parent company.
For example, Santander Group’s U.S.
subsidiary, Santander Bank (formerly
Sovereign Bank), is legally incorporated
in the U.S. and reports an income
stream identifiably separate from that
of its parent company. Should the U.S.
subsidiary fail, the parent company’s
losses are limited to its equity investment in the subsidiary; that is, the parent can “walk away” from its subsidiary.
Santander Bank’s U.S. bondholders
and depositors have no claim on the assets of the parent company. However,
they do have priority over any equity

For example, prior to the crisis, New Zealand
and Mexico required foreign banks to establish
local subsidiaries. In both countries, foreign
banks dominated their national banking
systems. In such situations, host country bank
regulators have viewed more intrusive regulation as a lever to ensure that their national
interests were adequately protected. See, for
example, the entertaining speech by the former
governor of the Reserve Bank of New Zealand,
Alan Bollard.

12

Mian argues that small local businesses are
more “opaque” — for example, they use less
formal bookkeeping practices — and require
the specialized knowledge of a local banker.

10

11
Bang Nam Jeon and his coauthors found that,
in a sample of developing nations, the effects
of foreign bank competition are stronger when
the bank enters de novo — that is, under a new
charter — than when it enters by purchasing an
existing bank. Note that lowering entry costs
should increase competition regardless of the
home countries of the new entrants. It is a challenge to disentangle empirically the effect of
competition from foreign banks from the effect
of more competition per se.

13
I’m simplifying things here. For example, the
U.S. permits foreign units to adopt a number of
organizational forms, mainly because of regulatory differences between the U.S. and the home
countries.

www.philadelphiafed.org

holders (including the parent company)
if the U.S. subsidiary fails.14
Unlike subsidiaries, branches are
not legally separate from their parent companies.15 Take Deutsche Bank
AG New York, a branch of Germanybased Deutsche Bank that engages in
wholesale lending and currency and
derivatives trading.16 Deutsche Bank is
fully liable for the branch’s debts if the
branch can’t pay its creditors.
How does a bank decide between
a branch and a subsidiary? Regulation and taxes appear to be the most
important factors in whether a foreign
unit is set up as a branch or a subsidiary.17 Countries differ significantly in
restricting foreign banks’ organizational
choices. At one end of the spectrum,
under the European Union’s single
passport, a member nation’s banks are
free to open either branches or subsidiaries in any EU country. At the other
end of the spectrum, New Zealand,
Mexico, and Brazil permit only foreign
subsidiaries. Typically, subsidiaries are
regulated by the host country, while
branches are regulated by the home
country.18 As a result, many countries
restrict the activities of foreign branchPriority means that in the event of failure,
depositors and bondholders must be fully paid
off before Santander’s stockholders — mainly
Santander Group itself — receive a cent.

14

In this article, branch refers to a particular legal structure rather than to the local office of a
bank in your neighborhood or a suburban mall.

15

16
Retail banking serves small depositors and
small businesses. Wholesale banking involves
seeking funds in money markets while making
large loans and providing other services to large
firms.
17
The empirical literature on the choice of
organizational form by global banks is sparse.
Here, I summarize the main empirical results
of Eugenio Cerutti and his coauthors and
Jonathon Fiechter and his coauthors. The latter
provide an excellent summary of the factors
behind the choice of organizational form.

As a formal matter, this description is too
simple, since host country regulators are always
given some regulatory oversight role. As a practical matter, the simple description is accurate.

es operating on their soil, which tends
to promote foreign entry via subsidiaries. For example, the U.S. does not
permit foreign branches to take retail
deposits — that is, deposits smaller
than $250,000, the limit per customer
for FDIC insurance. So a branch such
as Deutsche Bank AG New York relies
on wholesale deposits, among many
other funding sources.
Eugenio Cerutti and his coauthors find that banks are more likely
to set up subsidiaries than branches in
countries where macroeconomic risk is
high. They argue that a parent bank
can walk away if a serious economic
downturn in the host country causes
financial problems at its subsidiary.

FROM A LIGHT TOUCH TO
TIGHTER RULES
Before the financial crisis, the
U.S. had a rather hands-off approach
to the regulation of foreign banks. See
the accompanying comparison, Before
and After: Regulation of Foreign Banks

Regulation and taxes appear to be the most
important factors in whether a foreign unit is
set up as a branch or a subsidiary.
On the other hand, using various
measures of the risk of intervention
by the host country’s political authorities, Cerutti and his coauthors find
that in countries where political risk is
high, banks are more likely to choose
the branch form. Since branches are
legal extensions of the parent, they
are better insulated against interventions and expropriations, which could
range from taxes to nationalization,
by the host country.19 A bank is also
more likely to use a branch structure
in a country where corporate taxes
are higher than at home because it is
easier to transfer profits from a branch
— which, unlike a subsidiary, doesn’t
produce a legally separate income
stream — back home for tax purposes.
Broad organizational strategies
and the history of a bank’s global expansion also appear to be important.
Some banks have a strict preference

18

www.philadelphiafed.org

for the subsidiary form; for example,
Santander Group purchases mainly
retail-oriented foreign banks, which
it retains as subsidiaries. Other
global banks such as Citigroup have
amassed a crazy quilt of subsidiaries
and branches around the world, which
appears to reflect a mix of history and
regulatory and tax incentives over decades of headlong growth.

Giovanni Dell’Ariccia and Robert Marquez
present a theoretical model of these tradeoffs.

19

in the U.S., for details. Most notably,
banks could choose their preferred
organizational form for their U.S.
operations, and in 1991, foreign banks
were no longer subject to U.S. capital
regulations, subject to some qualifications.20 This approach reflected the
trends of the second age of globalization — expanding international trade,
financial liberalization in developing
markets, the opening of markets in
Eastern Europe, and broad deregula-

20
As stated in the Fed Board of Governors’
2001 supervision and regulation letter: “In
cases in which the Board has determined
that a foreign bank operating a U.S. branch,
agency, or commercial lending company is wellcapitalized and well-managed under standards
that are comparable to those of U.S. banks
controlled by [financial holding companies],
the presumption will be that the foreign bank
has sufficient financial strength and resources
to support its banking activities in the United
States.” Financial holding companies include
commercial bank holding companies as well
as regulated holding companies in which the
parent company is an insurance company or
investment bank.

Business Review Q1 2015 5

Before and After: Regulation of Foreign Banks in the U.S.
Before 2014
•

•

•

•

The Federal Reserve oversaw
U.S. operations of foreign banks.
Their home regulators had
primary oversight of their global
operations.
Foreign banks were not
required to meet Fed capital
requirements as long as they
were deemed well managed and
well capitalized and their home
regulations were comparable to
U.S. regulations.

To be phased in
•

•

Foreign banks were free to
choose their organizational
structure, subject to approval by
the Fed.
Foreign banks faced restrictions
on their asset and liability mix:
xx

Branches could not take
retail deposits.

xx

Branches were required to
consistently hold certain
amounts of high-quality
assets in the U.S.

•

•

Foreign banks with total combined assets between $10 billion and $50
billion must:
xx

Meet home country capital stress test requirement or perform
company-run stress tests.

xx

Have a risk committee for U.S. operations if publicly traded.

Foreign banks with total combined assets exceeding $50 billion and
combined U.S. assets of less than $50 billion must:
xx

Meet home country capital stress test requirement or perform
company-run stress tests.

xx

Have a risk committee for U.S. operations.

xx

Certify to the Fed that they meet home country capital standards
consistent with the Basel Accords.

xx

Perform company-run liquidity stress tests for either combined
operations or U.S. operations.

Foreign banks with total combined assets exceeding $50 billion and
combined U.S. assets exceeding $50 billion must:
xx

Meet home country capital stress test requirement or perform
company-run stress tests.

xx

Have a risk committee and risk officer for U.S. operations.

xx

Certify that they meet home country capital standards consistent
with the Basel Accords.

xx

Perform company-run liquidity stress tests for their U.S. operations.

Foreign banks with total combined assets exceeding $50 billion and
combined U.S. assets (excluding assets held by branches or agencies)
exceeding $50 billion must form an intermediate holding company that:
xx

Satisfies capital and liquidity requirements comparable to
requirements for U.S. bank holding companies.

xx

Satisfies capital stress tests run by the Fed.

Source: For the full regulatory rule, including an extended discussion of the rationale, see the Federal Reserve Board, “Enhanced Prudential
Standards for Bank Holding Companies and Foreign Banking Organizations.”
Notes: The compliance date for U.S. bank holding companies subject to the rule is January 1, 2015. The compliance date for foreign banking
organizations is July 1, 2016. Leverage ratios for foreign-owned U.S. intermediate holding companies are generally deferred until 2018. See www.
federalreserve.gov/newsevents/press/bcreg/20140218a.htm. Total combined assets include all of the bank’s assets worldwide. Combined U.S. assets
include those held by U.S. subsidiaries, branches, and other agencies.

tion of domestic and international
banking markets. Financial crises in
developing countries in the 1990s notwithstanding, most regulators, policymakers, and economists were focused
on the efficiency benefits of global
banking rather than on the potential
costs under crisis conditions. They
agreed that a light regulatory touch
permitted global banks to operate ef6 Q1 2015 Business Review

ficiently at modest risk.21 Broadly, regulators believed that the international
Basel capital standards that were being

21
Since the crisis, some economists have argued
that the widespread support for unfettered
capital flows and deregulation had been the
result not of a true accounting of the costs and
benefits but rather of the vested interests of big
banks (Simon Johnson and James Kwak) or of
economists’ idealized models (Paul Krugman).

phased in at the time were sufficiently
uniform and that regulators were sufficiently vigilant that the safety and
soundness of the global financial system could be assured.22
The financial crisis was a shock
in a lot of ways, but for regulators the
main lessons were that global banks
could fail (in droves) and that the
international banking system had
www.philadelphiafed.org

evolved beyond the capacities of national regulators. Of course, financial economists and regulators were
already aware that global banks could
become a source of financial instability, although the developed nations
were largely insulated from the worst
effects of the international crises of
the 1980s and 1990s. But the capital
flows from host countries to home
countries through banks’ internal
capital markets, the messy failures of
large global banks operating across
multiple jurisdictions, and the fact that
taxpayer money was used to bail out
global banks focused regulators on a
more intrusive approach.
For example, Britain has adopted
stringent capital and liquidity requirements for foreign banks, including liquidity requirements for foreign
branches. These requirements are particularly noteworthy because London is
a global banking center, so they affect
most global banks. (Indeed, some analysts believe that Britain’s regulations
will ultimately diminish its role as a
global financial hub.) Furthermore,
in light of the many EU bank failures
during the financial crisis and the poor
coordination among national regulators in handling these failures, the EU
has given the European Central Bank
primary responsibility for supervising
large EU banks, including deciding
whether a large bank should be placed
in resolution.
In the U.S., new regulations the
Fed adopted in February 2014 continue to obey the principle of national
treatment and equality of competitive
opportunity, which means that foreign
banks have the right to compete on a
level playing field with U.S. banks. Of

course, moving from principle to practice is not so simple, most notably because parent banks are also regulated
by their home countries. So while the
principles stay constant, their implementation will change dramatically as

some commentators suggest that U.S.
regulators retain an implicit threat to
impose further restrictions on branches should foreign banks shift activities
from subsidiaries to branches to skirt
the new regulations.24

The financial crisis was a shock in a lot of
ways, but for regulators the main lessons were
that global banks could fail (in droves) and that
the international banking system had evolved
beyond the capacities of national regulators.
the new regulations are phased in.
The most notable change is that
a foreign bank with a U.S. presence
exceeding $50 billion will be required
to group its U.S. subsidiaries under an
intermediate holding company subject
to precisely the same capital and liquidity regulations as for large U.S. banks.23
Furthermore, just like large U.S. banks,
the holding companies will be required
to perform company-run stress tests
and be subject to stress tests carried out
by the Fed. Although smaller foreign
banks will be subject to fewer restrictions, they will be required to set up
risk committees to evaluate and manage the risk of their U.S. operations.
While the new regulatory framework is a significant change, foreign
banks are still free to decide whether
to organize a U.S. unit as a branch
or a subsidiary. They need not house
U.S. branches in an intermediate
holding company, and the $50 billion
cutoff excludes branch assets. So,
foreign banks retain considerable
organizational discretion, although

The Fed’s regulations implemented the Collins amendment of the Dodd-Frank Act, which
required foreign banks that had been subject
to SR 01-01 to be made subject to U.S. capital
regulations. At its discretion, the Fed may
permit a foreign bank to operate more than one
intermediate holding company.

WHAT RISKS DO THE NEW
RULES TARGET?
Financial shocks are transmitted
internationally through global banks.
While I emphasized the stabilizing effect of geographically diversified banks
earlier, numerous studies have also
found that economic shocks from the
home country can be transmitted to
the host country through global banks’
internal capital markets. This occurs
when parent banks suffer financial
problems; for example, a banking crisis
in the home country leads to declines
in the foreign units’ capital levels. In
the financial crisis, global banks suffered such losses on a grand scale,
triggering dramatic capital flows across
national lines, in particular from host
countries to home countries.
Funds head home in a crisis. Many
studies document a “flight home”
effect in which global banks withdraw
funding from host markets and transfer
funds to the home market. This
effect is best documented in loan
markets. Mariassunta Giannetti and
Luc Laeven study syndicated lending

23

Capital requirements limit the amount of debt
(including deposits) that banks can use to fund
their loans and other investments. See Ronel
Elul’s Business Review article on capital regulation for more detail about the various iterations
of the Basel capital accords.

22

www.philadelphiafed.org

In his 2014 speech, Governor Tarullo argues
that there is a credible case for imposing capital
and liquidity requirements on foreign branch
operations, although the new regulations do
not do so.

24

Business Review Q1 2015 7

by global banks during banking crises
between 1997 and 2008.25 They find
that a banking crisis in the home
market led banks to cut syndicated
lending to borrowers in host countries
much more than to borrowers at home.
Victoria Ivashina, David Scharfstein,
and Jeremy Stein compare the lending
behavior of U.S. and European
banks during the European sovereign
debt crisis in 2011. They find that
compared with U.S. banks, European
banks dramatically cut back dollar
lending in global syndicated loan
markets and shifted their attention to
home lending.26
Foreign units can become undercapitalized. While the flight home can
have particularly harsh contractionary
effects in emerging markets, the flow
of funds within global banking organizations may also pose problems for developed countries. There the concern
is not so much a collapse of lending to
domestic firms dependent on foreign
banks, but rather that the foreign
units might become undercapitalized.
In his 2014 speech, Governor Tarullo
argues that U.S. regulators can’t be

A syndicated loan is one in which a number
of banks lend pro rata shares of a large loan.

25

26
There are many unresolved questions about
the flight home effect. Among the reasons cited
for this effect are stronger relationships between
home banks and home borrowers, political pressures to support home borrowers (Giannetti and
Laeven; De Haas and Van Horen), and capital
market frictions that affect cross-border lending
(Ivashina and coauthors). When foreign banks
have a large presence in a country, as Swedish
banks did in the Baltics, or when foreign banks
have subsidiaries, rather than branches, in the
host country, the flight home effect is weaker
(Claessens and Van Horen and the Committee on the Global Financial System). In their
study of internal funding flows at U.S. global
banks during the financial crisis, Cetorelli and
Goldberg argue that the flight home story must
be qualified. They find that these banks tended
to shift funds from “core funding markets” to
“core lending markets,” rather than from foreign
to home markets per se. See Claessens and Van
Horen’s survey for an account of a large body
of literature on foreign banks and financial
stability.

8 Q1 2015 Business Review

confident that parent banks will act
as a source of strength for their foreign
banking units, leaving U.S. regulators
to deal with the resulting financial
problems.27 In the extreme case, parent banks can take funds from their
foreign units and then walk away.
(That said, we did not witness global
banks leaving their U.S. subsidiaries to
fail during the financial crisis.)
Regulatory intervention and
resolution are complicated for foreign
banks. By virtue of its size alone, the
failure of a large bank is a messy and
complicated affair, completely apart
from the international scope of its
operations. But global banks pose additional problems that make their failures
even messier and more complicated.
The primary dilemma facing
regulators is that banks are global in
life but national in death.28 The unifying view behind the Fed’s new regulations is that regulators must have more
robust techniques for both preventing
and resolving failures of foreign units
and that this task will fall to U.S.
regulators for the foreseeable future.29
A fundamental reason for this view
is that national regulators often have
conflicting interests. As Franklin Allen and his coauthors note, “[N]ational
regulators care first and foremost about
domestic depositors, domestic borrowers, domestic owners, and ultimately,
domestic taxpayers.” For example,
large Icelandic banks had opened
branches throughout the EU to collect
deposits to fund loans that now seem

27
The source of strength doctrine says that
parent companies should respond to financial
difficulties at subsidiaries or branches by providing financial support.
28
Former Bank of England Governor Mervyn
King made this observation in a speech in New
York in 2010 and, by some accounts, beforehand as well. It also appeared in The Economist
in 2009, www.economist.com/displaystory.
cfm?story_id=13057265.

See Governor Tarullo’s 2014 speech for an
articulation of the U.S. approach.

29

spectacularly risky, especially given
the relative size of the Icelandic banks
and the Icelandic economy. When
the Icelandic banking system collapsed
in 2008, Icelandic bank regulators
compensated only Icelandic depositors,
leaving other European depositors out
in the cold.
The Icelandic case highlights
another barrier to the effective resolution of global banking organizations:
information flows. Icelandic regulators
were slow to recognize the evolving
problems in their banking system — in
this, they were not alone — but they
were even slower in communicating
their information to other national
banking regulators. Years before the
crisis, Robert Eisenbeis and George
Kaufman had emphasized how hard
it is for regulators to collect timely
information about foreign banks operating in their countries — especially
branches without separate income
flows that could be observed by outside regulators.30
With or without information
about the financial health of the parent bank, host regulators often have
limited power to intervene. U.S. regulators were able to intervene successfully to strengthen large U.S. banks,
but they had to depend on European
regulators to handle their own banks.
In the fall of 2008, U.S. regulators
required the largest U.S. banks to
accept capital injections through the
Troubled Asset Relief Program, and
in the spring of 2009, U.S. regulators
performed stress tests on 19 large U.S.
banks to ascertain whether they would
have adequate capital in the event of
seriously adverse economic conditions.
The capital infusion and stress-testing
exercise are widely viewed as successful regulatory interventions that

30
Allen and his coauthors suggest that lack of
information may have been a larger problem
because Icelandic banks operated through
branches.

www.philadelphiafed.org

enhanced confidence and mitigated
the crisis. In contrast, many European
banks — including banks with substantial operations in the U.S. — remained undercapitalized, and a series
of stress tests carried out by European
banking regulators were viewed as seriously flawed by most economists and
market participants.
Meanwhile, the sheer complexity of many foreign banks creates huge
coordination problems in the event
of failure. Apart from the problems
that would arise in any large, complex organizations, foreign banks fall
under multiple regulatory frameworks
and multiple resolution regimes.31
For example, when Lehman Brothers filed for Chapter 11 bankruptcy in
September 2008, the firm comprised
over 700 separate legal entities in over
40 countries.32 In response to these

concerns, the new U.S. regulations
place intermediate holding companies under the supervision of the Fed
and require them to maintain capital
levels identical to those required of
large U.S. banks and to carry out stress
tests. With all of a foreign bank’s U.S.
subsidiaries in a single holding company, the Federal Deposit Insurance
Corporation would gain a key element
of its proposed resolution mechanism,
a single point of entry through which
it can take over the holding company
and keep the healthy subsidiaries operating in the event of failure.33
CONCLUSION
Although capital flight and the
costly failures of global banks convinced policymakers that more in-

32

31
See Allen and his coauthors for an account
of the resolution of Fortis bank that was finally
carried out independently by three national
regulators.

PricewaterhouseCoopers presentation, (2009).

See David Skeel’s working paper for a description and critical discussion of the FDIC’s
proposed single point of entry approach to the
resolution of failing banks.

trusive controls were needed, foreign
banks will not be passive in the face
of the new regulations. Some foreign
banks have announced that they will
shift some operations outside their
U.S. subsidiaries to avoid hitting asset thresholds that would trigger the
most restrictive new regulations. And
public announcements are only the
tip of the iceberg, as other banks can
be expected to make similar moves to
minimize the impact of the regulations
on their bottom line. Indeed, global
banks and other global financial firms
have the capacity to shift activities
toward lightly regulated sectors or nations — the problem of the so-called
shadow banking sector.34 Whether
more stringent regulations will actually
lead to a loss of operational efficiency
and whether the regulations will actually enhance financial stability remain
open questions. BR

33

See Daniel Sanches’s Business Review article
for an introduction to shadow banking.

34

REFERENCES
Allen, Franklin, Thorsten Beck, Elena
Carletti, Philip R. Lane, Dirk Schoenmaker, and Wolf Wagner. Cross-Border Banking
in Europe: Implications for Financial Stability
and Macroeconomic Policies, London: Center for Economic Policy Research (2011).
Berlin, Mitchell. “Jack of All Trades?
Product Diversification in Nonfinancial
Firms,” Federal Reserve Bank of Philadelphia Business Review, (May/June 1999).
Bernanke, Ben, Carol Bertaut, Laurie
Pounder DeMarco, and Steven Kamin.
“International Capital Flows and the Returns to Safe Assets 2004-2007,” Federal
Reserve Board International Finance Discussion Paper 1014 (2011).

Board of Governors of the Federal Reserve
System, Division of Banking Supervision
and Regulation (2001). “Application of
the Board’s Capital Adequacy Guidelines
to Bank Holding Companies Owned
by Foreign Banking Organizations,”
Supervision and Regulation SR Letter 0101 (January 5), www.federalreserve.gov/
boarddocs/srletters/2001/sr0101.htm.
Board of Governors of the Federal Reserve
System (2014), “Enhanced Prudential
Standards for Bank Holding Companies
and Foreign Banking Organizations,” final
rule (Docket No. 1438), Federal Register,
vol. 79 (March 27), www.gpo.gov/fdsys/
pkg/FR-2014-03-27/pdf/2014-05699.pdf.

Bollard, Alan. “Being a Responsible Host:
Supervising Foreign-Owned Banks,” address delivered at the Federal Reserve
Bank of Chicago Conference, Systemic
Financial Crises — Resolving Large Bank
Insolvencies, Chicago (October 2, 2004).
Buch, Claudia. “Why Do Banks Go
Abroad? Evidence from German Data,”
Kiel Working Paper 948 (1999).
Cerutti, Eugenio, Giovanni Dell’Ariccia,
and Maria Soledad Martinez Peria. “How
Banks Go Abroad: Branches or Subsidiaries?” Journal of Banking and Finance, 31
(2007), pp. 1,669-1,692.

continued on next page

www.philadelphiafed.org

Business Review Q1 2015 9

Cetorelli, Nicola, and Linda Goldberg. “Liquidity Management of U.S. Global Banks:
Internal Capital Markets in the Great Recession,” Journal of International Economics,
88 (2012a), pp. 299-311.

Fiechter, Jonathon, Inci Otker-Robe, Anna
Ilyina, Michael Hsu, Andre Santos, and Jay
Surti. “Subsidiaries or Branches: Does One
Size Fit All?” International Monetary Fund
Staff Discussion Note (May 2011).

Cetorelli, Nicola, and Linda Goldberg.
“Banking Globalization and Monetary
Transmission,” Journal of Finance, 67
(2012b), pp. 1,811-1,843.

Giannetti, Mariassunta, and Luc Laeven.
“The Flight Home Effect: Evidence from
the Syndicated Loan Market During
Financial Crises,” Journal of Financial
Economics 104 (2012), pp. 23-43.

Claessens, Stijn, and Neeltje Van Horen.
“Foreign Banks: Trends and Impact,”
Journal of Money, Credit and Banking, 46
(2014), pp. 295-326.
Claessens, Stijn, and Neeltje Van Horen.
“Impact of Foreign Banks,” De Nederlandsche Bank Working Paper 370 (2013).
Committee on the Global Financial System, Bank for International Settlements.
“Funding Patterns and Liquidity Management of Internationally Active Banks,”
CGFS Paper 3 (2010).
De Haas, Ralph, and Neeltje Van Horen.
“Running for the Exit: International Banks
and Crisis Transmission,” Review of Financial Studies, 26 (2013), pp. 244-285.
De Haas, Ralph, and Iman van Lelyveld.
“Multinational Banks and Global Financial Crisis Transmission,” Journal of Money,
Credit and Banking, 46 (2014), pp. 333-364.
Dell’Ariccia, Giovanni, and Robert Marquez. “Risk and the Corporate Structure
of Banks,” Journal of Finance, 65 (2010),
pp. 1,075-1,096.
Eisenbeis, Robert, and George Kaufman.
“Bank Crisis Resolution and ForeignOwned Banks,” Federal Reserve Bank of
Atlanta Economic Review (Fourth Quarter
2005), pp. 1-18.
Elul, Ronel. “The Promise and Challenges
of Bank Capital Reform,” Federal Reserve
Bank of Philadelphia Business Review
(Third Quarter 2013).

10 Q1 2015 Business Review

Goldberg, Linda. “Understanding Banking Sector Globalization,” International
Monetary Fund Staff Paper 56 (2009), pp.
171-197.
Goulding, William, and Daniel Nolle.
“Foreign Banks in the U.S.: A Primer,”
Federal Reserve Board International
Finance Discussion Paper 1074 (2012).
Ivashina, Victoria, David Scharfstein,
and Jeremy Stein. “Dollar Funding and
the Lending Behavior of Foreign Banks,”
NBER Working Paper 18528 (2012).
Jeon, Bang Nam, María Pía Olivero, and Ji
Wu. “Do Foreign Banks Increase Competition? Evidence from Emerging Asian
and Latin American Banking Markets,”
Journal of Banking and Finance 35 (2011),
pp. 856-875.
Johnson, Simon, and James Kwak. 13
Bankers: The Wall Street Takeover and the
Next Financial Meltdown. New York: Pantheon Books, 2010.
King, Mervyn. “Banking – From Bagehot
to Basel and Back Again,” speech delivered
at the Second Bagehot Lecture, Buttonwood Gathering, New York (October 25,
2010), www.bis.org/review/r101028a.pdf.
Krugman, Paul. “How Did Economists Get
It So Wrong?” New York Times, September
2, 2009.

Morgan, Donald, Bertram Rime, and
Philip Strahan. “Bank Integration and
State Business Cycles,” Quarterly Journal of
Economics, 119 (2004), pp. 1,555-1,584.
Obstfeld, Maurice, and Alan Taylor. Global
Capital Markets: Integration, Crisis, and
Growth. Cambridge: Cambridge University
Press, (2004).
PricewaterhouseCoopers. “Lehman
Brothers’ Bankruptcy: Lessons Learned for
the Survivors,” presentation (2009), www.
pwc.com/en_JG/jg/events/Lessons-learnedfor-the-survivors.pdf.
Sanches, Daniel. “Shadow Banking and
the Crisis of 2007-08,” Federal Reserve
Bank of Philadelphia Business Review
(Second Quarter 2014).
Schnabl, Philipp. “The International
Transmission of Bank Liquidity Shocks:
Evidence from an Emerging Market,”
Journal of Finance, 67 (2012), pp. 897-932.
Skeel, David. “Single Point of Entry and
the Bankruptcy Alternative,” University of
Pennsylvania Law School working paper
(2014).
Tarullo, Daniel. “Regulation of Foreign
Banking Organizations,” speech delivered
at the Yale School of Management Leaders
Forum (November 28, 2012), www.
federalreserve.gov/newsevents/speech/
tarullo20121128a.htm.
Tarullo, Daniel. “Regulating Large
Foreign Banking Organizations,” speech
delivered at the Harvard Law Symposium
on Building the Financial System of the
Twenty-first Century: An Agenda for
Europe and the United States, (March 27,
2014), www.federalreserve.gov/newsevents/
speech/tarullo20140327a.htm.

Mian, Atif. “Distance Constraints:
The Limits of Foreign Lending in Poor
Economies,” Journal of Finance, 61 (2006),
pp. 1,465-1,505.

www.philadelphiafed.org

The Government-Sponsored Enterprises:
Past and Future
BY RONEL ELUL

I

n September 2008, facing mounting losses and difficulty
in rolling over their debt, Fannie Mae and Freddie Mac,
also known as the government-sponsored enterprises,
or GSEs, agreed to enter government conservatorship
and have operated under government control ever since.
Their losses through 2012 have been estimated at $300 billion. The
role of the GSEs in the housing bubble and ensuing financial crisis has
been a source of controversy. Did the GSEs precipitate the crisis? Or
perhaps they merely amplified it? Can we quantify some of the benefits
of the GSEs in more normal times and compare them with the losses
during the crisis? Should the GSEs be phased out? Short of that, how
should they be reformed?

To answer these questions, we
present a brief history of the GSEs,
summarize the benefits they provide
to the housing market, and discuss
how they lost market share during the
boom and then recaptured it during
the bust, leading to large losses. Finally, we discuss the advantages and disadvantages of the proposals that have
been advanced to reform the GSEs.
A BRIEF HISTORY OF THE GSEs
To understand the role of the
GSEs in the housing market, it is first
helpful to understand that there are
several steps involved when a homeowner takes out a mortgage to purchase a home or refinance an existing
mortgage. First, a financial institution originates or issues the mortgage
to a borrower and then either retains

the loan as an asset on its own books
or sells it to another investor.1 Loans
that are sold are often bundled into
mortgage-backed securities (MBS).2 As
part of this securitization process, the
payments on the mortgages underlying these MBS may be guaranteed to
encourage investors to purchase them.
1
One incentive a lender may have to sell a
loan is to conserve regulatory capital. Another
reason may be to avoid the risk of holding a
large portfolio of mortgage loans. See my 2005
Business Review article, “The Economics of Asset Securitization,” for further detail.
2
MBS are created by bundling or pooling
many mortgages into securities that are sold to
investors, who then have a claim on the cash
flow from the principal and interest payments
homeowners make on the underlying mortgages.
These MBS are often further subdivided into
securities known as tranches, based on priority
in case of default or with respect to the allocation of principal and interest payments.

Ronel Elul is a senior economic advisor and economist at the Federal
Reserve Bank of Philadelphia. The views expressed in this article
are not necessarily those of the Federal Reserve. This article and
other Philadelphia Fed research and reports are available at www.
philadelphiafed.org/research-and-data/publications.

www.philadelphiafed.org

The Federal National Mortgage
Association (Fannie Mae) was set up
in the Great Depression as a government agency dedicated to purchasing
Federal Housing Administrationinsured loans from banks so that they
could make more loans.3 Initially, Fannie Mae borrowed money to purchase
mortgages guaranteed by the FHA and
then held those mortgages on its own
books. In 1958, Fannie Mae became
a mixed-ownership corporation, with
the federal government holding the
preferred stock while private investors held the common stock. In 1968,
Fannie Mae’s role of purchasing FHAinsured loans was spun off into a new
federal agency, the Government National Mortgage Association (Ginnie
Mae), within the Department of Housing and Urban Development. By 1970,
Fannie Mae had become fully privately
owned and became able to buy loans
issued by private lenders — that is,
those not guaranteed by the government. Also in 1970, the Federal Home
Loan Mortgage Corporation (Freddie
Mac) was set up with a similar charter:
to buy mortgages from savings and
loans and banks and thereby expand
the secondary mortgage market.
That same year, Ginnie Mae
issued the first mortgage-backed security; underlying it were loans guaranteed by the FHA. Freddie Mac issued

3
The Federal Housing Administration (FHA),
a government agency set up during the Great
Depression, facilitates homeownership by guaranteeing mortgages made by the private sector.
It played an important role in the adoption of
long-term amortizing fixed-rate mortgages. Today, FHA insurance helps borrowers who have
relatively small down payments or relatively
weak credit histories qualify for mortgages.

Business Review Q1 2015 11

its own MBS in 1971, while Fannie
Mae did not begin issuing MBS until
1983. Since the loans they securitized
were not FHA-insured, the GSEs
themselves guaranteed the timely
payment of interest and principal on
these loans. Of course, in assessing the
strength of this guarantee, investors
in these MBS took into account the
support they perceived that the GSEs
would receive from the government.
The securitization of mortgages not
guaranteed by either the FHA or GSEs
began in the early 1990s, although as
we discuss below this market remained
small until around 2003. Today about
two-thirds of all U.S. mortgages outstanding are securitized, with almost
all securitization now conducted
through the GSEs or FHA.
The GSEs increased their market
share until 2003, by which time they
were guaranteeing nearly 50 percent
of all new mortgages. From 2003 to
2006, they lost market share (see Figure
1), particularly to the rapidly growing
private mortgage-backed securitization

sector, which attracted borrowers by offering them riskier loans and then bundling them into MBS. Many of these
private securitizations included either
subprime mortgages, made to borrowers with poor credit histories, or alt-A
mortgages, made to borrowers with better credit histories but who posed other
risks such as a lack of income documentation or an interest-only loan in
which no principal payments needed to
be made. By 2006, the GSEs’ share had
fallen to only 27 percent of all mortgage
originations. Then the collapse of the
housing market in 2007 was associated
with a dramatic contraction in private
securitization, and the GSEs regained
their share of the market, in part by
buying and guaranteeing riskier loans
to resell in their MBS, as we will show.
In September 2008, their losses mounting, they entered government conservatorship. With the private securitization
market still essentially dormant, the
GSEs continue to play a large role in
housing markets, guaranteeing over 60
percent of new mortgages.

FIGURE 1
GSE MBS as Share of Total Originations
Percent
70
60
50
40
30
20

THE GSEs’ IMPACT
ON HOUSING MARKETS
A central motivation behind
setting up the GSEs was to facilitate
homeownership, particularly for lowincome households. Underlying this
goal is a belief that society benefits
when more people own their homes.4
This goal explains both the preferential treatment the GSEs received —
mainly implicit government support,
which lowered their cost of borrowing,
and exemption from state and federal
taxes and from securities regulation
— as well as the mandates that were
placed on the GSEs to promote affordable housing. The GSEs have supported the housing market in various
ways: by providing liquidity, facilitating
lending to low-income homebuyers,
and purchasing privately originated
mortgage-backed securities for their
own portfolios. As we will see, it is not
clear that these efforts have always
achieved their goals.
The GSEs’ funding advantage:
Who benefits? Because of the GSEs’
quasi-governmental status, investors
believed that the federal government
would support the GSEs if they ran into
difficulty. So investors were willing to
lend to them at lower rates. In principle, much of this funding advantage
could have been passed on to homeowners in the form of lower mortgage
interest rates. But it is also possible
that since the GSEs did not face much
competition, some of this advantage
accrued to other parties. For example,
mortgage rates could have remained
high, and the GSEs could instead have
used the profit resulting from their low
funding costs and the higher mortgage
interest rates to pay their employees

10

It should be noted, however, that promoting homeownership may have social costs; for
example, it may divert investment away from
other, possibly more productive, uses. For an
assessment of the economic costs and benefits
of homeownership, see the 2010 Business Review
article by Wenli Li and Fang Yang.

4

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: Inside Mortgage Finance.

12 Q1 2015 Business Review

www.philadelphiafed.org

and management generously or to lobby
government officials, or they could
have passed it onto their shareholders
in the form of higher dividends.
By comparing the yield on the
GSEs’ bonds with those of other highly
rated financial institutions, Wayne
Passmore, Shane Sherlund, and Gillian
Burgess (2005) first determine that the
GSEs’ funding advantage was approximately 20 to 40 basis points, depending on the comparison group. Moreover, they conclude that while some of
this funding advantage was passed on
to homeowners in the form of lower
interest rates, much was not. They find
that interest rates on mortgages eligible
to be purchased by the GSEs (known
as “conforming” mortgages) averaged
about 7 basis points below rates on
mortgages with similar terms (such
as loan-to-value ratios) but that were
too large to be purchased by the GSEs
(known as “jumbo” mortgages).5 It is
also important to note that this lower
cost was in essence a transfer from taxpayers, who were on the hook for this
implicit guarantee, to homeowners. As
we discuss next, however, these lower
interest rates do not necessarily capture all of the benefits that the GSEs
provided to the housing market.
The GSEs enhanced the secondary mortgage market. By virtue of
their size, the GSEs have facilitated
the standardization of the mortgage
market. For example, through the development of automated underwriting
procedures, the GSEs have established
fairly clear criteria for which loans they
will buy. For homeowners who can
meet these standards, as well as for
lenders, this standardization substantially reduces uncertainty. (As we will
discuss, many of the reform proposals

The GSEs are restricted to purchasing mortgages below the conforming loan limit, which is
set yearly by their regulator. Until mid-2007 this
limit was the same across most of the United
States.
5

www.philadelphiafed.org

try to maintain these benefits.)
In addition, this standardization
enhances liquidity in the secondary
mortgage market. James Vickery and
Joshua Wright point out that the uniformity of the underwriting standards
the GSE used, along with the safety
that an implicit government guarantee
provided to investors, was important
in enabling the GSEs to trade in what
is known as the to-be-announced, or
TBA, market. A unique feature of the
secondary market for GSE-guaranteed
mortgages is that many MBS pools
actually trade before the underlying

they will be unable to sell the mortgages they originate. Second, it makes it
less expensive for homeowners to lock
in interest rates. By comparing interest
rates on GSE-insured mortgages eligible to trade in the TBA market with
those that are not, Vickery and Wright
estimate that the overall effect of TBA
trading is to lower interest rates on
GSE-insured mortgages by 10 to 25
basis points.
In addition to the benefits that
arise from TBA trading, the GSEs
have provided a backstop for the
mortgage market during times of stress.

By virtue of their size, the GSEs have
facilitated the standardization of the
mortgage market.
mortgages are even originated. In this
TBA market, the GSEs and the buyers
of these securities agree on their general terms — the coupon rate, issuer,
approximate face value, and price.
However, the parties do not determine
the precise mortgages that will be
pooled until just before the settlement
date, which can be several months
after the initial trade. Vickery and
Wright state that over 90 percent of all
MBS trading takes place in the TBA
market. Another reason that GSE
MBS are able to trade in the TBA
market is that they are exempt from
Security and Exchange Commission
registration requirements.6
There are at least two benefits
from TBA trading of GSE MBS. First,
it makes it easier for lenders to hedge
their pipeline risk — that is, the risk

6
In general, companies seeking to issue securities to the public must file a registration statement detailing the securities’ characteristics and
the risks the companies face. Were the GSEs
not exempt from registration requirements, they
would be unable to trade in the TBA market, as
the individual mortgages backing the MBS are
determined only after issuance.

For example, Vickery and Wright find
that conforming interest rates fluctuated much less than jumbo ones during
the financial crisis. Similarly, Andreas
Fuster and Vickery show that the share
of fixed-rate mortgages in the conforming mortgage market was stable
during the financial crisis, while in the
jumbo market the share of fixed-rate
mortgages fell dramatically during this
period. They attribute this difference
to the fact that lenders who offered
jumbo loans became more reluctant to
originate fixed-rate mortgages during
the crisis because of the likelihood
that they might be forced to hold them
to maturity and thus incur substantial
interest rate risk.7 This was not the
case for the conforming market, where
the GSEs continued to securitize
loans. More generally, Joe Peek and
James Wilcox show that residential
investment — for example, new home

7
Interest rate risk refers to the tendency of debt
securities with fixed interest rates to fall in price
when prevailing interest rates in the market rise.
For more on interest rate risk, see www.sec.gov/
investor/alerts/ib_interestraterisk.pdf.

Business Review Q1 2015 13

construction and renovations — as a
share of GDP became more stable as
the GSEs securitized more mortgages.
This stabilization occurred, they argue,
because securitization made mortgage
lending less dependent on banks and
thus less sensitive to both regional and
general fluctuations in the economy.
Congressional mandates to promote affordable housing. Starting in
1992, Congress required Fannie and
Freddie to dedicate a certain fraction
of their mortgage activity to low-income and underserved borrowers and
markets. The GSEs were also permitted to meet these affordable housing
goals by purchasing portions, or tranches, of securities containing privately
securitized loans (mainly subprime and
alt-A) that met these criteria. These
goals were raised over time until 2008,
when HUD determined that the collapse of the housing market had made
meeting them infeasible.8
The adoption of these mandates
raises important questions: First, to
what extent did the GSEs’ affordable
housing goals actually expand the
supply of credit to households who
otherwise would not have received
mortgages? Second, did these mandates lead the GSEs to take on more
risk than they otherwise would have?
That is, did these goals have a significant impact on GSE mortgage
purchases and guarantees or on their
purchases of mortgage-backed security
tranches? And if so, did the purchases
and guarantees induced by these goals
contribute to their overall risk?
Neil Bhutta considers one goal,
the underserved area goal, from the
mid-1990s through 2003. A loan
counted toward the goal if it was for an

8
For more on the GSE goals and how they
changed over time, see the FHFA’s Mortgage
Market Note 10-2. Also note that other federal
policies that do not involve the GSEs also encourage low-income homeownership, such as the
Community Reinvestment Act, which imposes
mandates on commercial banks and thrifts.

14 Q1 2015 Business Review

owner-occupied home in a census tract
where either (a) the median family income did not exceed 90 percent of the
median for the whole metro area, or
(b) at least 30 percent of the residents
were minorities and the median family
income did not exceed 120 percent of
the median for the metro area. Bhutta
compares loans just above and below
these thresholds and finds that goal
eligibility increased the likelihood that
a mortgage was purchased by the GSEs
by about 4 percent. This effect is statistically significant but economically
very small, suggesting that these goals
did not have an important influence
on the types of loans that the GSEs directly purchased and thus probably did
not increase their risk by very much.
As we have discussed, the GSEs
were also able to meet their goals
through purchases of privately securitized MBS tranches. So it is also
important to determine the extent to
which the housing goals influenced
the development of this market. Andra
Ghent and others study this question also by using the discrete cutoffs
for goal-eligible loans. Examining
the mortgages included in privately
securitized MBS tranches, they do not
find any clustering of loans around
the eligibility cutoffs for GSE goals.9
They also do not find that the interest
rates for loans just below the cutoffs
were lower, which would indicate an
attempt to increase the share of goaleligible loans in these securities. They
thus conclude that the GSE housing
goals did not have a significant impact
on subprime MBS originations.
To sum up, it would be fair to say

9
For example, if the underserved area goal discussed above had a significant impact on the
subprime MBS market, then one would expect
to see a disproportionate share of mortgages
in these private MBS pools that were made to
borrowers with incomes just below 90 percent
of the area median, which is the cutoff for this
goal. The authors do not observe this pattern,
however.

that the existing evidence suggests the
housing goals played a minor role, at
most, in expanding the subprime mortgage market and, consequently, in increasing the risk that the GSEs took on.
THE GSEs DURING
THE BOOM AND BUST
The GSEs lost market share
during the housing boom. During
the housing boom, the share of first
mortgages originated that were GSEguaranteed fell dramatically — from
49 percent in 2003 to only 27 percent
by 2006. By contrast, the privately
securitized share grew dramatically
during this time (see Figure 1). There
are several possible causes for this
shift. First, banks found it more attractive to invest in non-GSE MBS
— particularly in the tranches with
the highest credit ratings — after the
capital requirements for these securities were lowered in 2002. In addition, the GSEs were under increasing
scrutiny following accounting scandals
in the early 2000s and may have been
less able to respond to the growth of
the private sector.10 As discussed by
Marsha Courchane, Rajeev Darolia,
and Peter Zorn, the Federal Housing
Administration also experienced a
decline in market share through 2006,
followed by a recovery beginning in
2007. They suggest that this decline
was due, at least in part, to the rise
and collapse of the subprime market.
In Table 1 we examine the
evolution of mortgage underwriting
standards over time across the various market segments. In particular,
we compare characteristics of loans
in GSE-guaranteed MBS with those
in privately securitized MBS and to

For example, on December 21, 2004, the
Office of Federal Housing Enterprise Oversight
pointed to earnings restatements resulting from
Fannie Mae’s accounting problems in designating it “significantly undercapitalized”; this
subjected Fannie Mae to greater oversight.

10

www.philadelphiafed.org

loans retained by banks in their own
TABLE 1
portfolios. Observe that during the
boom years of 2003 to 2006, the GSEs
Risk Profiles of Underlying Loans:
did not appear to dramatically reduce
GSE MBS vs. Others					
their underwriting standards, whereas
those mortgages that were sold as
FICO <660 LTV >80% Piggyback CLTV >80% PMI
part of private securitizations were far
GSE
12%
12%
8%
23%
14%
riskier: They had lower FICO scores
2003 Private Securitized
10
10
11
25
9
and higher combined loan-to-value
11
(LTV) ratios.
Portfolio
20
16
12
32
12
In a paper with Viral Acharya,
I examine the dynamics of the GSEs
GSE
15
12
14
30
15
and the private sector during the
2004 Private Securitized
26
15
21
42
12
housing boom and its aftermath and
Portfolio
24
15
17
38
9
identify the following factors that
contributed to the decline in the GSE
GSE
15
12
17
34
13
share. First, we show that as house
2005 Private Securitized
34
17
25
49
8
prices rose, private lenders were able
Portfolio
19
14
22
43
5
to lend larger amounts than the GSEs
were permitted to guarantee, including
GSE
17
15
19
40
14
cash-out refinancings to homeown2006 Private Securitized
41
19
27
54
4
ers who wanted to take advantage of
Portfolio
19
22
18
44
5
their homes’ rise in value by replacing
their GSE-guaranteed mortgages with
GSE
20
23
15
45
26
jumbo mortgages. In addition, as can
2007 Private Securitized
26
16
24
47
7
be seen in Table 1, borrowers who took
Portfolio
27
30
16
50
9
out privately securitized loans from
2003 to 2006 were much more likely to 						
Sources: Statistics on FICO, LTV, and PMI are from the Lender Processing Services (LPS)
take out second (“piggyback”) mortdata set. The figures for Piggyback and CLTV are from the merged LPS-Federal Reserve Bank
gages at the time of origination than
of New York/Equifax Consumer Credit Panel data set used by Bond et al. (2012).
were those with GSE-insured mortgagNotes: Values represent the percentage of total mortgages originated in that year and sector
es. This made these loans more attracwith these characteristics. FICO: Fair Isaac and Company consumer credit score. LTV: first
tive to borrowers seeking high-LTV
mortgage loan-to-value ratio. Piggyback: second mortgages. CLTV: combined first and second
mortgage loan-to-value ratio. PMI: private mortgage insurance.
mortgages, because the GSEs typically
required such borrowers to take out
relatively expensive private mortgage
mortgages in assessing the risk of prisector also expanded into areas with
12
13
insurance. This strategy may also
vate securitization. It also explains
many subprime borrowers and was also
have benefited from the fact that, until
why the first-mortgage LTVs were relamore likely to serve borrowers who had
2006, some credit rating agencies gave
tively low for borrowers with privately
never had a prior mortgage.
little weight to the presence of second
securitized mortgages, whereas their
The GSEs amassed large portcombined LTVs were much higher.
folios. While the GSEs lost market
Finally, the private securitization
share in mortgage originations, they
11
A FICO score is a credit score developed by
amassed large portfolios of privately
Fair Isaac and Company that rates a consumer’s
loan default risk based on his or her credit
securitized MBS. These portfolios
12
bureau file, with higher scores being predictive
Under their federal charters, the GSEs canpeaked at around $1.6 trillion in 2003
of lower rates of default. LTV denotes the ratio
not purchase a mortgage with an LTV above
between the mortgage balance and the value
of the property securing that mortgage; higher
LTV ratios are associated with higher default
rates because, for instance, the homeowner
has less of his or her own money at stake. See
Elul and others (2010), which quantifies the
relationship among credit scores, LTV ratios,
and mortgage default.
www.philadelphiafed.org

80 percent unless either (a) the portion above
80 percent is insured by a qualified mortgage
insurer, (b) the seller agrees to repurchase or
replace the loan in case of default, or (c) the
institution that sells the loan retains at least a
10 percent stake. In practice, the GSEs typically
require private mortgage insurance if the loan
exceeds 80 percent of the value.

13
For example, until it introduced a new model
on July 1, 2006, Standard & Poor’s ignored the
presence of second mortgages when rating subprime MBS as long as fewer than 30 percent of
the underlying borrowers had second mortgages.
See Michael Kling (2006).

Business Review Q1 2015 15

and remained at that level through
2008.14 The GSEs generally purchased
the least risky, AAA-rated tranches
of MBS containing subprime or alt-A
mortgages — loans that they were reluctant to purchase and guarantee directly. Notwithstanding their initially
high ratings, many of these tranches
later defaulted or were downgraded,
leading to large losses.
As we discuss, concern regarding
the risk of their portfolios certainly
played a role in pushing the GSEs
into conservatorship. So why did they
maintain such large portfolios? One
possible reason is that they appeared
to be very profitable, as the GSEs were
able to issue short-term bonds at low
interest rates and use the proceeds to
buy AAA-rated tranches of MBS paying high interest rates. According to
Dwight Jaffee, the spread between the
return they earned on these investments and their funding costs could
exceed 100 basis points; by contrast,
the spread on their guarantee business
was typically only 25 basis points. Furthermore, the required capital for holding the portfolios was sufficiently low
that it did not offset the high returns.
Nor, as we shall see, was the capital
adequate to cover their risks.15
Another reason for the growth of
the portfolios may be that the GSEs
were permitted to use them to meet
their housing goals, and the portfolios
did indeed contain many mortgages
that qualified toward meeting these
goals.16 We have already presented

One reason they did not grow after 2003 was
that the GSEs were under increased scrutiny
following their accounting scandals in the early
2000s.

14

15
While the capital requirements for banks were
similar in many respects to those for the GSEs,
only banks were subject to a leverage ratio
requirement (of 3 percent at the time). Indeed,
the GSEs had higher leverage than most banks.
For more on bank capital regulation, see my
2013 Business Review article. And for further
discussion of GSE leverage ratios, see Acharya
and coauthors (2011).

16 Q1 2015 Business Review

evidence that suggests that the GSE
housing goals did not encourage the
growth of the subprime MBS market.
One might also ask whether the GSEs’
large purchases of these MBS encouraged the private sector to make riskier
loans than they otherwise would have.
Manuel Adelino and his coauthors
suggest that the answer is no. They use
the fact that many privately securitized
pools had tranches designed to cater
specifically to the GSEs by including
only loans below the conforming loan
limit. They then show that the default
rate on GSE-eligible MBS tranches was
lower than on similar ineligible tranches. This suggests that, if anything, the
GSEs looked for safer loans in which
to invest. Taken together, this evidence suggests that the GSEs’ primary
motivation for investing in privately
securitized MBS was profit, not housing
goals, and that they did not significantly contribute to the development of
risky lending practices in this sector.
The GSEs guaranteed risky
loans in 2007 and regained much
of their market share. Sometime in
2006, the private securitization market
peaked and originations began to decline, particularly for subprime borrowers. This trend accelerated in the first
half of 2007 and by the middle of 2007
was evident even for prime MBS.17 In
addition, house prices peaked in 2006,
after rising for many years. Finally, the
share of homeowners who were past
due on their mortgages also began
to increase in mid-2006 (reaching 10
percent in 2010). As the private sector
pulled back, the GSEs expanded and
regained market share, guaranteeing
44 percent of all originations in 2007.18
We will argue that, in doing so, the
GSEs purchased and guaranteed loans
that were riskier in some dimensions

16

than in the past and may thus have
amplified the housing crisis.
In part, they did this by agreeing
to guarantee loans with high LTVs;
25 percent of all the loans the GSEs
purchased in 2007 had first-mortgage
LTVs above 80 percent; the comparable figure for 2006 was only 15
percent. Also, many of these loans
were refinancings of existing mortgages,19 which suggests that this was
an attempt to regain market share and
not simply a response to high house
prices that made it difficult for buyers
to come up with larger down payments. These high-LTV loans later
led to large losses, as they were made
when house prices were close to their
peak. Furthermore, unlike the private
securitization market in earlier years,
in which the combined LTV was often
shared between first and second lienholders, borrowers for the GSE-guaranteed loans originated in 2007 were less
likely to have second mortgages. Part
of the reason was that the GSEs relied
more on private mortgage insurance.
In addition, banks may have become
more reluctant to originate second
mortgages in 2007 amid signs that the
housing boom was ending. The GSEs
also began guaranteeing more loans to
riskier borrowers. The share of their
loans made to borrowers with credit
scores below 660 rose to 20 percent in
2007, from 17 percent in 2006 and just
12 percent in 2003.20
These borrowers were also subsequently much more likely to default,
and thus these loans made an outsize
contribution to the GSE losses. By
November 2012, 7 percent of loans
the GSEs had guaranteed in 2007
Total mortgage originations fell from roughly
$3 trillion in 2006 to $2.4 trillion in 2007.
Moreover, the dollar amount of originations not
guaranteed by the GSEs, FHA, or Veterans Administration fell 35 percent during this period.

18

See Scott Frame (2008).

See the 2013 Mortgage Market Statistical
Annual I.

19

Lender Processing Services data set.

20

See Table 1.

17

www.philadelphiafed.org

were either delinquent or already in
default, compared with 4 percent of
GSE-guaranteed loans originated
from 2003 to 2006. However, compared with privately securitized loans,
they were still much safer: The default
rate on the 2007 vintage for the latter
is 16 percent.21
Finally, in my paper with Acharya, we show more directly that this
expansion in the GSEs’ market share
led them to guarantee loans that were
riskier than those they had insured in
the past. We study the performance
of loans that the GSEs guaranteed in
2007, specifically by comparing those
borrowers who had previously taken
out privately securitized loans with
those borrowers whose previous loans
were GSE-insured. We find that the
former were nearly twice as likely to
default after just two years.22
Summarizing, although the decline in lending standards that led to
the housing crisis originated in the
private securitization market, the GSEs
amplified the crisis as they sought to
recapture market share when house
prices began to tumble.
GSE losses in the financial crisis. The GSEs experienced large losses
in the wake of the collapse of the housing market. Their write-downs on their
portfolio holdings totaled $57 billion by
the end of 2012. In addition, their losses on loans that they had guaranteed
ended up being far larger — reaching $235 billion by 2012. To gauge the
magnitude of these losses, it is useful
to compare them with the benefits that
the GSEs may provide, in particular in
the form of lower interest rates.23

21
These figures are from the Lender Processing
Services (LPS) data set. For further detail on
this data set, see Elul and coauthors (2010).

These statistics are from the merged Equifax–
LPS data set used in Bond et al. (2012).

22

Recall, however, that lower mortgage rates
might not constitute an unambiguous benefit
to society.

As discussed earlier, various studies have provided differing estimates of
the impact of the GSEs on mortgage
interest rates. For example, Vickery
and Wright determined that TBA
trading lowers mortgage rates by up
to 25 basis points. At the start of the
financial crisis, there was roughly $4.5
trillion in GSE MBS outstanding, with
an average interest rate of 6 percent.24

Although the decline in lending standards that
led to the housing crisis originated in the private
securitization market, the GSEs amplified the
crisis as they sought to recapture market share
when house prices began to tumble.
So, on the basis of their estimate, the
GSE benefit for these borrowers was
roughly $11 billion per year. Even
assuming that these borrowers had
kept these mortgages for 30 years, the
present value of these savings would
have totaled only $150 billion, or just
half of the GSE losses in the crisis. Of
course, this comparison does not account for the less tangible benefits the
GSEs provided, such as supporting the
mortgage market in times of crisis, or
the benefits they may have provided to
past and future borrowers.
As discussed earlier, many of the
loans that the GSEs guaranteed in
2007 were particularly risky. Furthermore, their risk was exacerbated
because the GSEs tended to lend the
entire balance and relied on private
mortgage insurance to cover losses in
excess of 80 percent LTV in case of default. However, several of these insurers shut down because of high losses,
and the ability of the remainder to pay
these claims was called into question.
Even though the GSEs’ portfolios

23

www.philadelphiafed.org

ended up being responsible for only
a small fraction of their losses — the
lion’s share was due to guarantees —
Diana Hancock and Wayne Passmore suggest portfolio losses played a
disproportionate role in the collapse
of the GSEs because of the portfolios’
size, opacity, and financing by shortterm borrowing that needed to be
rolled over quarterly. In particular, in

See the 2013 Mortgage Market Statistical
Annual II and LPS data set.

24

July 2008, financial markets became
concerned that the GSEs would not be
able to roll over their debt; as a result,
the Federal Reserve and U.S. Treasury
increased their support for the GSEs.
Another factor that exacerbated
the losses was weak oversight by the
Office of Federal Housing Enterprise
Oversight (OFHEO), which did not
clamp down on the risky behavior
described above and in July 2008 was
replaced by the newly created Federal
Housing Finance Agency (FHFA),
which had stronger regulatory powers.25 In September of that year, the
FHFA determined that the GSEs could
not “continue to operate safely and
soundly” and announced they would
enter conservatorship.26

The FHFA also replaced the Federal Housing Finance Board as the regulator of the 12
regional Federal Home Loan Banks, which lend
to local lenders to finance housing and other
economic activity. The OFHEO had been subject to criticism since at least 2002, in the wake
of the GSE accounting scandals. For further
detail on early efforts to strengthen the GSEs’
regulator, see Frame and White (2004).

25

26
Statement of James B. Lockhart, then
director of the FHFA, on September 7, 2008,
www.treasury.gov/press-center/press-releases/
Documents/fhfa_statement_090708hp1128.pdf.

Business Review Q1 2015 17

REFORMING THE GSEs
There have been many proposals
that suggest how to reform or replace
the GSEs. Although, as we shall see,
they differ along many lines, most
suggest curtailing the GSEs’ portfolios. One reason is that amassing large
portfolios does not appear to be central
to the GSEs’ role in housing markets.
Moreover, as noted above, their portfolios were an important contributor to
their entering conservatorship.
As early as 2004, Alan Greenspan, then chairman of the Federal
Reserve, had suggested that their portfolios be limited to $200 billion each,
about a quarter of what they had held
at the time. Legislation passed the following year did mention reducing the
portfolios as a goal but set no explicit
limits or timetable, an outcome widely
seen as a victory for the GSEs. Greenspan had also proposed raising their
capital ratios to match those required
of large banks, which arguably would
also have helped prevent their collapse.
Current reform proposals fall into
three classes that reflect the extent of
government involvement they envision: public, fully private, and hybrid.
Public models. The public proposals favor maintaining the government’s role in securitizing mortgages,
with an explicit government guarantee. One prominent example is
described by Hancock and Passmore.
They argue that mortgage securitization is inherently fragile and subject
to “runs” in which investors become
concerned about risks and become unwilling to supply further funding to the
market. There are several reasons for
this fragility. First, mortgages are paid
back over a long time, but banks tend
to fund these long-lived assets with
short-term liabilities such as demand
deposits that can be withdrawn at any
time. In addition, since a steep fall in
the housing market such as we saw in
the aftermath of the last recession is
so strongly correlated with a decline
18 Q1 2015 Business Review

in the rest of the economy, it would
be very difficult for a private party to
credibly insure against the risk of a
decline in the housing market because
a private insurer might also founder
in the ensuing economic contraction.27 Thus, they conclude, only the
government can stem runs by credibly insuring against the risk of a steep
and sustained fall in house prices.
Moreover, they point out that without
this government insurance, mortgage
lending might well end up being concentrated in the largest institutions,
with the risk effectively shifted to the
Federal Deposit Insurance Corporation
(FDIC), since investors would believe
that only these too-big-to-fail institutions would be safe. Finally, maintaining a formal government role would
allow the GSEs to be restructured in a
way that would leverage their expertise
and technology, and the TBA market
could be preserved.28
Private models. Fully private
models have also been proposed. One
of these, advanced by Jeb Hensarling
of the House Financial Services Committee, would wind down the GSEs
and set up a privately owned National
Mortgage Market Utility that would
maintain some of the benefits that the
GSEs provided, such as a standardized
securitization structure, but would be
prohibited from originating, securitizing, or guaranteeing mortgages or
mortgage-backed securities. Note that
this proposal makes it explicit that
there would be no government guarantee. The advantages over a public model include: Taxpayers would be protected (at least in theory). There would
be less scope for political interference

27
Indeed, this is precisely what happened to
several private mortgage insurers during the
financial crisis.
28
Recall that the GSEs’ exemption from SEC
registration requirements facilitated TBA
trading; fully private issuers, however, would not
be exempt.

such as housing goals. And without
a government guarantee, investors in
mortgage markets would be less likely
to take the kind of risks the GSEs did
such as amassing large portfolios of
subprime mortgage-backed securities.
Recall, however, that as Hancock and
Passmore point out, the risk might
shift to the FDIC, and the potential for
runs would remain.
Hybrid approaches. Between
these extremes lie the hybrid proposals. They generally have some sort of
government backstop, but with the
private sector absorbing a share of
the losses. They all propose winding
down the GSEs. One advantage of
the hybrid plans is that they maintain
a government guarantee, which can
help preserve liquidity in the mortgage
market, particularly in times of crisis.
On the other hand, they also conceive
of a role for the private sector, the
idea being that private institutions are
better run and less subject to political
pressure or that it would reduce the
risk of moral hazard.
Most hybrid proposals envision the
private sector absorbing the first losses
and the government providing insurance after that, in the “tail events.” For
example, the Corker-Warner Senate
bill has private entities covering the
first 10 percent of losses before the
government-provided catastrophic
coverage would kick in.29 A paper by
Toni Dechario and others envisions
a similar structure but also proposes
that a nonprofit cooperative owned by
banks that participate in the mortgage
market carry out securitization for its
members. This approach has several
advantages: Having a single entity carrying out securitization would make it
easier to set up a structure to continue
TBA trading. Individual lenders’ mar-

Corker-Warner Housing Finance Reform and
Taxpayer Protection Act (s.1217), www.gpo.
gov/fdsys/pkg/BILLS-113s1217is/pdf/BILLS113s1217is.pdf.

29

www.philadelphiafed.org

ket power would be checked, putting
small banks on a more even footing.
Members would have an incentive to
monitor one another. And insuring
against tail risk would be simplified,
since the cooperative would buy insurance for its members.
Two other papers propose different hybrid structures. David Scharfstein and Adi Sunderam’s paper puts
more emphasis on the private market
than do other hybrid proposals. The
private market would provide credit
and guarantee most loans except in
times of crisis. During normal economic times, the government guarantor would be limited to 5 percent to 10
percent of the total market. If a crisis
were declared, however, the government guarantor would be allowed to
expand its market share in order to
stabilize the mortgage market. The
rationale behind this structure is that,
as we have seen, the primary benefit
the GSEs provide is during crises, so it
makes sense to limit the guarantee to
when it is needed. The main disadvantage is that it would be difficult to
determine when a crisis is occurring,
and the formal declaration would be
politically fraught.

www.philadelphiafed.org

Acharya and others (2011) propose a different structure: a publicprivate partnership that would share
risk. A private insurer would guarantee 25 percent of losses. At the same
time, the government would provide
capital to reinsure the remaining 75
percent of the risk. That is, for every
dollar lost, the private sector would
cover 25 cents and the government 75
cents. The advantage of this approach
is that it would allow the price of the
insurance to be set by the private market, which may be better at pricing the
guarantee; the government has a history of underpricing it, which creates
incentives to take risks.
CONCLUSIONS
One of the significant events of
the financial crisis was the collapse of
the GSEs in 2008. While the GSEs
were not at the forefront of the housing
bubble, they had also modestly lowered
their lending standards from 2003 to
2006. Nevertheless, their market share
shrank in favor of private securitization. And as the housing market was
collapsing in 2007 and private securitizers withdrew, the GSEs dramatically
increased their market share and risk,

which led to elevated default rates. In
addition, they amassed large portfolios
of privately securitized MBS, which
also led to significant losses and played
an important role in their collapse.
The GSEs’ risk-taking, in both the
sphere of their guarantee activity and
in their portfolios, appears to have
been driven primarily by a desire for
profit. Evidence suggests that their
affordable housing goals played only a
small role, at most.
Several proposals aim to reform or
replace the GSEs. Many of them envision a continued role for the government in providing a backstop in times
of stress, though all of them argue
against allowing the GSEs to maintain
large portfolios.
What is still not well understood
is the interaction between government intervention in the mortgage
market and the private sector — both
during the bubble years and as the
housing market started to collapse
— and whether this interaction may
have increased incentives for all parties to take risks. BR

Business Review Q1 2015 19

REFERENCES
Acharya, Viral V., and Ronel Elul. “GSEs
Versus Banks: The Quest for Market
Share and a Race to the Bottom,” forthcoming manuscript, 2015.
Acharya, Viral V., Matthew Richardson,
Stijn van Nieuwerburgh, and Lawrence
J. White. Guaranteed to Fail: Fannie Mae,
Freddie Mac, and the Debacle of Mortgage
Finance, Princeton: Princeton University
Press, 2011.
Adelino, Manuel, W. Scott Frame, and
Kristopher Gerardi. “The Role of Large
Investors in Debt Markets: Fannie Mae,
Freddie Mac, and Subprime MBS,” manuscript (May 2013).
Bond, Philip, Ronel Elul, Sharon GarynTal, and David Musto. “Does Junior Inherit? Refinancing and the Blocking Power of
Second Mortgages,” Federal Reserve Bank
of Philadelphia Working Paper 13-3 (2012).
Bhutta, Neil. “GSE Activity and Mortgage
Supply in Lower-Income and Minority
Neighborhoods: The Effect of the Affordable Housing Goals,” Journal of Real
Estate Finance and Economics, 45:1 (2012),
pp. 238-261.
Courchane, Marsha, Rajeev Darolia, and
Peter Zorn. “Industry Changes in the Market for Mortgage Loans,” Connecticut Law
Review, 41:4 (May 2009), pp. 1,143-1,175.
Dechario, Toni, Patricia Mosser, Joseph
Tracy, James Vickery, and Joshua Wright.
“A Private Lender Cooperative Model for
Residential Mortgage Finance,” Federal
Reserve Bank of New York Staff Report,
466 (August 2010).
Elul, Ronel. “The Promise and Challenges
of Bank Capital Reform,” Federal Reserve
Bank of Philadelphia Business Review
(Third Quarter 2013).
Elul, Ronel. “The Economics of Asset
Securitization,” Federal Reserve Bank of
Philadelphia Business Review (Third Quarter 2005).

20 Q1 2015 Business Review

Elul, Ronel, Nicholas S. Souleles, Souphala
Chomsisengphet, Dennis Glennon, and
Robert Hunt. “What ‘Triggers’ Mortgage
Default?” American Economic Review
Papers and Proceedings, 100:2 (May 2010),
pp. 490-494.
Federal Housing Finance Administration.
“The Housing Goals of Fannie Mae
and Freddie Mac in the Context of the
Mortgage Market: 1996-2009,” Mortgage
Market Note 10:2 (February 1, 2010),
www.fhfa.gov/PolicyProgramsResearch/
Research/PaperDocuments/20100201_
MMNote_10-2_508.pdf.
Frame, W. Scott. “The 2008 Federal
Intervention to Stabilize Fannie Mae and
Freddie Mac,” Journal of Applied Finance,
18:2 (2008), pp. 124-136.
Frame, W. Scott, and Lawrence J. White.
“Regulating Housing GSEs: Thoughts on
Institutional Structure and Authorities,”
Federal Reserve Bank of Atlanta Economic
Review (Second Quarter 2004).

Kling, Michael J. “Tougher Rating Criteria
May Impact Issuers,” MortgageOrb, 2:1
(July 2006), www.mortgageorb.com/e107_
plugins/content/content.php?content.1261.
Li, Wenli, and Fang Yang. “American
Dream or American Obsession? The Economic Benefits and Costs of Homeownership,” Federal Reserve Bank of Philadelphia Business Review (Third Quarter 2010).
Mortgage Market Statistical Annual I.
Bethesda, MD: Inside Mortgage Finance
Publications, 2013, p. 17.
Mortgage Market Statistical Annual II.
Bethesda, MD: Inside Mortgage Finance
Publications, 2013, p. 5.
Passmore, Wayne, Shane M. Sherlund, and
Gillian Burgess. “The Effect of Housing
Government-Sponsored Enterprises on
Mortgage Rates,” Real Estate Economics
(2005), pp. 427-263.

Fuster, Andreas, and James Vickery. “Securitization and the Fixed-Rate Mortgage,”
Federal Reserve Bank of New York Staff
Report 594 (January 2013).

Peek, Joe, and James A. Wilcox. “Housing,
Credit Constraints, and Macro Stability: The Secondary Mortgage Market and
Reduced Cyclicality of Residential Investment,” American Economic Review (2006),
pp. 135-140.

Ghent, Andra C., Rubén HernándezMurillo, and Michael T. Owyang. “Did
Affordable Housing Legislation Contribute
to the Subprime Securities Boom?” Federal
Reserve Bank of St. Louis Working Paper
2012-005B (2012).

Scharfstein, David S., and Adi Sunderam.
“The Economics of Housing Finance
Reform,” in Martin Neil Bailey, ed., The
Future of Housing Finance, Washington,
D.C.: Brookings Institution Press, 2011,
pp. 146-198.

Hancock, Diana, and Wayne Passmore.
“Catastrophic Mortgage Insurance and
the Reform of Fannie Mae and Freddie
Mac,” in Martin Neil Bailey, ed., The
Future of Housing Finance, Washington,
D.C.: Brookings Institution Press, 2011,
pp. 111-145.

Vickery, James, and Joshua Wright. “TBA
Trading and Liquidity in the Agency MBS
Market,” Federal Reserve Bank of New
York Economic Policy Review (May 2013).

Jaffee, Dwight M. “The Role of the GSEs
and Housing Policy in the Financial
Crisis,” Washington, D.C.: Financial Crisis
Inquiry Commission, (February 2010),
http://fcic-static.law.stanford.edu/cdn_
media/fcic-testimony/2010-0227-Jaffee.pdf.

www.philadelphiafed.org

Smart Money or Dumb Money:
Investors’ Role in the Housing Bubble
BY WENLI LI

W

hat drove the remarkable 50 percent rise in U.S. house
prices from 1996 to 2006 — and their dramatic 30
percent fall by 2011?1 To explain this historic cycle,
most research points to three factors: low interest rates,
the growth of subprime mortgages, and increasingly lax
lending standards.2 But there appears to be increasing evidence of
another important factor: speculation by individual investors. Investors
can improve market efficiency under certain circumstances. Yet, as this
article summarizes from recent research, they also have an outsize effect
on house price changes. To assess what part investors played in the
housing bubble, it will help to understand investor characteristics and
what factors drive their buying and selling.

HOW INVESTORS DIFFER
FROM TYPICAL HOMEOWNERS
Residential real estate investors
buy homes with no intention of living
1
Calculated using the Federal Housing Finance
Agency house price index deflated by the
headline consumer price index.
2
For example, John Taylor cites low interest
rates that he attributes to overly expansionary
monetary policy (although see Ben Bernanke’s
2005 remarks for a different view on the cause
of low rates). Yulia Demyanyk and Otto Van
Hemert find that mortgage quality had deteriorated for six years before the crisis and that
securitizers were aware of the trend. Atif Mian
and Amir Sufi closely correlate the increase
in securitization of subprime mortgages with
mortgage lending growth in zip codes where
subprime mortgages were prevalent but income
growth was not. Tim Landvoigt finds that
expectations of higher-than-average price gains
were greater at the beginning of the boom but
had nearly evaporated by 2004, two years before
the bust, while down payment requirements
continued to be relaxed throughout the boom.

in them. Some investors rent their
properties out, but most look to resell
them after a short holding period to
make a profit. Although ordinary
homeowners may also view owning a
home as an investment — one that
may yield a capital gain or loss when
they eventually sell it — their primary
motivation for buying a house is to
have a place to live — shelter.
For this article, I will focus on
individual investors as opposed to
institutional investors such as homebuilders, construction contractors, real
estate agencies, and financial firms.
Because data are limited, relatively
little is known at this point about institutional investors’ role in the housing
crisis. In addition, I will restrict the
discussion to single-family homes due
to data limitations.

Wenli Li is a senior economic advisor and economist at the Federal
Reserve Bank of Philadelphia. The views expressed in this article
are not necessarily those of the Federal Reserve. This article and
other Philadelphia Fed research and reports are available at www.
philadelphiafed.org/research-and-data/publications.

www.philadelphiafed.org

There are at least two reasons to
believe that housing transaction and
default costs — financial as well as
emotional — are lower for real estate
investors than for typical homeowners.
First, when selling its primary home, a
household needs to find an alternative
place to live and perhaps a new school
for the kids and a new mode of transportation to work. All these activities
take time and money. Second, if its
house is foreclosed upon, a household
may feel more stigmatized if the house
is its primary residence. Neighbors will
learn of the foreclosure more quickly
and may shun the family. Of course,
investors also strive to avoid losses on
their real estate assets, but for them
the fallout is chiefly financial, since
they don’t live in the house and so it is
less likely that other people will learn
about the foreclosure.
A simple model of housing investment. These lower costs make real
estate investors more price sensitive,
as outlined in a simple stylized model
that Zhenyu Gao and I constructed.
The basic elements of the model are
that households consume both housing
and nonhousing goods and that they
save exclusively by investing in housing, which is a simple way of focusing
attention on the role of investment
in housing. We assume that households are uncertain about their future
income and future house prices, which
are standard assumptions in models
of household consumption and saving
decisions. Our model is specialized
to draw out the implications of two
basic features of investment in housing.
Consistent with my description of real
estate investors, our model assumes
that households find it more expensive
Business Review Q1 2015 21

to buy and sell a primary residence
than an investment home and to default on a mortgage on a primary residence than on investment housing.
In this setup, only relatively rich
households that expect their incomes
to fall in the future, such as in retirement, will save by purchasing investment housing. In addition, because of
the lower transaction costs associated
with investment housing, households
that purchase investment housing are
more sensitive to current prices and
to expectations about future prices in
their buying and selling decisions than
are households that purchase only a
primary residence. For example, in our
model, demand for investment homes
will rise more than demand for primary residences in response to greater
optimism about future house prices.
Our model also makes predictions about household default rates and
credit standards. Because households
face lower costs when they default
on a second home than on a primary
home, pessimism about future prices
will lead to more defaults on mortgages
on investment homes than on ordinary homes. Of course, lenders are not
unaware of this phenomenon, so they
impose higher standards on borrowers
seeking to finance investment homes.
Lenders will require investment homebuyers to have higher incomes, lower
loan amounts, or higher mortgage
interest rates than required of ordinary
primary homebuyers.3
Real estate investors and market
efficiency. Because they are more
sensitive to current and expected price
movements, investors can significantly
influence prices in the residential market. Whether they improve market efficiency, however, depends on whether
they act with superior information and

on how they act based on that superior
information. In economics, market efficiency is defined as the degree to which
prices reflect all the relevant information.4 In the case of the housing market, this information would include local demographics, income distribution,
the labor market, land availability, zoning restrictions, public services, and so
on. Economists refer to such information as market fundamentals. Following
Friedrich Hayek’s Nobel prize-winning
insight, each investor’s information
drives individual buying and selling
decisions, which in turn are aggregated
in the market into a single statistic —
a price. Real estate investors improve
market efficiency if they keep prices in
line with market fundamentals by possessing and acting on superior information about those fundamentals. That is,

Real estate investors will not improve market
efficiency if they simply bet on future house price
movements based on past and current price
movements without any superior information.
the market becomes more efficient if,
through their experience or diligence,
investors do more than just guess about
the ultimate direction in which house
prices are headed.
For example, suppose real estate
investors correctly predict that there
will be an influx of immigrants to
the city that will increase demand
for housing. If this information is not
available to other homebuyers, then
investors will be more willing to purchase from sellers and more willing to
pay higher prices.5

4

This type of prediction illustrates the benefit
of examining a formal model in which households and lenders adjust to each other’s likely
behavior.
3

22 Q1 2015 Business Review

But real estate investors will not
improve market efficiency if they
simply bet on future house price
movements based on past and current
price movements without any superior information. For example, when
investors bet that the housing boom
would continue longer than implied by
market fundamentals, they effectively
boosted house prices even higher than
they would have risen had it not been
for investor speculation. Similarly,
when investors later bet that the housing bust would last longer than implied
by market fundamentals by unloading
their properties cheaply or defaulting,
they further depressed house prices
and exacerbated the bust. As we will
see, studies suggest that real estate
investors generally did not possess superior information.

See Fama (1965).

5
Real estate investors often fix up their investment homes before selling, thereby improving
the quality of the housing stock on the market.
This is, however, a separate argument from
market efficiency.

One might argue that in comparison with ordinary homeowners, there
are relatively few real estate investors
and so their effect may not be large.
However, Monika Piazzesi and Martin
Schneider show that even a relatively
small group of real estate investors can
have a large effect on house prices.
Unlike stocks, houses are not standardized assets traded in highly competitive markets. Instead, households
search for individual houses that suit
them and bargain with sellers over the
price. Once they have found a suitable
house, they cannot easily exchange
it for an equivalent house. In search
markets, where buyers search for sellers
and then bargain over prices, house
prices will reflect only actual transactions, no matter how sparse these
transactions are relative to the stock of
www.philadelphiafed.org

housing for sale. As a practical matter,
actual transactions (not the stock of
offer prices) are the primary source of
information for appraisals.6
In summary, real estate investors can drive up house prices without
spending substantial wealth or obtaining as large a market share as speculators in other markets, such as the
stock market, do.
INVESTOR SHARE OF DEMAND
SOARED THEN SANK
Interestingly, as a share of total
U.S. households, those that owned
investment homes did not fluctuate
much in the years leading up to and
following the bubble. According to the
Survey of Consumer Finances (SCF),
13 percent of households owned investment homes in 1989. The share
rose to 14 percent in 2007 but returned
to 13 percent in 2010. By contrast, the
share of households that owned their
primary residence moved up from 64
percent to 70 percent in 2007 and then
dropped back to 67 percent in 2010.
However, this more or less constant fraction of households that invested in residential real estate is misleading. According to the Federal Reserve
Bank of New York/Equifax Consumer
Credit Panel, the share of new mortgages taken out for home purchases (as
opposed to mortgage refinancings) by
households with more than one first
lien went from 20 percent in 2000 to
35 percent in 2006-07.7 In the four
states with the most dramatic house
price movements — Arizona, California, Florida, and Nevada — the rise
was from 20 percent in 2000 to 45
percent in 2006-07 (see Figure 1). In

6
See Leonard Nakamura’s 2010 Business Review
article in which he also discusses the problems
that arise in housing markets when too few
transactions take place to form accurate appraisals.
7

See Haughwout and his coauthors.

www.philadelphiafed.org

FIGURE 1
Average Number of Houses Investors Held
Rose Before Crisis
Share of new purchase mortgages taken out by households
carrying more than one first lien.
Number
of first liens
2
3
4+

Percent for U.S.
45
40
35
30
25
20
15
10
5
0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2003

2004

2005

2006

2007

2008

2009

2010

Percent for AZ, CA, FL, NV
45
40
35
30
25
20
15
10
5
0

2000

2001

2002

Source: Calculations by Haughwout and coauthors (2011) based on the Federal Reserve Bank of
New York/Equifax Consumer Credit Panel data set.

other words, although the fraction of
households that owned investment
homes didn’t change dramatically, the
average number of investment houses
they held increased prior to the crisis.8
This observation is consistent with
William Wheaton and Gleb Nechayev’s
calculation that in 2005, total housing

production exceeded household formation by 60 percent.9
Turning to the flow of buying and
borrowing for real estate purchases,
using Home Mortgage Disclosure Act
(HMDA) data, Gao and I calculate the
fraction of mortgage applications for
nonprimary residences as reported by

8
An alternative but complementary explanation
is that investors were buying and selling houses
so frequently — that is, flipping properties —
that the quarterly credit data were capturing
multiple mortgages between transactions.

9
As the U.S. Census Bureau defines it, a
household consists of all the people, related and
unrelated, who occupy a housing unit, including
any lodgers, foster children, wards, or live-in
domestic help.

Business Review Q1 2015 23

borrowers themselves and find a similar albeit less dramatic pattern than
Haughwout and his coauthors find (see
Figure 2). The fraction of mortgage
applications for nonprimary residences
went from a low of 5 percent in 2000
to a high of about 14 percent in 2006,
falling to less than 10 percent by 2010.
Applications in Arizona, Florida, and
Nevada rose and fell more steeply than
in the country as a whole.
Investors: Good credit risks who
made bad investments. As mentioned earlier, one popular narrative
of the housing crisis is that too many
homebuyers with low credit scores resulting from poor repayment histories
were able to get subprime mortgages.
More generally, many researchers have
pointed to a decline in credit standards
for all homebuyers, even those who
qualified for prime mortgages.10
Investors appeared creditworthy.
An examination of SCF data from

10

See Ronel Elul’s Business Review article.

2001, 2004, 2007, 2009, and 2010
reveals that owners of second and
investment houses actually had higher
incomes than those who owned only
their primary residences. For example,
the median income for owners of just
a primary residence was $31,176 in
2007 in 1980-84 dollars versus $46,645
for owners of second and investment
homes. In fact, in 2007, 90 percent of
those who owned investment homes
already owned their primary residence,
consistent with the theory that Gao
and I have outlined.
Calculations using HMDA data
confirm the pattern that incomes of
mortgage borrowers were noticeably
higher for investment homebuyers
than for typical homebuyers. In 2007,
the median income for primary mortgage applicants was $30,316 in 198084 dollars and $59,394 for nonprimary
mortgage applicants. Other data also
indicate that people with second or
investment mortgages had higher
credit scores on average than those
with just a primary mortgage.11 For

FIGURE 2
Investment Mortgages as Share
of Total Applications
Percent
35
United States
Florida
Nevada
Arizona
California

30
25

11
See my paper with Gao for data from LPS and
CoreLogic. Also, it is worth noting that both
the SCF and HMDA rely on what households
report about themselves. Comparing consumer
credit bureau data with loan-level mortgage
data, Haughwout and his coauthors discover
that households underreport how many first
liens they have.

20
15
10

Credit scores in those data sets range from
350 to 800.

12

5
0

example, in 2007 at the height of the
mortgage crisis, the median credit
score at the time of mortgage origination was 720 for owner-occupants
with prime-rate mortgages and 750 for
nonowner-occupants with prime-rate
mortgages. For subprime borrowers,
the median credit score was 630 for
owner-occupants as opposed to 663
for nonowner-occupants.12
But appearances can be deceiving. Despite their apparently superior
risk credentials, there is some evidence
that real estate investors may have
been more leveraged. All else equal,
more leveraged borrowers typically
pose more risk, as they are more vulnerable to declines in house prices and
in their own financial situation. Additionally, Gao and I find that among
prime-rate borrowers, investors tended
to take out riskier types of mortgage
contracts such as adjustable-rate and
interest-only mortgages more often
than did noninvestors.13 Empirically,
these types of mortgages have been
found to have higher rates of delinquency and default than traditional
fixed-rate mortgages.
Another telling phenomenon is
that many real estate investors were
out-of-town or distant buyers; that is,
they bought properties outside the
area where their primary residence was
located. Alexander Chinco and Christopher Mayer find that 12 percent of

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Sources: Calculations by Gao and Li (2012) using Home Mortgage Disclosure Act data.

24 Q1 2015 Business Review

13
With an interest-only mortgage, the borrower pays only the interest on the principal
for a set period, leaving the principal balance
unchanged. We use LPS Applied Analytics data
for prime mortgages and CoreLogic data for
subprime and near-prime mortgages.

www.philadelphiafed.org

single-family homes purchased in Las
Vegas by distant investors in 2000 were
resold within 24 months.14 By 2005,
that share had risen to 25 percent.
They find that compared with local
buyers, distant investors were less likely
to be well informed about local market
conditions. In that sense, distant investors may behave like so-called noise
traders in many financial markets who
buy and sell for reasons other than
market fundamentals. They speculate
and are not well informed.
Indeed, there is significant evidence that, rather than using market
fundamentals to predict where and
when prices would rise, investors
gravitated to areas where prices were
already rising rapidly, further fueling
excess short-term appreciation. Studying zip code-level mortgage demand,
Gao and I find that real estate investors responded more strongly to recent
local house price movements than did
people buying their primary homes.
In other words, investors were more
attracted to areas where single-family
house prices had risen rapidly.
Patrick Bayer, Christopher
Geissler, and James Roberts distinguish
between experienced versus inexperienced investors who purchased homes
in Los Angeles between 1988 and
2009 with the intention of quickly reselling them.15 The researchers define
experienced investors as those engaged
in buying and selling four or more
properties at a time.16 They find that
experienced investors bought homes
at below-market prices from motivated
sellers and resold them quickly and
that they invested in housing during

14

They use county deed records from DataQuick.

Bayer and his coauthors use home sales data
from DataQuick.

15

16
This is obviously not a perfect definition, as
those who flip four or more houses at a time can
still be very inexperienced. According to their
paper, only about 1 percent of purchases are
made by experienced investors.

www.philadelphiafed.org

both boom and bust years. In doing so,
these experienced investors did appear
to provide liquidity to the local housing market in addition to contributing
to market efficiency. Inexperienced
investors, on the other hand, invested
in periods and areas of rapid market
appreciation. Their speculative activity
increased sharply during the boom and
fell during the bust.
Finally, Chinco and Mayer document that many more out-of-town buyers than local investors bought homes
just before house prices peaked and on
average lost money on those investments, with the worst relative performance in those markets where prices
fell the most. Put simply, distant buyers
seemed overconfident and uninformed
about local housing market conditions.
In a nutshell, it appears that real
estate investors during the housing
bubble tended to buy high and sell low.
EFFECT OF INVESTORS ON
LOCAL HOUSE PRICES
All of this raises an important
question: Did real estate investors’ behavior influence local house prices as
theory predicts, fueling the boom and
prolonging the bust?
Analyzing house price movements and relative demand by real
estate investors by zip code, Gao and
I show that even after controlling for
local fundamentals including population growth, income growth, and the
unemployment rate, real estate investment helps predict house price movements. In the short run — within one
to two years — house prices appreciated more in areas with high percentages
of investment home purchases than
in areas where investment purchases
were scarce. However, after three to
four years, house prices in these areas
on average declined more significantly
than in areas where investment home
purchases were less prevalent.
For the Los Angeles area, Bayer
and his coauthors also find that a great-

er percentage of purchases by inexperienced investors predicts above-average
rates of appreciation for the area over
the next one to two years and belowaverage price increases over the following three years. Unlike experienced
investors and traditional homebuyers,
inexperienced investors kept buying
after prices peaked and held onto their
houses well after 2007, when house
prices had declined significantly.
Focusing on distant buyers, Chinco and Mayer show that an increase
in purchases by distant second-home
buyers as a fraction of total sales in a
metropolitan area predicts an increase
in house price appreciation rates in the
following year.
Another channel through which
real estate investors affect local house
prices is through their propensity to
default. There is strong evidence that
investors are more likely than owners
of just a primary residence to default
on their mortgages and thus depress
local house prices. For example, using the Federal Reserve Bank of New
York/Equifax Consumer Credit Panel,
Haughwout and his coauthors show
that investor-owned homes accounted
for more than 30 percent of mortgages
90 or more days delinquent in 2007.
Similarly, Gao and I find that for
prime mortgages, 90-day delinquency
rates were 14 percent higher for investors than for owner-occupants.17
Combining our results with those of
Atif Mian and Amir Sufi, we conclude
that increases in investment home
foreclosure rates further slowed house
price growth by 1.61 percent. Breck
Robinson and Richard Todd also find
that defaults and foreclosures occurred
more often among investor-owned
homes than owner-occupied homes.
Sorting out cause and effect.
When we see higher prices in markets where purchases by investors are

17

We use LPS Applied Analytics data.
Business Review Q1 2015 25

more prevalent, how do we know that
expectations of higher prices based on
market fundamentals are not causing
more investors to enter a particular
market? Or perhaps something else
altogether is causing both higher prices
and higher investor demand. Toward
this end, Bayer and his coauthors and
Chinco and Mayer analyze the timing
of speculative transactions and establish that buying by investors continued to rise after house prices peaked
and that sales by investors did not rise
until after house prices had begun to
decline. Put simply, investors had no
better information about local house
price dynamics than did traditional
homebuyers. Rather than accurately
reflecting the long-term outlook for
house prices, investor behavior fueled

short-term price movements and led to
a long-term price correction.18
CONCLUSION
Research into the causes of the
housing boom and bust has pointed
largely to credit-related factors such

Gao and I estimate the causal relationship
using a different strategy often employed in
economics, epidemiology, and other disciplines
when controlled experiments are not feasible
that relies on instrumental variables. We identified two instruments for investor demand —
state homestead exemptions, which protect a
portion of the value of a primary residence from
creditors’ claims in personal bankruptcy cases,
and the share of local employment in leisure
and hospitality — that are reasonably closely
related to investor demand but not related to
prices through any channel other than investor
demand. States with higher homestead exemp-

as low interest rates, the growth of
subprime mortgages, and increasingly
lax lending standards. However, as
this article has shown, recent evidence
strongly indicates that intense speculation by individual real estate investors
also significantly magnified the boom
and worsened the bust. BR

18

tions provide greater incentives to buy costlier
primary homes and thus should reduce the
relative share of investment home purchases.
The exemptions by themselves have no direct
effect on home prices. Similarly, leisure and
hospitality employment in a locality increases
the relative demand for vacation homes, which
are significantly more likely to be investment
homes, but has no other connection to local
home prices. See Gao and Li (2012). For the
mathematical reasoning behind the instrumental variable approach and the actual implementation, see Greene (2012).

REFERENCES
Bayer, Patrick, Christopher Geissler, and
James W. Roberts. “Speculators and Middlemen: The Role of Flippers in the Housing Market,” National Bureau of Economic
Research Working Paper 16784 (2011).
Bernanke, Ben. “The Global Saving Glut
and the U.S. Current Account Deficit,”
remarks at the Sandridge Lecture, Virginia
Association of Economists, Richmond, VA,
2005.
Chinco, Alexander, and Christopher
Mayer. “Noise Traders, Distant Speculators
and Asset Bubbles in the Housing Market,”
manuscript, Columbia University (2011).
Demyanyk, Yulia, and Otto Van Hemert.
“Understanding the Subprime Mortgage
Crisis,” Review of Financial Studies, 24:6
(2011), pp. 1,848-1,880.
Elul, Ronel. “What Have We Learned
About Mortgage Default?” Federal Reserve
Bank of Philadelphia Business Review
(Fourth Quarter 2010).
Fama, Eugene F. “The Behavior of StockMarket Prices,” Journal of Business, 38:1
(1965), pp. 34-105.

26 Q1 2015 Business Review

Gao, Zhenyu, and Wenli Li. “Real Estate
Investors and the Boom and Bust of the
U.S. Housing Market,” manuscript (2012).
Greene, William H. Econometric Analysis,
Seventh Edition, Upper Saddle River, NJ:
Prentice Hall (2012), pp. 228-229.
Haughwout, Andrew, Doonhoon Lee,
Joseph Tracy, and Wilbert van der Klaauw.
“Real Estate Investors, the Leverage Cycle,
and the Housing Market Crisis,” Federal
Reserve Bank of New York Staff Report 514
(2011).
Hayek, Friedrich. “The Use of Knowledge
in Society,” American Economic Review, 35
(1945), pp. 519-530.
Landvoigt, Tim. “Housing Demand During the Boom: The Role of Expectations
and Credit Constraints,” working paper
(2011).
Mian, Atif, and Amir Sufi. “The Consequences of Mortgage Credit Expansion:
Evidence from the U.S. Mortgage Default
Crisis,” Quarterly Journal of Economics,
124:4 (2009), pp. 1,449-1,496.

Nakamura, Leonard. “How Much Is That
Home Really Worth? Appraisal Bias and
House-Price Uncertainty,” Federal Reserve
Bank of Philadelphia Business Review (First
Quarter 2010).
Piazzesi, Monika, and Martin Schneider.
“Momentum Traders in the Housing Market: Survey Evidence and a Search Model,”
American Economic Review: Papers and
Proceedings, 99:2 (2009), pp. 406-411.
Robinson, Breck L., and Richard M.
Todd. “The Role of Non-Owner-Occupied
Homes in the Current Housing and Foreclosure Cycle,” Federal Reserve Bank of
Richmond Working Paper 10-11 (2010).
Taylor, John B. “Responses to Additional
Questions from the Financial Crisis
Inquiry Commission,” mimeo (November
2009), www.stanford.edu/~johntayl/
Responses%20to%20FCIC%20
questions%20John%20B%20Taylor.pdf.
Wheaton, William C., and Gleb Nechayev.
“Past Housing ‘Cycles’ and the Current
Housing ‘Boom’: What’s Different This
Time?” manuscript, Massachusetts Institute of Technology (2006).

www.philadelphiafed.org

Research Rap

Abstracts of
research papers
produced by the
economists at
the Philadelphia
Fed

Economists and visiting scholars at the Philadelphia Fed produce papers of interest to the professional researcher on banking, financial markets, economic forecasting, the housing market, consumer
finance, the regional economy, and more. More abstracts may be found at www.philadelphiafed.org/
research-and-data/publications/research-rap/. You can find their full working papers at
http://www.philadelphiafed.org/research-and-data/publications/working-papers/.

Using Bankruptcy to Reduce Foreclosures:
Does Strip-Down of Mortgages Affect the
Supply of Mortgage Credit?
The authors assess the credit market impact of mortgage “strip-down” — reducing the
principal of underwater residential mortgages
to the current market value of the property
for homeowners in Chapter 7 or Chapter 13
bankruptcy. Strip-down of mortgages in bankruptcy was proposed as a means of reducing
foreclosures during the recent mortgage crisis
but was blocked by lenders. The authors’ goal
is to determine whether allowing bankruptcy
judges to modify mortgages would have a large
adverse impact on new mortgage applicants.
Their identification is provided by a series of
U.S. Court of Appeals decisions during the
late 1980s and early 1990s that introduced
mortgage strip-down under both bankruptcy
chapters in parts of the U.S., followed by
two Supreme Court rulings that abolished it
throughout the U.S. The authors find that the
Supreme Court decision to abolish mortgage
strip-down under Chapter 13 led to a reduction of 3% in mortgage interest rates and an
increase of 1% in mortgage approval rates,
while the Supreme Court decision to abolish
strip-down under Chapter 7 led to a reduction
of 2% in approval rates and no change in interest rates. The authors also find that markets
react less to circuit court decisions than to
Supreme Court decisions. Overall, the authors’
results suggest that lenders respond to forced
renegotiation of contracts in bankruptcy, but
their responses are small and not always in
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the predicted direction. The lack of systematic
patterns evident in the authors’ results suggests
that introducing mortgage strip-down under
either bankruptcy chapter would not have strong
adverse effects on mortgage loan terms and could
be a useful new policy tool to reduce foreclosures
when future housing bubbles burst.
Working Paper 14-35. Wenli Li, Federal Reserve
Bank of Philadelphia; Ishani Tewari, Yale School of
Management; Michelle J. White, University of California, San Diego, Cheung Kong Graduate School of
Business; National Bureau of Economic Research.
Enhancing Prudential Standards
in Financial Regulations
The financial crisis has generated fundamental reforms in the financial regulatory system in
the U.S. and internationally. Much of this reform
was in direct response to the weaknesses revealed
in the precrisis system. The new “macroprudential” approach to financial regulations focuses on
risks arising in financial markets broadly, as well
as the potential impact on the financial system
that may arise from financial distress at systemically important financial institutions. Systemic
risk is the key factor in financial stability, but our
current understanding of systemic risk is rather
limited. While the goal of using regulation to
maintain financial stability is clear, it is not obvious how to design an effective regulatory framework that achieves the financial stability objective
while also promoting financial innovations. This
paper discusses academic research and expert
opinions on this vital subject of financial stability
and regulatory reforms. Specifically, among other
Business Review Q1 2015 27

issues, it discusses the impact of increasing public disclosure
of supervisory information, the effectiveness of bank stress
testing as a tool to enhance financial stability, whether the
financial crisis was caused by too big to fail (TBTF), and
whether the Dodd-Frank Wall Street Reform and Consumer
Protection Act (DFA) resolution regime would be effective
in achieving financial stability and ending TBTF.
Working Paper 14-36. Franklin Allen, Wharton School,
University of Pennsylvania, Imperial College London; Itay
Goldstein, Wharton School, University of Pennsylvania; Julapa
Jagtiani, Federal Reserve Bank of Philadelphia; William W.
Lang, Federal Reserve Bank of Philadelphia.
Banking Panics and Protracted Recessions
This paper develops a dynamic theory of money and
banking that explains why banks need to hold an illiquid
portfolio to provide socially optimal transaction and liquidity services, opening the door to the possibility of equilibrium banking panics. Following a widespread liquidation of
banking assets in the event of a panic, the banking portfolio
consistent with the optimal provision of transaction and
liquidity services during normal times cannot be quickly
reestablished, resulting in an unusual loss of wealth for all
depositors. This negative wealth effect stemming from the
liquid portion of the consumers’ portfolio is strong enough to
produce a protracted recession. A key element of the theory
is the existence of a dynamic interaction between the ability
of banks to offer transaction and liquidity services and the
occurrence of panics.
Working Paper 14-37. Daniel R. Sanches, Federal Reserve
Bank of Philadelphia.
Understanding House Price Index Revisions
Residential house price indexes (HPI) are used for a
large variety of macroeconomic and microeconomic research
and policy purposes, as well as for automated valuation models. As is well known, these indexes are subject to substantial
revisions in the months following the initial release, both
because transaction data can be slow to come in, and as a
consequence of the repeat sales methodology, which interpolates the effect of sales over the entire period since the house
last changed hands. The authors study the properties of the
revisions to the CoreLogic House Price Index. This index
is used both by researchers and in the Financial Accounts
of the United States to compute the value of residential real
estate. The authors show that the magnitude of revisions to
this index can be significant: At the national level, the ratio
of standard deviation of monthly revisions to the growth
rate of the index, relative to the standard deviation of the
growth rate in the index, is 29%, which is comparable to the
relative ratio for other macroeconomic series. The revisions
28 Q1 2015 Business Review

are also economically significant and impact measures used
by policymakers: Revisions over the first 12 releases of the
index reduce estimates of the fraction of borrowers nationwide with negative equity by 4.3%, corresponding to 423,000
households. Lastly, the authors find that revisions are ex-ante
predictable: Both past revisions and past house price appreciation are negatively correlated with future revisions.
Working Paper 14-38. Ronel Elul, Federal Reserve Bank of
Philadelphia; Joseph M. Silverstein, University of Pennsylvania;
Tom Stark, Federal Reserve Bank of Philadelphia.
House-Price Expectations, Alternative Mortgage
Products, and Default
Rapid house-price depreciation and rising unemployment were the main drivers of the huge increase in mortgage
default during the downturn years of 2007 to 2010. However,
mortgage default was also associated with an increased reliance on alternative mortgage products such as pay-option
and interest-only adjustable rate mortgages (ARMs), which
allow the borrower to defer principal amortization. The goal
of this paper is to better understand the forces that spurred
use of alternative mortgages during the housing boom and
the resulting impact on default patterns, relying on a unifying conceptual framework to guide the empirical work.
The conceptual framework allows borrowers to choose the
extent of mortgage “backloading,” the postponement of loan
repayment through various mechanisms that constitutes
a main feature of alternative mortgages. The model shows
that, when future house-price expectations become more
favorable, reducing default concerns, mortgage choices shift
toward alternative products. This prediction is confirmed by
empirical evidence showing that an increase in past houseprice appreciation, which captures more favorable expectations for the future, raises the market share of alternative
mortgages. In addition, using a proportional-hazard default
model, the paper tests the fundamental presumption that
backloaded mortgages are more likely to default, finding support for this view.
Working Paper 15-01. Jan K. Brueckner, University of
California, Irvine; Paul S. Calem, Federal Reserve Bank of
Philadelphia; Leonard I. Nakamura, Federal Reserve Bank of
Philadelphia.
Recourse and Residential Mortgages: The Case of Nevada
The state of Nevada passed legislation in 2009 that
abolished deficiency judgments for purchase mortgage loans
made after October 1, 2009, and collateralized by primary
single-family homes. In this paper, the authors study how the
law change affected lenders’ decisions to grant mortgages
and borrowers’ decisions to apply for them and subsequently
default. Using unique mortgage loan-level application and
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performance data, the authors find strong evidence that
lenders tightened their lending standards for mortgages affected by the new legislation. In particular, lenders reduced
approval rates and loan sizes for mortgages after implementation of the law. Borrowers, by contrast, did not delay their
mortgage applications until after the law change. Furthermore, the law change did not appear to have affected borrowers’ default decisions. These results cast a cautionary note
on the effectiveness of policy recommendations that intend
to use deficiency laws to curb mortgage defaults.
Working Paper 15-02. Wenli Li, Federal Reserve Bank of
Philadelphia; Florian Oswald, University College London.
Localized Knowledge Spillovers: Evidence from the
Agglomeration of American R&D Labs and Patent Data
The authors employ a unique data set to examine the
spatial clustering of private R&D labs, and, using patent
citations data, they provide evidence of localized knowledge
spillovers within these clusters. Jaffe, Trajtenberg, and Henderson (1993, hereafter JTH) provide an aggregate measure
of the importance of knowledge spillovers at either the state
or metropolitan area level. However, much information is
lost regarding differences in the localization of knowledge
spillovers in specific geographic areas. In this article, the
authors show that such differences can be quite substantial.
Instead of using fixed spatial boundaries, they develop a new
procedure — the multiscale core-cluster approach — for
identifying the location and size of specific R&D clusters.
This approach allows the authors to better capture the geographic extent of knowledge spillovers. The authors examine
the evidence for knowledge spillovers within R&D clusters
in two regions: the Northeast Corridor and California. In
the former, the authors find that citations are from three to
six times more likely to come from the same cluster as earlier
patents than in comparable control samples. The results are
even stronger for labs located in California: Citations are
roughly 10 to 12 times more likely to come from the same
cluster. The authors’ tests reveal evidence of the attenuation
of localization effects as distance increases: The localization
of knowledge spillovers is strongest at small spatial scales (5
miles or less) and diminishes rapidly with distance. At the
smallest spatial scales, the authors’ localization statistics are
generally much larger than JTH report for the metropolitan
areas included in their tests.
Working Paper 15-03. Kristy Buzard, Syracuse University; Gerald A. Carlino, Federal Reserve Bank of Philadelphia;
Robert M. Hunt, Federal Reserve Bank of Philadelphia; Jake
K. Carr, Ohio State University; Tony E. Smith, University of
Pennsylvania.

www.philadelphiafed.org

Housing over Time and over the Life Cycle:
A Structural Estimation
The authors estimate a structural model of optimal lifecycle housing and nonhousing consumption in the presence
of labor income and house price uncertainties. The model
postulates constant elasticity of substitution between housing
service and nonhousing consumption and explicitly incorporates a housing adjustment cost. The authors’ estimation
fits the cross-sectional and time-series household wealth and
housing profiles from the Panel Study of Income Dynamics
(1984 to 2005) reasonably well and suggests an intratemporal
elasticity of substitution between housing and nonhousing
consumption of 0.487. The low elasticity estimate is largely
driven by moments conditional on state house prices and
moments in the latter half of the sample period and is robust
to different assumptions of housing adjustment cost. The
authors then conduct policy analyses in which they let house
price and income take values as those observed between
2006 and 2011. The authors show that the responses depend
importantly on the housing adjustment cost and the elasticity of substitution between housing and nonhousing consumption. In particular, compared with the benchmark, the
impact of the shocks on homeownership rates is reduced, but
the impact on nonhousing consumption is magnified when
the house selling cost is sizable or when housing service and
nonhousing consumption are highly substitutable.
Working Paper 15-04. Supersedes Working Paper 09-7.
Wenli Li, Federal Reserve Bank of Philadelphia; Haiyong Liu,
East Carolina University; Fang Yang, Louisiana State University; Rui Yao, Baruch College.
Weather-Adjusting Employment Data
This paper proposes and implements a statistical
methodology for adjusting employment data for the effects of deviation in weather from seasonal norms. This is
distinct from seasonal adjustment, which only controls for
the normal variation in weather across the year. Unusual
weather can distort both the data and the seasonal factors.
The authors control for both of these effects by integrating a
weather adjustment step in the seasonal adjustment process.
They use several indicators of weather, including temperature, snowfall and hurricanes. Weather effects can be very
important, shifting the monthly payrolls change number by
more than 100,000 in either direction. The effects are largest
in the winter and early spring months and in the construction sector.
Working Paper 15-05. Michael Boldin, Federal Reserve
Bank of Philadelphia; Jonathan H. Wright, Johns Hopkins
University.

Business Review Q1 2015 29

History and the Sizes of Cities
The authors contrast evidence of urban path dependence with efforts to analyze calibrated models of city sizes.
Recent evidence of persistent city sizes following the obsolescence of historical advantages suggests that path dependence
cannot be understood as the medium-run effect of legacy
capital but instead as the long-run effect of equilibrium selection. In contrast, a different, recent literature uses stylized
models in which fundamentals uniquely determine city size.
The authors show that a commonly used model is inconsistent with evidence of long-run persistence in city sizes and
propose several modifications that might allow for multiplicity and thus historical path dependence.
Working Paper 15-06. Hoyt Bleakley, University of Michigan; Jeffrey Lin, Federal Reserve Bank of Philadelphia.
A Seniority Arrangement for Sovereign Debt
A sovereign’s inability to commit to a course of action
regarding future borrowing and default behavior makes longterm debt costly (the problem of debt dilution). One mechanism to mitigate the debt dilution problem is the inclusion
of a seniority clause in sovereign debt contracts. In the event
of default, creditors are to be paid off in the order in which
they lent (the “absolute priority” or “first-in-time” rule). In
this paper, the authors propose a modification of the absolute
priority rule that is more suited to the sovereign debt context
and analyze its positive and normative implications within a
quantitatively realistic model of sovereign debt and default.
Working Paper 15-07. Satyajit Chatterjee, Federal Reserve
Bank of Philadelphia; Burcu Eyigungor, Federal Reserve Bank of
Philadelphia.

30 Q1 2015 Business Review

Credit Risk Modeling in Segmented Portfolios:
An Application to Credit Cards
The Great Recession offers a unique opportunity to analyze the performance of credit risk models under conditions
of economic stress. The authors focus on the performance
of models of credit risk applied to risk-segmented credit card
portfolios. Specifically, the authors focus on models of default
and loss and analyze three important sources of model risk:
model selection, model specification, and sample selection.
Forecast errors can be significant along any of these three
model-risk dimensions. Simple linear regression models are
not generally outperformed by more complex or stylized
models. The impact of macroeconomic variables is heterogeneous across risk segments. Model specifications that
do not consider this heterogeneity display large projection
errors across risk segments. Prime segments are proportionally more severely impacted by a downturn in economic
conditions relative to the subprime or near-prime segments.
The sensitivity of modeled losses to macroeconomic factors
is conditional on the model development sample. Models
estimated over a period that does not incorporate a significant period of the Great Recession may fail to project default
rates, or loss rates, consistent with those experienced during
the Great Recession.
Working Paper 15-08. José J. Canals-Cerdá, Federal Reserve Bank of Philadelphia; Sougata Kerr, Federal Reserve Bank
of Philadelphia.

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