Monday, October 26, 2015

Housing, A Series: Part 72 - Bankers have a numeraire problem

Following up on yesterday's post, I think there is an interesting problem regarding mortgage financing and duration matching, and it ends up relating to the problem of the credit crisis and bailouts.

I can't remember the link, but recently I saw a nice piece about the very long term performance of bonds.  One of the interesting parts of the piece was a graph of short and long term bond yields.  In the 19th century, when we used various monetary regimes that tended to be tied to gold, etc., short term yields were volatile, and long term yields tended to be lower than short term yields.  This is because there tended to be currency shocks and bank panics, but over the long term currency value was tethered to a commodity, so there was significant mean reversion.

But, with a fiat currency, there is much less mean reversion.  So, I think it is more useful to think of long term bond yield spreads not so much as reflecting maturity risk or inflation risk, but instead as numeraire risk.  The numeraire we use is the dollar.  Since there is only one source for dollars, by law, then long term bonds really have Federal Reserve risk.

This is where banks are unavoidably intertwined with the federal government.  There are different kinds of risks that damage them with any sort of numeraire instability, whether it is deflationary or inflationary.

The risk that reared its head in this crisis was somewhat unique.  We informally implemented a set of monetary and regulatory policies that were based on the presumption that the collateral behind bank assets needed to be devalued.  There was never a policy statement that said as much, but we thought we knew prices were too high, the Federal Reserve pushed interest rates to levels that usually lead to economic contraction, and as home prices fell, everyone looked at each other and nodded.  Even now, talking about his new book, Ben Bernanke reviews that period of time and says, "Well, again, we were aware of the fact that house prices were very high. And we thought it quite possible that they would correct at some point."  And everyone nods, and says what a shame it was that the banks did this to us.

In 2006 and 2007, the Fed mostly pushed real estate values down by aggressively selling treasuries and reducing the present value of future rent payments with high real interest rates.  Eventually, demand was so hampered that even expected future nominal rent cash flows declined.  And, by the end of 2008, access to mortgage credit had been so undermined that home prices ceased to even reflect basic interest rate or rent expectations.  This is still the case.

So, while there are significant governance problems with all of the discretionary crisis-mode provisions that were made, if I think about even a firm like AIG, especially after the shareholders had been wiped out, I'm not sure there was a more appropriate place to set the risk of what remained than on the backs of taxpayers.  AIG basically took a large, unhedged position on the idea that the federal government wouldn't lose its mind with regard to managing the numeraire on financial contracts.  That clearly wasn't a good risk to take.  But, given that we have little choice about what numeraire to use, it seems reasonable to me that we should match the consequences of numeraire risk to the source of that risk.

Really, this is the reason Fannie and Freddie exist.  The problem isn't so much that it is hard to match maturities between mortgages and houses.  The problem is that homes are real assets (their value grows with inflation) and it would be very difficult to create a mortgage contract based on real terms.  Actually, some of the negative amortization mortgages that were being used late in the boom would address this problem, but they aren't exactly politically popular.  Since it is difficult to create mortgages with real terms, what banks have is a numeraire matching problem.  Even the problem of prepayments, which is a major factor in mortgage valuations, is a numeraire problem.  Most of the potential fluctuations in rates that lead to prepayments and refinancing are related to persistent inflation variation.

So, a default crisis that is bad enough for Fannie and Freddie to fail is probably due to numeraire shocks.  This is why I think, as long as we have a discretionary fiat currency regime, we probably need institutions like Fannie and Freddie.  And, if we need Fannie and Freddie, they probably should just be public institutions.

This is one of many problems that NGDP level targeting would solve.  It would create mean reversion in yields and currency values and would reduce numeraire risk.  I think it would lead to a less steep yield curve spread, which should lead to more long term investments.  But, I think if it worked well and became permanent and trusted, it would remove the numeraire problem in the mortgage market.  There wouldn't be as much of a problem regarding the matching of nominal mortgages with real homes.  There might still be some reasons for securitization, but there could be more liquid and safe private markets, and many of these governance problems in finance would be decreased.

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