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Ratings

Agencies

This paper examines the role of credit rating agencies in the subprime crisis that
triggered the 2007​–​2008 financial turmoil. We focus on two aspects of ratings
that contributed to the boom and bust of the market for structured debt: rating
inflation and coarse information disclosure. The paper discusses how regulation
can be designed to mitigate these problems in the future. Our preferred policy is
to require rating agencies to be paid by investors rather than by issuers and to
grant open and free access to data about the loans or securities underlying structured
debt products. A more modest (but less effective) approach would be to
retain the ‘issuer pays’ model but require issuers to pay an upfront fee irrespective
of the rating, ban ‘credit shopping’, and prescribe a more complete format
for the information that rating agencies must disseminate.
— Marco Pagano and Paolo Volpin

Credit ratings failures and


policy options
Marco Pagano and Paolo Volpin

Two issues fare prominently in this respect.


First, since 2007 even very highly rated structured debt products have performed
very poorly: the value of AAA-rated residential mortgage-backed securities
(RMBSs), as measured by the corresponding credit default swaps prices, fell by
70% between January 2007 and December 2008. Moreover, massive and severe
rating downgrades occurred in 2007 and 2008. This suggests that the initial ratings
of structured debt securities greatly understated their risk. Such ‘ratings inflation’

played a key role in the crisis: insofar as many naively based their investment in
these securities mainly or solely on inflated credit ratings, these led to a massive
mispricing of risk, whose correction later detonated the crisis.

Second, in the process of securitization and rating much detailed information


about the risk characteristics of the underlying assets was lost: ratings provide very
coarse and limited information about these characteristics. This information loss is
particularly serious in view of the heterogeneity of the collateral and the great complexity
of structured debt securities. Once a scenario of widespread default materialized,
this detailed information would have been essential to identify the ‘toxic
assets’ in the maze of existing structured debt securities, and to price them correctly.
Absent such information, structured debt securities found no buyers, and
their market froze. So the information loss involved in the process of securitization
and rating is largely at the source of the illiquidity that plagued securities markets
since the crisis broke out.

The common source of both of these failures of credit ratings is an incentive


problem: CRAs are paid by issuers, so that their interest is more aligned with that
of securities’ issuers than with that of investors.

Moreover, in the case of ratings the problem is exacerbated by the possibility


for issuers to engage in ‘rating shopping’, by soliciting only the most favourable
rating among those potentially available from competing agencies.

Issuers benefit from rating inflation if at least some investors are naive, that is,
do not realize that ratings are excessively optimistic. In this situation, rating inflation
leads to under-pricing of risk. A similar situation occurs even if all investors
are rational, but regulation forces them to buy highly rated securities (for instance,
only AAA-rated ones) and these are in scarce supply. A third possibility is that these
investors are rational portfolio managers who have an excessive incentive to take
risk, even when it is mispriced.

Ratings’ inflation and low informativeness may also reinforce each other. To the
extent that investors are rational, they will see through CRAs’ incentives to inflate
ratings and therefore will consider them as relatively uninformative. Conversely, the
coarseness of ratings may reinforce the tendency to inflate them, as it expands the
room for collusion between issuer and rating agency, and therefore the conflict of
interest with investors. For instance, if ratings are set on a discrete scale, friendly
rating agencies can suggest to issuers how to structure their securities or tranches so
as to just attain a given rating. So in each rating class a disproportionate number
of issues or tranches will have a risk corresponding to the low end of that class.
This enhances ratings inflation compared to a situation where ratings are set on a
finer grid.

First, since both of the problems discussed above


arise from the conflict of interest between CRAs and investors, it is of essence to
eliminate (or at least reduce) this conflict by addressing the issue of ‘who pays’. If
rating agencies are tempted to please issuers by inflating their credit ratings and/or
by choosing excessively coarse ratings, the most appropriate solution is to have
investors – not issuers – pay for their services, as indeed was the case before the
1970s. But switching from the ‘issuer pays’ to the ‘investors pay’ model may not be
easy to implement in practice, because free-riding or information leakage could
erode CRAs’ revenues and thus their incentives to produce informative ratings.
This would in turn require regulators to reduce (or eliminate) the reliance of bank-
ing and security regulations on ratings. Moreover, to reap the benefits from the
‘issuer pays’ model one must prevent indirect payments by issuers to CRAs in the
form of the purchase of consulting or pre-rating services.

Second, in order to increase transparency, issuers should disclose the complete


data about the pool of loans (or bonds) underlying their structured finance products,
so that buy-side investors may feed them into their own models to assess
their risk characteristics. Clearly, many buy-side investors would not have the technical
skills to do this, and would stay away from securitized products. This will
constrain issuance of these securities, at least until new specialized information
processors enter the fray to supply financial advice to investors, in competition
with CRAs.

Such sweeping changes will meet not only the likely opposition of CRAs, but also
that of regulators, due to their considerable transitional costs. Therefore, policymakers
may also want to consider a second-best policy, which tries to address the
above-discussed problems without overhauling the current setup. Specifically, they
may retain the ‘issuer pays’ model but constrain the way in which agencies contract
with issuers and are paid by them: issuers should pay an upfront fee irrespective of
the rating issued (the so-called ‘Cuomo plan’, named after New York Attorney
General Andrew Cuomo), and credit shopping should be banned. Similarly, regulators
could enhance transparency not by forcing issuers to grant open and free
access to all relevant data, but simply by prescribing a more complete and detailed
format for the information that CRAs must disseminate.

These more limited reforms may still be consistent with the current regulatory
delegation of vast powers to a select group of rating agencies. But their effectiveness
in addressing the failures of CRAs exposed by the current crisis is likely to be limited.
First, even if issuers must pay an upfront fee and cannot engage in explicit rating
shopping, implicit collusion may still be sustainable: issuers may systematically
patronize the agency that offers them the best ratings, which they can identify by
comparing the models that agencies use to rate securities.

Second, prescribing which pieces of information and statistics CRAs should disseminate
would shift the burden of identifying such information on the regulator,
which can be complex in the presence of very diverse financial products. It may
also expose such detailed regulation to the danger of becoming rapidly outdated in
the presence of innovations in the design of structured debt securities, some of
which may even be induced by regulation itself.

In contrast, an open-access, non-prescriptive approach by regulators would shift


on issuers and investors the burden of determining the pieces of information that
are most relevant to evaluate the risk of each security, and would not run the risk
of obsolescence. It would also reduce, instead of further increasing, the tangle of
regulations in this area. This is an instance in which less regulation might also be
safer and better regulation, in contrast to what is currently suggested by many.

2. SECURITIZATION PROCESS AND RATING AGENCIES


Asset-backed securities have been around for decades. However, between 2001 and
2006 there was a spectacular growth in the issuance of two new types of structured
debt products: subprime Mortgage Backed Securities (MBSs), and Collateralized
Debt Obligations (CDOs). Subprime MBSs are backed by pools of mortgage loans
that do not conform to the standards set by Fannie Mae and Freddie Mac because
of low Fair Isaac Corporation (FICO) score, poor credit history or limited documentation.
CDOs are backed by pools of corporate bonds and other fixed income
assets, or by portfolios of tranches of MBSs and other CDOs. As shown in Table 1,
between 2001 and 2006 the combined issuance of subprime MBSs and CDOs grew
ten times, from $100 billion to more than $1 trillion.
This remarkable growth in the market for asset-backed securities would have
been impossible without the help of CRAs. The reason is simple: for this market to
succeed, it needed to attract the large pool of institutional investors that are subject
to rating-based constraints. In other words, the market for subprime MBSs and
CDOs needed to be a ‘rated’ market, in which the risk of tranches was assessed by
CRAs using the same scale as bonds. In that way, the rating provided access to a
pool of potential buyers, who would have otherwise perceived these securities as
very complex and would have possibly shied away from them. Interestingly, rating
agencies were very explicit in reassuring investors that the rating of structured securities
was directly comparable with the rating of bonds. ‘Our ratings represent a
uniform measure of credit quality globally and across all types of debt instruments.
In other words, an ‘‘AAA’’ rated corporate bond should exhibit the same degree of
credit quality as an ‘‘AAA’’ rated securitized issue’ (Standard & Poor’s, 2007, p. 4).
This led to a massive repackaging of risks into a vast quantity of newly issued
AAA-rated securities: according to Fitch (2007), 60% of all global structured prod-

ucts were AAA-rated, in contrast to less than 1% of the corporate issues. Rating
agencies benefited a lot from the growth of structured products. By 2006, 44% of
Moody’s reported revenue came from rating structured finance products, with
respect to 32% of revenues from the traditional business of rating of corporate
bonds (Coval et al., 2008). In this way the issuers of structured products and the rating
agencies became very much dependent on each other, until the collapse in late
2007.
The extent of the crisis in the market for asset-backed securities can be best
appreciated by looking at the dynamics of the ABX price indexes reported in Figure
1. ABX indexes provide an indicative measure of the value of MBSs, as they
are based on the price of credit default swaps offering protection against the default
of baskets of subprime MBSs of different ratings. In other words, a decline in the
ABX index indicates an increase in the cost of insuring a basket of mortgages of a
certain rating against default. It is clear from the graph that the crisis was first felt
in March 2007 by the BBB-rated MBS. A few months later, in July 2007, all
tranches (even the AAA-rated securities) experienced a substantial drop in value,
as UBS shut down its internal hedge fund, Dillon Read, after suffering about

$125 million of subprime-related losses. As the crisis worsened, the indexes kept
declining across all ratings. The loss to the holders of structured debt securities was
compounded by the massive and severe downgrades of their ratings by CRAs in
2007 and 2008 (Benmelech and Dlugosz, 2009b).
The extent to which the performance of CRAs came to depend on the securitization
process in recent years can be exemplified by comparing the profits of Moody’s
– one of the three largest agencies – with those of Reuters – a leading financial
publisher and data provider – over the past 6 years. The choice of Reuters as a
benchmark is justified by the fact that CRAs define themselves as ‘financial publish-
1900 
2100 
2300 
EBIT ($mil) 
500 
700 
900 
1100 
1300 
1500 
1700 
Moodys 
Reuters 
5% 
6% 
7% 
8% 
9% 
60% 
70% 
80% 
90% 
100% 
Return on Assets 
3% 
4% 
40% 
50% 
Moodys (left axis) 
Reuters (right axis) 
Moody's Market Capitalization Relative to Reuters 
0% 
10% 
20% 
30% 
40% 
50% 
60% 
70% 
80% 
90% 
Figure 2. Moody’s vs. Reuters
Notes: The top chart shows earnings before income and taxes (EBIT), and the second the return on assets
(ROA) of the two companies. The bottom chart displays the stock market capitalization of Moody’s relative
to that of Reuters.
Source: Worldscope.
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ers’, and as such are treated by US law, even though their activity arguably goes
beyond the simple publication of financial ‘opinions’.3 The top chart in Figure 2
shows that Moody’s earnings before interest and taxes (EBIT) grew threefold from
$541 million at the beginning of 2003 to $1,439 million in the third quarter of
2007, and then reverted to $683 million by the third quarter of 2009, in perfect
synchrony with the crisis. In contrast, Reuters’ profits took only a modest dip at the
start of the crisis, and kept growing thereafter. The time pattern of the two companies’
return on assets (ROA) in the second chart paints a similar picture, although
the level of Moody’s profitability greatly exceeds that of Reuters throughout the
period (even at its lowest value in the third quarter of 2009, it stands at 40%
against Reuters’ 6%). Perhaps most tellingly, the ratio between the two companies’
market capitalization, shown in the bottom chart of Figure 2, peaked at approximately
80% between late 2005 and early 2006, and dropped continuously thereafter,
down to the current level around 20%.
To understand how securitization works, what information is made available to
investors and how CRAs contribute to it, it is best to illustrate it with reference to
a real subprime MBS. The special-purpose vehicle (SPV) shown in Table 2 is called
GSAMP-Trust 2006-NC2 and owns 3,949 subprime loans for an aggregate principal
of $881 million. The originator of the underlying loans is New Capital Financial,
at the time the second largest subprime lender in the US: it originated $51.6
billion in mortgage loans in 2006, and filed for bankruptcy in April 2007. The
arranger of the deal is Goldman Sachs, who bought the portfolio from the originator
and sold it to the SPV named GSAMP-Trust 2006-NC2. The SPV funded the
purchase of this loan through the issue of asset-backed securities (listed in Table 2).
These securities entitle their holders to the cash flow generated by the loan portfolio,
according to the seniority structure of their tranches (a ‘waterfall’ scheme):
holders of junior tranches can be paid only after senior tranches have been paid in
full. Therefore, in case of default the ‘junior’ tranche is the first to absorb losses
from the underlying collateral loans, and when it becomes worthless the ‘mezzanine
tranche’ starts absorbing further losses, with the senior tranche (typically AAArated)
being the most protected against default risk.
If sold to the public, these securities – or their tranches, if any – must be rated
by a CRA and must be described in a public prospectus. In our example, there
were 17 tranches: 5 AAA-rated senior tranches, 9 mezzanine tranches with ratings
ranging from AA+ to BBB), 2 B tranches with ratings BB+ to BB, and an equity
tranche X with no rating. It is worth noticing that the first 5 tranches representing
almost 80% of the total were AAA-rated. Tranche X (the riskiest one), being
unrated, was not sold to the public. The prospectus of this MBS is a document of

555 pages deposited at the Securities and Exchange Commission (SEC) on 31


March 2006.
Prospectuses contain several summary statistics on the underlying pool of loans.
From the prospectus of GSAMP-Trust 2006-NC2, we learn that 88.2% of the
loans have adjustable rate (the remaining have a fixed rate); 98.7% are first-lien
(that is, the first mortgage on the property); 90.7% are for first homes; 73.4% of
the mortgaged properties are single-family homes; 38% and 10.5% are secured
by residences in California and Florida, respectively, the two dominant states in
this securitization. The average borrower in the pool has a FICO score of 626:
out of 100 loans, 31.4 have a FICO score below 600, 51.9 between 600 and
660, and 16.7 above 660. The average mortgage loan in the pool has a loanto-
value ratio (LTV) of 80.34%: out of 100 loans, 62.1 have a LTV of 80%
or lower, 28.6 between 80% and 90%, and 9.3 between 90% and 100%. The
ratio of total debt service of the borrower to gross income is 41.78%. However,
this information is not available for all loans, as only 52% of them have full
documentation, that is, provide information about income and assets of the
applicants.
The above information is contained in 20 pages. The rest of the document
describes the originator (New Capital Financial), the arranger (Goldman Sachs), the
servicer (Ocweb), the securities administrator (Wells Fargo), the underwriting guidelines,
and contains a list of disclaimers and warranties (e.g., the absence of any
delinquencies or defaults in the pool).
Table 2. Example of REMBS: GSAMP-Trust 2006-NC2
Tranche description Width Credit rating Coupon rate (%)
Class Notional % of total S&P Moody’s 1-month LIBOR +
A-1 $239,618,000 27.2 AAA Aaa 0.15
A-2A $214,090,000 24.3 AAA Aaa 0.07
A-2B $102,864,000 11.7 AAA Aaa 0.09
A-2C $99,900,000 11.3 AAA Aaa 0.15
A-2D $42,998,000 4.9 AAA Aaa 0.24
M-1 $35,700,000 4.0 AA+ Aa1 0.30
M-2 $28,649,000 3.2 AA Aa2 0.31
M-3 $16,748,000 1.9 AA) Aa3 0.32
M-4 $14,986,000 1.7 A+ A1 0.35
M-5 $14,545,000 1.7 A A2 0.37
M-6 $13,663,000 1.6 A) A3 0.46
M-7 $12,341,000 1.4 BBB+ Baa1 0.90
M-8 $11,019,000 1.2 BBB Baa2 1.00
M-9 $7,052,000 0.8 BBB) Baa3 2.05
B-1 $6,170,000 0.7 BB+ Ba1 2.50
B-2 $8,815,000 1.0 BB Ba2 2.50
X $12,340,995 1.4 NR NR
Sources: Ashcraft and Schuermann (2008), SEC-filed prospectus for GSAMP 2006-NC2.
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At this point, it is worth making three remarks on the quality of the information
available to investors. First, the data provided in the prospectus are not enough to
price the RMBSs, being entirely made of summary statistics: these contain information
about the average claim but not on the individual loans in the portfolio, which
may be critical to assess the risk of default of the portfolio and its tranches. Valuing
these risks was of limited importance when house prices were rising and defaults
were few. But as house prices stopped rising and the number of defaults started
increasing, information about the underlying securities became very important. Yet,
it was not available in the prospectus and in the yearly reports produced by the
SPVs.
Second, detailed information on the pool of underlying loans is available through
data providers like Loan Performance and McDash Analytics. Loan Performance’s
securities databases are the industry’s largest and most comprehensive: they include
loan-level data on more than 90% of the market for MBSs. As stated on the website
of McDash Analytics, these companies ‘collect loan level data directly from
servicers into an anonymous database, distribute the cleansed data, and provide
them to clients who want to perform prepayment and default benchmarking analysis
on their mortgage asset holdings’. The catch is that the subscription to these
datasets is very expensive, the data are provided only with a delay after the issue of
a RMBS, and considerable skills are required to analyse them. Hence, most investors
did not bother to use them to assess the risks of their investment decisions (and
check the quality of the credit ratings) until the crisis hit them. After all, why should
they spend their money to replicate what rating agencies were (supposed to be)
doing for free?
Third, no information is available on the stake retained by originators and
arrangers and on their subsequent trades. This information might have been very
important to help investors to assess the value of MBSs because securitization of
subprime loans generates a clear moral hazard problem. If so, holdings and trades
of originators and arrangers would signal the quality of the underlying pool of
loans, and thus provide very valuable information for investors. In tranched securitizations,
even the precise retention mechanism – whether, for instance, the originator
retains a fraction of the equity tranche or of all tranches – may convey different
signals to investors (see Fender and Mitchell, 2009a, 2009b).
3. CONFLICT OF INTEREST, RATING INFLATION AND COARSENESS
As noted by Partnoy (2006), among all ‘financial gatekeepers’ CRAs are those who
face the most serious conflicts of interest. This is due to a combination of factors.
First, differently from analysts (but not from auditors), since the 1970s they are
paid by the issuers whose instruments they rate. This change in practice came at
the same time as the approval of a body of US regulations that depend exclusively
on credit ratings issued by Nationally Recognized Statistical Rating Organizations
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(NRSROs), a status until recently awarded only to Moody’s, Standard & Poor’s,
and Fitch.4 Being paid by the issuers creates an obvious incentive for rating agencies
to distort ratings so as to please their clients, and win further business from
them.
Second, unlike other gatekeepers, CRAs are allowed to sell ancillary services to
their clients, in particular pre-rating assessments and corporate consulting. For
instance, an issuer can ask a rating agency how it would rate a financial instrument
with certain characteristics, and even ask how these should be modified to (just)
obtain a certain rating. This type of activity facilitates rating shopping, that is, it
allows an issuer to identify the rating agency that would provide the most favourable
rating to its financial instruments.
Thirdly, CRAs are largely immune to civil and criminal liability for malfeasance,
because according to several US court decisions they are to be considered as ‘journalists’
and their ratings as opinions protected by the First Amendment (freedom of
speech). In contrast, after the Sarbanes-Oxley Act auditors and corporate boards
face new rules regarding conflicts of interest, and financial analysts at investment
banks are subject to restrictions on their activity and compensation. Therefore, for
CRAs regulators have made much less of an effort to mitigate the conflict of interest
than for other financial gatekeepers.
3.1. Rating inflation
By now, there is a considerable amount of evidence that CRAs engaged in rating
inflation before the crisis: this is not only witnessed by the sharp drop in AAA-rated
issues during the crisis shown in Figure 1 and by the massive downgrades by CRAs
in 2007–2008 (Benmelech and Dlugosz, 2009b), but also by evidence that the
actual ratings reported by CRAs for CDOs were inflated relative to those predicted
by their models. Griffin and Tang (2009) analyze data from one of the three major
CRAs, and report that, by ‘adjustments’ in their ratings, the CRA increased the
size of AAA rated tranches on average by 12.1%, and CDOs with larger ‘adjustments’
experienced worse subsequent performance. They conclude that, had the
CRA followed its model, ‘the AAA tranches would have been rated BBB on average’
(p. 5), resulting in a 20.1% lower valuation.
Such rating inflation may have resulted from collusion between CRAs and issuers
at the expense of investors, as highlighted by Bolton et al. (2009) and Mathis et al.
(2009). In particular, Bolton et al. (2009) show that such collusion is facilitated when
issuers can engage in ‘rating shopping’, that is, solicit ratings from several CRAs
and only reveal to investors the most favourable one (see Box 1).
4 Since 2003, the number of the NSSRO has risen to ten: between 2003 and 2005, the SEC designated two
new NSSRO,
and pursuant to the passage of the Credit Rating Agency Reform Act in 2006 by the US Congress it
designated five more –
two Japanese ones and three small US ones.
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Box 1. Competition and reputation in the rating industry
Bolton et al. (2009) show that in the presence of rating shopping the conflict
of interest is exacerbated under duopoly compared to monopoly. In their
model, CRAs have noisy information about the quality of a security and
can provide reports communicating that information. Issuers can purchase
and publicize a report or shop around by having certain reports not disclosed
to investors. Some investors are naive, that is, they believe the CRAs’
stated ratings; other investors are rational, in the sense that they understand
that these reports are biased. Issuers will never buy a bad rating, so that
CRAs have an incentive to overstate the quality of any given issuance if the
reputation costs (i.e. future forgone profits) are low enough or if the share of
naive investors is large enough. Bolton et al. (2009) show that an increase in
the number of CRAs, that is, more aggressive competition, actually makes
investors worse off, as it gives issuers more opportunity to shop around for a
good rating. That competition has undesirable effects in this situation is also
confirmed by the evidence in Becker and Milbourn (2009), who show that
the entry by Fitch has been associated with greater ratings inflation.
Ratings inflation is reduced by reputational concerns: the more a CRA
inflates its ratings, the lower is its future credibility, hence its future profits.
Indeed a standard defence that CRAs invoke when accused of colluding
with issuers is that such collusion is not in their own best interest, as it
would damage their reputation. However, Mathis et al. (2009) show that this
argument is flawed if CRAs earn a sufficiently large fraction of their revenue
from rating complex securities. If this is the case, the temptation to inflate
ratings and cash in on pre-existing reputation exceeds the value of maintaining
its reputation. Interestingly, the model by Mathis et al. (2009) generates
endogenous reputation cycles. When a new complex security is introduced,
investors are not very trustful, and the CRA has the incentive to behave well
so as to build up its reputation. With time, the increase in investors’ trust
raises issuance and thereby the CRAs’ revenues from rating the security, up
to the moment when the temptation to inflate becomes irresistible. This
leads to a default, a loss of confidence in the CRA and a collapse in issuance,
after which the cycle will start again.
Clearly, rating inflation benefits issuers only if at least some investors fail to take it
into account in their investment decisions, either because they are naive or because
their portfolio decisions are dictated by regulations prescribing investment in highly
rated securities.
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Indeed some market participants appeared to behave credulously in the pre-crisis
period: ‘certain investors assumed the risk characteristics for structured finance
products, particularly highly rated instruments, were the same as for other types of
similarly rated instruments’, and ‘some investors may not have performed internal
risk analysis on structured finance products before purchasing them’ (Federal Register,
Vol. 73, No. 123, p. 36235, 25 June 2008). Precisely on this basis the SEC later
recognized the need for differentiated ratings for structured products and corporate
bonds. Also the Committee on the Global Financial System (2005) indicated that
several investors interviewed by their Working Committee ‘claim to rely almost
exclusively on the rating agencies’ pre-sale reports and rating opinions for information
on deal specifics and performance’ (p. 23).5
Why did the spectacular failure of ratings occur in conjunction with structured
debt securities, and not until CRAs confined themselves to rating corporate bonds?
Probably because the shift from corporate debt to structured debt securities
increased tremendously the complexity of the instrument being rated and therefore
the number of investors who can be considered as ‘naive’ in pricing them. Moreover,
such complexity may have increased the genuine rating errors made by
CRAs, thereby generating a more dispersed distribution of ratings from which
issuers could shop (Skreta and Veldkamp, 2009). Thus, there is a direct link
between the complexity of structured debt securities and the scope and incentive to
shop for rating.
The complexity of structured debt securities arises from the fact that, as illustrated
in Section 2, these are portfolios of many assets, often with very diverse risk
characteristics. The extent to which the risk of these assets is correlated is very
important to determine the sensitivity of structured debt securities to aggregate risk,
as underlined by Coval et al. (2008). In addition, for MBSs the risk of the underlying
mortgage loans stems from two quite different sources: prepayment risk,
which materializes when borrowers find early repayment worthwhile because of
improved refinancing conditions; and default risk, which instead occurs when interest
costs escalate, housing prices decline, or there are adverse shocks to the borrowers’
employment or income. The socio-economic and geographic composition of
the underlying loan portfolio determines the exposure of the MBS to each of these
risks. Complexity is further increased by ‘tranching’: for instance, an AAA tranche
has different exposure to default risk depending on whether it is protected by a
thick layer of mezzanine tranches or not. So its value depends greatly on the size
and number of the junior tranches.
Another likely reason for the emergence of rating inflation has been the growing
regulation-driven demand for highly rated securities, which may have increased
5 Consistently with this, Firla-Cuchra (2005) documents that ratings explain between 70% and 80% of launch
spreads on
structured bonds in Europe. Indeed, he interprets this as evidence that ‘some investors might base their pricing
decisions
almost exclusively on ratings’.
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financial intermediaries’ reliance on ratings in their investment policies. Pension
funds, banks, investment funds and insurance companies are all subject to ratingbased
regulations, whose scope has greatly expanded over time. For instance, since
1989 US pension funds are allowed to invest in highly rated asset-backed and mortgage-
backed securities. Moreover, in November 2001 the Federal Deposit Insurance
Corporation (FDIC) reduced from 8% to 1.6% the capital requirement of banks on
their investments in MBSs and in most CDOs issued by non-governmental entities
and rated AA or better (to be compared to the 4% capital requirement applying to
mortgages and lower rated mortgage securities), creating a huge inducement for
banks both to securitize their loans and to invest in highly rated asset-backed and
mortgage-backed securities.
3.2. Rating coarseness
Credit ratings are coarse in more than one sense. First, they are discrete, rather
than continuous, with classes defined by letters (such as AAA, AA, A, BBB, etc.).
Second, they tend to capture only some dimensions of credit risk: the ratings issued
by S&P and Fitch just reflect their estimate of default probabilities; instead, Moody’s
ratings reflect its assessment of the expected default loss, that is, the product of
the probability of default and the loss given default. But even this is not a comprehensive
measure of credit risk, as it disregards the security’s exposure to systematic
risk, that is, the covariance between default losses and the marginal utility of consumption,
as pointed out by Brennan et al. (2009).6
Knowing the exposure to systematic risk is particularly important for structured
debt securities, since portfolio diversification eliminates most of the idiosyncratic risk
of the underlying securities, as pointed out by Coval et al. (2008). Moreover, the distribution
of risk across tranches is very sensitive to the assumed correlation of
defaults in the underlying portfolio, which happens to be one of the weakest spots
of the methodology commonly used by CRAs: for instance, S&P simply assumes
corporate bonds to have a 15% correlation if they are in the same sector, and a
5% correlation if they are from different sectors (Benmelech and Dlugosz, 2009a,
p. 629), irrespective of the aggregate state of the economy. But default correlations
are much higher in downturns than in expansions, which may help account for the
massive failure of structured debt ratings in the current recession.
At another level, the coarseness of ratings reflects the limited amount of detailed
loan-level data used by CRAs to evaluate the risk of the underlying portfolio. As
late as 2007, Moody’s reported that it was about to request more detailed loan-level
data from issuers for the first time since 2002, and the newly requested data
6 Before the crisis, the Committee on the Global Financial System (2005) already warned that ‘the
one-dimensional nature of
credit ratings based on expected loss or probability of default is not an adequate metric to fully gauge the
riskiness of these
instruments. This needs to be understood by market participants’ (p. 3). Clearly it was not!
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included items that Moody’s itself considered to be ‘primary’, such as a borrower’s
debt-to-income (DTI) level, the appraisal type and the identity of the lender that
originated the loan. As noted by Mason and Rosner (2007), it is surprising that
these data would not have been collected by Moody’s earlier, considering that
‘traditionally the loan to value ratio (LTV), FICO score and the borrowers’ DTI
are the three most significant measures of credit risk on a mortgage’ (p. 24). The
same can be said about neglecting the identity of the loan originator, which turns
out to be an important predictor of subsequent rating downgrades, as documented
by Johnson et al. (2009) for S&P ratings.
To effectively convey all this information about the risk of MBSs, CDOs and
their tranches, CRAs would have had to produce multidimensional ratings, and
report statistics on the sensitivity of their ratings to the most crucial assumptions of
their models, such as those about the correlation between the defaults of the assets
in the underlying portfolio. This, however, would have made their ratings much
harder to understand and interpret for many investors, thus limiting the issuance of
structured debt and contradicting the role that rating agencies saw for themselves
in the development of this market. Indeed, as wittily pointed out by Partnoy (2006),
‘with respect to these new instruments, the agencies have become more like ‘‘gateopeners’’
than gatekeepers; in particular, their rating methodologies for collateralized
debt obligations (CDOs) have created and sustained that multi-trillion-dollar
market’ (p. 60).
This idea is captured by the model of Pagano and Volpin (2008), who show that
issuers may wish to release only simple information, because most market participants
would be unable to grasp the pricing implications of complex information: if
such information were released, unsophisticated investors would lose out in trading
with more sophisticated ones, and would require a compensating price discount to
buy into structured debt securities (see Box 2).
Box 2. Private and public choice of transparency in the market for
structured debt
In the model by Pagano and Volpin (2008), issuers of structured debt securities
choose how much information they wish to release to investors via a
CRA. Beside the security’s probability of default and the loss given default,
they may disclose the precise composition of the underlying portfolio, which
determines the security’s exposure to systematic risk. The key assumption is
that the pricing implications of the latter piece of information are hard to
process for many potential market participants: these unsophisticated investors
know how to price a typical structured debt security, but not how to
adapt its pricing in light of the specific risk characteristics of each security.
Instead, sophisticated investors have no such problem.
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As a result, releasing such information would expose unsophisticated investors
to a ‘winner’s curse’ in the primary market: when the security has high systematic
risk, sophisticated investors would refrain from buying it and leave the
entire issue to the unsophisticated; in contrast, when the security has low risk,
sophisticated investors would compete for it. To compensate the resulting losses,
unsophisticated investors would buy the security only at a discount. To avoid
such underpricing, issuers might choose not to provide precise information
about the composition (and therefore the systematic risk) of the underlying portfolio.
However, suppressing price relevant information may backfire: while it
avoids underpricing in the primary market, it may reduce liquidity in the secondary
market or even cause it to freeze. This is because the information undisclosed
at the issue stage may still be uncovered by sophisticated investors
later on, especially if it confers them the ability to earn large rents in secondary
market trading. So limiting transparency at the issue stage shifts the adverse
selection problem onto the secondary market. In choosing the degree of rating
transparency, issuers effectively face a trade-off between primary and secondary
market liquidity. The key parameters in this trade-off are the value that investors
place on secondary market liquidity and the severity of the adverse selection
problem in the primary market. If investors care little for secondary
market liquidity and/or adverse selection in the primary market would induce
severe initial under-pricing, then issuers will go for opacity, that is, will prefer
ratings to be coarse and uninformative.
Importantly, the degree of ratings transparency chosen by issuers may fall
short of the socially optimal one: a freeze of the market for structured debt is
more costly for society at large than for individual investors whenever it triggers
a cumulative process of defaults and/or liquidation of assets in the economy,
for instance due to ‘fire sale externalities’ or to the knock-on effect arising from
banks’ interlocking debt and credit positions. Fire-sale externalities can arise if
holders of structured debt securities, being unable to sell them, cut back on
their lending or liquidate other assets, thereby triggering drops in the value of
other institutions holding them, as in Acharya and Yorulmazer (2008) and
Wagner (2006, 2009). Alternatively, the market freeze may force holders of
structured debt securities to default on their debts, damaging institutions
exposed to them, and thus triggering a chain reaction of defaults, as in Allen
and Gale (2000) or Freixas et al. (2000).
These externalities create a rationale for regulation mandating a degree
transparency above the level that issuers of structured debt securities would
spontaneously choose (as well as for liquidity injections targeted at distressed
holders of these securities in case of a market freeze).
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The point that disclosing detailed information about securitized assets may hinder
their liquidity is also made intuitively by Woodward (2003) and Holmstrom
(2008). The latter draws a parallel with the sale of wholesale diamonds, which
de Beers sells in pre-arranged packets at non-negotiable prices, and argues that
this selling method is aimed at eliminating the adverse selection costs that would
arise if buyers were allowed to negotiate a price contingent on the packets’ content.
Similarly, Kavajecz and Keim (2005) show that asset managers are able to
achieve a 48% reduction in trading costs via ‘blind auctions’ of stocks, whereby
they auction a set of trades as a package to potential liquidity providers, without
revealing the identities of the securities in the package to the bidders.
3.3. Interaction between coarseness and rating inflation
The coarseness of ratings may further exacerbate rating inflation. To see why, consider
that the discrete nature of ratings implies that each rating class corresponds to
a range of possible values of credit risk, which confers some discretion to the CRA
and thus allows it to grant an overly generous rating to its clients. For instance, the
CRA may provide a pre-rating assessment to the issuer, explaining which rating
the security would obtain depending on different potential structures of the underlying
portfolio of assets. This allows the issuer to choose the portfolio structure that
enables the MBS or the CDO to be, for instance, just AAA-rated. Therefore, AAArated
structured debt issues will end up having not the rating corresponding to the
average AAA-rated corporate bond but rather to the marginal one, implying that they
are correspondingly riskier. The same ‘trick’ could be applied to the rating of tranches,
in which case the issuer can adjust not only the composition of the underlying
portfolio but also the details of the ‘waterfall’ scheme of seniority between tranches.
If ratings were continuous, rating agencies could obviously not play this trick, as
each rating class would be infinitesimal.
This may go a long way towards understanding the true meaning of the very
large ‘credit enhancement’ achieved by structured debt issuers relative to the credit
risk of the underlying portfolio. Indeed, Benmelech and Dlugosz (2009a) find, using
data on 3,912 tranches of CDOs, that ‘while the credit rating of the majority of the
tranches is AAA, the average credit rating of the collateral is B+’ and observe that
the CDOs were structured according to a very uniform pattern – not only in their
tranche structure but also in the composition of the underlying portfolio. They suggest
that this uniformity may be explained by CRAs helping issuers to structure
their CDOs so as to just fit their requirements to achieve an AAA rating. In support
of this interpretation, they note: ‘Anecdotal evidence suggests that the S&P
rating model was known to CDO issuers and was provided to them by the rating
agency’ (p. 632). For instance, by making its CDO Evaluator software available via
its website, S&P allowed issuers to simulate different scenarios of expected default
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given the characteristics of the collateral they had chosen: ‘The CDO Evaluator
software enabled issuers to structure their CDOs to achieve the highest possible
credit rating at the lowest possible cost.’ This is reflected even in the wording that
S&P uses to define excess collateral: ‘what percentage of assets notional needs to be
eliminated (added) in order for the transaction to provide just enough … support at a
given rating level’ (p. 633).
It is worth noticing that, just as the coarseness of ratings may encourage their
inflation, the latter decreases their informativeness: if rational investors perceive ratings
as inflated, they will consider them as unreliable, and in the limit as totally
uninformative. Hence, even though we have discussed them separately for convenience,
the issues of rating inflation and of their informative content are mutually
related.
4. POSSIBLE POLICY INTERVENTIONS
In the previous discussion, we have identified rating inflation and coarse ratings as
the main targets for policy interventions. The obvious solution to address them is to
change the incentives of rating agencies. But, what are the specific policy reforms
to implement? In what follows we outline two possible courses of action.
The first, which we regard as the preferred policy, is quite drastic, in that it requires
not just an adjustment of existing rules but a complete reorientation of regulation
according to two new guiding principles: (1) ratings should be paid by investors,
and (2) investors and rating agencies should be given free and complete access to
all information about the portfolios underlying structured debt securities, as well as
about the design of their tranches.
The second policy, which we regard as a second-best one, imposes milder changes
to the current market model, but is likely to be less effective in addressing the problems
illustrated in this paper. Furthermore, it requires a considerable increase in an
already hypertrophic regulation, in contrast with the preferred policy, as underlined
also by Richardson and White (2009).
4.1. Preferred policy
(1) Creditrating companies should be paid by investors, not by
issuers. Since both rating inflation and the tendency to issue coarse ratings arise
from the conflict of interest between CRAs and investors, it is crucial to eliminate
(or at least reduce as far as possible) this conflict by addressing the issue of ‘who
pays’. If CRAs tend to please issuers by inflating their ratings and/or by making
them excessively coarse, then the most appropriate solution is to have investors –
not issuers – pay them for their services, as indeed was the case before the 1970s.
How would such a system work? Not too differently from the market for other
forms of financial information, spanning from the sale of price and transaction data
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by trading platforms and newspapers to the sale of advice by financial analysts and
of economic forecasts by econometric consultancies. Financial analysts are perhaps
the most fitting comparison: their analysis and recommendations are either sold to
investors on a standalone basis or are packaged together with financial services by
large banks or securities companies.7
It should be recognized that even this arrangement is not completely free from
incentive problems. First, agency problems in asset management can dull institutional
investors’ search for high-quality ratings. But competition in the asset management
industry should weed out institutional investors that systematically
patronize low-quality CRAs.8 Second, if some investors are large enough (or manage
to set up cooperative arrangements to purchase ratings), they may try to induce
CRAs to avoid or delay rating downgrades for securities in which they have
invested heavily. But it is hard to imagine that such large investors may wield sufficient
power as to distort the ratings of all the competing agencies, and presumably
other investors will try to patronize CRAs that show no such tendency to shade
their ratings so as to please their large customers.
More importantly, switching from the ‘issuer pays’ to the ‘investors pay’ model
may be problematic to implement in practice because of free-riding or information
leakage within the pool of investors: after buying a rating, an investor could re-sell
or leak the information to other investors, who could in turn resell or leak it to
others. The end result would be that ratings would yield negligible revenues.
Hence, CRAs would have little incentive to produce them, or at least to invest
effort in producing valuable ratings. The problem is akin to that arising in the
markets for music CDs or software, where the ability of consumers to reproduce
and disseminate music and software at low cost via the web makes life difficult for
their producers.
In principle, this hurdle can be overcome by appropriate public intervention: in
particular, institutional investors who are required to buy only investment-grade
asset-backed securities can be required to buy a rating at a pre-set fee. If there is
enough competition between CRAs, institutional investors will tend to patronize
the best CRAs, so that the market will ensure quality control. Of course, the regulator
will have to set the rating fee at the right level, so as to ensure the viability of
CRAs but avoid leaving excessive rents to them. A variant of this approach is the
‘platform pays’ model proposed by Mathis et al. (2009): when an issuer wants to
apply for a credit rating by a CRA, it is required to contact a platform (an
7 While in most cases analysts are paid by investors (‘sell-side analysts’), companies can also hire a fee-based
research firm to
prepare one or many reports (‘paid-for analysts’). Interestingly, Kirk (2008) documents that paid-for analysts
issue relatively
less accurate forecasts and more optimistic recommendations than sell-side analysts, which is consistent with
the idea that the
former are more exposed to a conflict of interest than the latter.
8 In contrast, Calomiris and Mason (2009) argue that the pervasiveness of agency problems in asset
management is such as
to make the buy side at least as collusive with low-quality CRAs as the sell side. On this basis, they reject the
‘issuer pays’
model as a possible solution to the conflict of interest between CRAs and final investors.
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exchange, a clearing house or a central depository), which would charge a fee to
the issuer and choose a CRA to get the rating done. The platform’s interposition
would thus prevent direct contracting between issuers and CRAs, and its concern
to retain trading activity by investors would presumably induce it to select the most
reliable CRA.
Even if the ‘investors pay’ model is accepted and successfully implemented, a
remaining problem arises from the danger of implicit collusion between issuers and
CRAs, in a situation where delegation by banking and securities regulations has
conferred a tremendous power to a select group of CRAs over issuers. To prevent
implicit collusion, it is essential to prohibit indirect payments by issuers to CRAs in
the form of the purchase of consulting or pre-rating services. A more direct (and
consequential) way to deal with the problem would be to eliminate the many regulations
that delegate powers to CRAs: once the rents that these regulations confer
to these agencies are gone, issuers will have less of an incentive to circumvent the
‘investors pay’ principle. However, it must be recognized that this poses the problem
of finding a substitute for ratings in the banking and securities regulation.
(2) Arrangers and servicers should disclose the complete data on the individual
loans (or bonds) underlying structured finance products. To face
the problems discussed in the previous sections, the disclosure of nothing less than
the entire set of data available to the arrangers and servicers should be required. It
should be clear from the discussion in Section 2 that currently prospectuses do not
contain enough information to allow investors to assess the risk of default of a specific
product and the change in risk characteristics over time. The information on
individual loans currently available (for many but not for all securities) through
expensive data providers like Loan Performance should become available for free
to all investors. With these data, buy-side investors may be able to form their own
assessment of the risk characteristics of the product.
It is important to notice that this form of disclosure reduces both the risk of secondary
market freezes (as all available information is given to all investors) and the
possibility of collusion between issuer and rating agency. In fact, when the information
becomes available on the market, specialized information processors will enter
and provide financial advice to investors. This will weaken the unhealthy bond that
now exists between issuers and CRAs.
It is also worth highlighting that imposing disclosure requirements on the issuers
is far better than imposing them on the CRAs themselves, as proposed by the Securities
Exchange Commission (SEC), in July. SEC (2008) indicates that CRAs should
disclose all information used to determine ratings for structured products. Although
this policy would make CRAs more accountable to the public, it would also reduce
their incentives to improve their risk models. Moreover, transparency about rating
models could lead to greater collusion with issuers: as seen above, S&P was so
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transparent about its CDO Evaluator Manual that issuers could predict perfectly
the rating they would get, and thus structure deals so as to just get an AAA rating!
As already highlighted in Section 3, the policy being proposed here should be
expected to reduce the price at which securitized assets can be sold at the issue
stage and therefore the size of the market for structured debt securities, in comparison
with the pre-crisis period. But at least the market would be placed on safer
foundations than it was at that time.
4.2. Second-best policy
This alternative policy retains the current principle that CRAs are paid by issuers,
but tries to restrain the conflict of interest with investors by limiting the way in
which agencies contract with issuers and are paid by them, and tries to remedy the
coarseness of ratings by prescribing a minimal informational detail to issuers and
CRAs.
(1) Rating agencies should be paid an upfront fee irrespective of the rating
issued and credit shopping (and paid advice to issuers) should be banned.
The requirement of an upfront fee is the so-called ‘Cuomo plan’, named after
New York Attorney General Andrew Cuomo. As noted by Bolton et al. (2009), this
requirement needs to be supplemented with the ban of rating shopping for it to be
effective. Even so, implicit collusion may still be sustainable: issuers may systematically
patronize the CRAs that offer them the best ratings, for instance because they
know the models that each agency is going to use to evaluate their securities. As a
result, the conflict of interest may persist.
Therefore, to be effective this policy needs to be complemented by active monitoring
by a supervisory body such as the SEC and by suitably large penalties to
deter implicit collusion. One way to reduce the danger of implicit collusion is to
assign CRAs randomly to each issuer, or – more modestly – to require that for a
certain fraction of randomly drawn issues a second rating be provided by another
CRA independently designated by the regulator.9 Of course, such random designation
may have limited bite in a context with few competing CRAs and repeated
interactions between issuers and CRAs, but it may still limit the scope for collusion.
(2) Transparency should be enhanced, by determining the information
that issuers and rating agencies must disseminate to the investing public.
This rule would require mandating a more complete format for the information
to be disseminated by CRAs. This is the policy suggested by the Committee on the
9 One such proposal has been advanced by Charles Schumer, a senior member of the US Senate Banking
Committee, who
has suggested that every tenth rating issued by a NRSRO be complemented by a second rating from another
agency independently
designated by the SEC.
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Global Financial System (2008), which recommends that CRAs present their ratings
so as to facilitate comparison within and across classes of different structured
finance products; provide clearer information on the frequency of their updates,
and better documentation about their models and the sensitivity of ratings to the
assumptions made in their models, and especially reduce the coarseness of their ratings
by producing multidimensional measures of the risk properties of structured
finance products. In the same spirit, the Financial Economists Roundtable (2008)
suggests that ratings should be complemented by an estimate of their margin of
error.
One may add yet three further suggestions. First, the statistics to be provided by
agencies should include measures of the systematic risk of the loan pool and of individual
tranches, not just estimates of the probability of default and of loss given
default. Second, to further reduce their coarseness, one may require ratings be
defined continuously on a common scale (say, between 0 and 10), instead of being
defined over a discrete grid chosen by each agency: this would reduce the scope for
discretion by CRAs and thus for collusion with issuers. Thirdly, issuers should disclose
the magnitude of the tranche that they retain in each issue and in each of its
tranches, as well as the fee paid to the CRA who rated the issue, since these pieces
of information may help investors to better gauge the quality of the issue and of its
tranches.
However, this prescriptive approach places considerable burdens and risks on the
shoulders of regulators. It requires them to identify the statistics that CRAs should
provide, which can be difficult in the presence of very diverse financial products. It
also exposes regulation to the risk of failing to keep pace with financial innovation,
for instance with new ways of designing structured debt securities, possibly spurred
by regulation itself. Finally, this approach may induce investors to forgo once more
an independent evaluation of the risk characteristics of these securities (for instance
by tapping additional data sources or other information processors), trusting that
the CRA already provided all the information required by regulators.
5. CONCLUSION
What has been the role of CRAs in the subprime crisis? This paper focuses on two
aspects that contributed to the boom and bust of the market for asset-backed securities:
rating inflation and coarse information disclosure.
Rating inflation, coupled with naive investment decisions, contributed to the
massive mispricing of risk before the crisis. The likely motive for the inflation of
credit ratings is an incentive problem: CRAs are paid by the issuers of the securities
being rated, and therefore their interest is more aligned with the issuers than with
the investing public. Several features of the ratings business, for instance the possibility
of issuers to solicit preliminary ratings and therefore ‘shop’ for the most
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favourable rating, expand the scope for collusion between CRAs and issuers at the
expense of investors, and therefore are likely to have spurred ratings inflation.
The coarseness of ratings is one of the main reasons for the illiquidity that plagued
securities markets as soon as the crisis broke out. After house prices stopped rising
and defaults on subprime mortgages started to increase, market participants realized
that the detailed information required to identify ‘toxic assets’ in the maze of structured
debt securities had simply been lost in the process of securitization, and that
ratings provided an insufficient guidance to identify them. We argue that the reason
why coarse (and uninformative) ratings had been produced was to expand the primary
market of these securities, by making them palatable also to investors who
could not easily process more complex information than coarse ratings.
It is also possible that the coarseness of ratings itself contributed to their inflation,
and that in turn rating inflation reduces their informativeness, so that these two
problems may have interacted and fed upon each other in the pre-crisis period.
What can be done to avoid or mitigate these failures in the future? Our preferred
policy option is to move towards a system where credit ratings are paid by
investors, and where arrangers and servicers disclose for free the complete data on
the individual loans underlying the structured finance products, so that buy-side
investors may feed them into their own models so as to assess their (changing) risk
characteristics. Admittedly, such reforms are not without implementation problems,
and are likely to reduce the liquidity and size of the primary market for structured
finance securities in comparison with the pre-crisis period. Yet, they will restore
investors’ confidence in the securitization process, which can still prove a valuable
tool to enlarge financial markets and transfer risk from lenders to investors. These
reforms will also create opportunities for specialized information processors providing
healthy competition to CRAs, and sharpen the investors’ awareness that they
must not place blind faith in ratings alone.
There are encouraging signs that some elements of the above reforms are already
being discussed seriously in the policy arena. On 17 September 2009, the SEC
voted at a public meeting to propose rules to bar companies from ‘shopping’ for
favourable ratings of their securities, by requiring companies to disclose whether
they have received preliminary ratings from other agencies – in other words,
whether ‘rating shopping’ has occurred. Even though this does not amount to a
ban on credit shopping, at least it informs investors whether any shopping went on,
and allows them to take this into account in pricing the corresponding securities.
Regarding disclosure, in July 2009 the American Securitization Forum (ASF) has
advanced a drastic proposal – essentially our preferred policy outlined in Section
4.1 (item 2). The ASF has developed very detailed and standardized templates for
loan-level information reporting by issuers of RMBSs. This information includes
both data at the time of the origination of the loan and monthly updates to monitor
its performance and the economic conditions of the borrower. Similar proposals
have been put forward in Europe, though with less detailed disclosure require-
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ments. If these proposals are implemented, the amount of standardized loan-level
information that will be available to purchasers of RMBSs will be as good as that
of the issuers and servicers themselves.
Discussion
Wolf Wagner
Tilburg University
Credit Rating Agencies (CRAs) have been widely blamed for contributing to the
crisis of 2007–2008 by giving too generous ratings to securitization products. A
popular explanation for this is that a significant portion of investors in these securities
were naive and took ratings at face value. CRAs could then take advantage of
this by inflating their ratings, for example, in order to please issuers.
There are few issues with this explanation. One of them is that such an incentive
to inflate should be present all the time. Why was it then that rating inflation was
so pronounced in recent years? Another issue is that it is unsatisfactory to base policy
implications on the naivety of investors. Even though investors may have been
naive in evaluating a new financial product in the past, presumably a lot of learning
has been going on during the subprime crisis. Very likely investors will not make
the same mistakes again with respect to the same securitization products, at least
not to the same extent. Yet another issue is that this story cannot explain the opaque
nature of securitization products. This opacity was one of the key (and novel)
features of the recent crisis (while other elements, such as loose monetary policy
and regulation, were also commonplace in other crises).
The analysis in this paper, and in particular the part of it that is based on an
earlier paper of the authors (Pagano and Volpin, 2008), addresses these issues. It
argues that:
• rating inflation really is a natural consequence of the securitization process and
hence is specific to the run-up to the crisis;
• the failure of CRAs to provide accurate ratings may indeed be a structural
problem – inefficiencies are hence not solely due to investor naivety;
• there are reasons to expect that securitization itself contributes to excessively
opaque assets.
What is the mechanism underlying these results? Based on their earlier paper the
authors consider a situation where issuers want to maximize the proceeds from selling
a securitization product. They do this by choosing the amount of information
to be released by the CRA (issuer and CRA work hand in hand in their paper,
there is no agency conflict between them). Being more transparent (that is, releasing
more information) about a securitization product entails a trade-off. On the one
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hand, higher transparency increases secondary market liquidity. This is valued by
buyers and hence increases the price in the primary market, thus benefitting sellers.
On the other hand, transparency increases adverse selection problems in the primary
market as only sophisticated investors can process complex information. This,
in turn, reduces the price sellers can obtain.
Crucially, there is an externality from secondary market liquidity (there are social
benefits from having more liquid markets, for instance arising from a more stable
financial system). As issuers ignore this effect, they choose too little transparency
from a welfare perspective. This opacity results in rating coarseness, which in turn
facilitates rating inflation, as issuers can design their securitization product such that
the rating requirement is just met.
Based on their analysis, the authors derive several policy implications. Their
more radical one entails a complete change in the remuneration of CRAs, by
making investors pay for ratings instead of issuers. Furthermore, they suggest forcing
issuers to disclose a wider range of information about the underlying pool of
securities they issue.
In my view the paper produces an appealing and coherent explanation of CRA
failures in previous years. Its appeal comes from the fact that it uses a single mechanism
that can address several issues at the same time. Another major advantage is
that it does not (exclusively) rely on naive investors to justify rating inflation. The
policy implications are interesting and to be taken seriously.
In my discussion I wish to highlight three issues. The first comment is on the
source of the opacity. Securitization products may either be opaque because information
is lost in the securitization process (the paper’s interpretation) or because
underlying assets are opaque. For example, Collateralized Loan Obligations (CLOs)
contain bank loans to medium-sized companies for which substantial informational
asymmetries exist. In fact, in contrast to this paper the prevalent view before the
crisis was that securitization transforms opaque assets into liquid marketable assets,
for example because their flexible tranching design reduces moral hazard and
adverse selection problems (e.g., deMarzo, 2005). The distinction between the two
sources is important as in the first case rating agencies are part of the problem,
while in the second case it is mainly a problem of risk shifting at banks. The
paper’s message could be strengthened by providing evidence that the opacity experienced
during crisis is really due to first source. One way of doing this would be,
for instance, by showing that markets for securitization were more affected than
loan sale markets (where individual loans are sold).
My second comment is on the connection between the underlying market failures
and the policy options presented by the authors. If we believe the main inefficiencies
to arise from the fact that issuers do not internalize the social value of secondary
market liquidity, the policy of forcing greater information disclosure about the
underlying pool of securities is indeed a good one as it will generally improve transparency.
However, the case is less clear considering their other policy option:
RATINGS AGENCIES 427
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moving payment of CRAs from issuers to investors. Individual investors may likewise
not internalize the social benefits from higher liquidity (for example, in terms
of more stability) and hence there may still be too much opacity in the system. In
this case, as the authors acknowledge, we do need additional inefficiencies to justify
their policy recommendations. Such inefficiencies may then require investor naivety
or may result from regulation itself (for example, because regulation forces certain
investors to only hold highly rated assets).
The final point I wish to highlight is the paper’s relation to the banking literature.
This literature looks at very similar problems as the ones considered in the
paper but models them in a different way. In the standard banking model banks
have a choice between investing in illiquid and liquid asset (e.g., Allen and Gale,
1998). Many contributions show that banks tend to under-invest in liquid assets
because of the presence of externalities from bank failures (such as the fire-sale
externalities emphasized in this paper). Instead of the illiquidity-liquidity trade-off,
one can also consider that banks have an opacity choice: when determining their
investments banks may choose among a menu of assets that differ with respect to
their returns, but also their opacity (opacity in the sense of having a lower value for
outsiders) (Wagner, 2007). The result is again that banks may under-invest in liquid
(less opaque) assets. The Pagano and Volpin paper obtains a similar liquidity
under-provision result. However, this is not because of an asset selection problem
as in the banking literature (the securities a bank wants to issue are given in their
paper). By contrast, here the opacity of a given asset is endogenous: it can be modified
by varying information disclosure about it. This is an intriguing and different
perspective on the liquidity under-provision problem commonly considered. It may
be interesting to consider the endogenous opacity approach akin to Pagano–Volpin
also in models of banking stability.
Panel discussion
Fabrizio Perri wondered what effect making Credit Rating Agencies liable for their
mistakes would have on ratings inflation and the disclosure of information. A number
of the panellists focused on how changes in market structure would impact on
the relationship between investors and CRAs. Stijn Claessens mentioned the proposal
to break the relationship between CRAs and issuers by pooling issuers which
are then assigned a CRA by random draw. Silvana Tenreyro suggested that transforming
the current market structure to a monopolistic type structure would internalize
the conflict of interest between the issuers and CRAs. Augustin Landier
believed that barriers to entry for CRAs must be very high. If investors are aware
that there is collusion between issuers and agencies then investors will demand
428 MARCO PAGANO AND PAOLO VOLPIN
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better independent ratings then new CRAs should have been encouraged into the
market.
Richard Portes noted that academic studies have shown there is very little value
added to rating on corporate bonds compared to asset bank securities. On the issue
of investors paying for ratings, Richard Portes pointed out that there is a demand
side for rating inflation from the institutional investors, so they can then go to the
regulator to show that they have investment grade securities. This leads to the effective
outsourcing of regulation to agencies as they know that institutional investors
need investment grade securities.
In reply to the comments by Xavier Freixas and Richard Portes on whether a
shift to a model where an investor pays for credit ratings is feasible, Marco Pagano
noted that some commentators have suggested a regulated system where investors
who buy products which have been rated must choose a rating agency, the agencies
would continue to compete but the price would be regulated. In response to Wolf
Wagner’s question on whether ratings were incorrect ex ante, Marco Pagano
informed the panel that a number of studies by New York Fed economists have
shown there were large rating mistakes implying that models were wrong. He noted
that whether the mistakes were intentional remains an open question. On the issue
of competition, he noted that increasing competition may not solve the problem of
ratings inflation if rating shopping is left to the issuers. Empirical studies show when
Fitch entered the market, ratings inflation actually worsened. In response to Fabrizio
Perri’s question on CRA liability, Marco Pagano agreed this was an important
issue and highlighted how CRA abstention from liability has created differences
between them and all other financial gatekeepers in the economy such as analysis
and auditors. He noted that CRAs have been described as financial gate openers
rather than financial gatekeepers.
Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire?
Author(s): W. Scott Frame and Lawrence J. White

Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire? W. Scott Frame and
Lawrence J. White he Federal National Mortgage Association and the Federal Home Loan Mortgage
Corporation-commonly known as Fannie Mae and Freddie Mac, respectively'-have led the way in dramatic
changes that have taken place in the structure of the U.S. residential mortgage markets since the 1970s.
Fannie Mae and Freddie Mac are quasi-private/quasi-public: for example, they have federal charters that
confer unique regulatory provisions; but their shares are publicly traded on the New York Stock Exchange. The
biggest advantage of Fannie Mae's and Freddie Mac's anomalous legal status arises because financial
markets treat their obligations as if those obligations are backed by the federal government-even though the
federal government explicitly does not do so. With the benefit of this special status, Fannie Mae and Freddie
Mac have grown into enormous financial institutions, with combined total assets of over $1.8 trillion in 2003.
One critic, Richard Carnell (2004), a former Assistant Secretary of the Treasury, has suggested that the two
companies' growth is at least partially a consequence of a "double game" that they play: " [They] tell Congress
and the news media, 'Don't worry, the government is not on the hook'-and then turn around and tell Wall
Street, 'Don't worry, the government really is on the hook."'

The preferential legal status of Fannie Mae and Freddie Mac serves as one of a number of mechanisms by
which the federal government encourages the consumption (and, arguably, the overconsumption) of housing in
the U.S. economy--this one with an on-budget cost of zero. But economists are congenitally economy--this one
with an on-budget cost of zero. But economists are congenitally suspicious of programs that seem to offer
something for nothing. After all, a federal suspicious of programs that seem to offer something for nothing.
After all, a federal guarantee of the deposits in savings and loans cost nothing for many decades- until the
early 1990s, when it cost taxpayers about $150 billion (U.S. Federal Deposit Insurance Corporation, 1997).
Furthermore, Federal Reserve Chairman Alan Greenspan (2004), among others, has suggested that the
anomalous situation of Fannie Mae and Freddie Mac may even pose systemic risks to the financial sector. This
article will offer a generalist's guide to the functions that Fannie Mae and Freddie Mac perform in the residential
mortgage financial markets and the con- troversies that swirl around them. Along the way we will highlight
some important-and perhaps underappreciated- changes that are occurring in the structure of U.S. residential
mortgage markets. Some Background What Do Fannie Mae and Freddie Mac Do? Fannie Mae and Freddie
Mac participate in the secondary mortgage market: Mortgage originators come to them with pools (bundles) of
mortgages and either swap these assets for securities or sell them outright to one of the two companies. Under
Fannie Mae's and Freddie Mac's "swap programs," an originator exchanges a mortgage pool for a
mortgage-backed security that is issued and guaranteed by one of the two companies and that represents an
interest in the same pool. Fannie Mae and Freddie Mac promise the security holders that the latter will receive
timely payment of interest and principal on the underlying mortgages, less an annual "guarantee fee" of about
20 basis points (0.20 percent) on the remaining principal. In essence, Fannie Mae and Freddie Mac are
providing insurance to holders of mortgage-backed securities against default risk on the underlying mortgages
and are thus bearing that risk themselves. This securitization activity illustrates one of their two core
businesses: mortgage credit guarantees. The other core business of Fannie Mae and Freddie Mac is their
investment portfolios. These portfolios consist largely of mortgage-backed securities that they have purchased
in the open market, as well as mortgages that they purchase from originators under their "cash programs."
Fannie Mae and Freddie Mac fund these assets largely by issuing debt, as the two companies are highly
leveraged with total equity that is less than 4 percent of total assets. The major differences between Fannie
Mae and Freddie Mac are in their historical roots. The National Housing Act of 1934 created the Federal
Housing Authority (FHA) and also provided for chartering national mortgage associations as entities within the
federal government. The only association ever formed was theW Scott Frame and LawrenceJ. White 161
National Mortgage Association of Washington in 1938, which eventually became the Federal National
Mortgage Association-now Fannie Mae. By issuing debt and purchasing and holding FHA-insured residential
mortgages from "mortgage banks," Fannie Mae was able to expand the available pool of finance to support
housing and also to provide a degree of unification to mortgage markets. During this time, mortgage markets
were localized for technological reasons, as well as for this time, mortgage markets were localized for
technological reasons, as well as for reasons rooted in laws that prohibited interstate banking and restricted
intrastate bank branches in many states during most of the twentieth century. In 1968, Fannie Mae was
converted into a private corporation, with publicly traded shares listed on the New York Stock Exchange,
although it retained a unique federal charter that is discussed further below. Apparently one major reason for
the privatization was that until 1968 Fannie Mae's debt was part of the federal debt; but when Fannie Mae
became a publicly traded company, that debt (which stayed with the company) was removed from the national
debt total. Fannie Mae was replaced within the federal government by the Government National Mortgage
Association (which became known as "Ginnie Mae"), an agency within the Department of Housing and Urban
Development (HUD) that guarantees mortgage-backed secu- rities that have as their underlying assets
residential mortgages that are insured primarily by the FHA or by the Department of Veterans Affairs (formerly
the Veterans Administration, or VA). Freddie Mac, by contrast, was created by Congress in 1970 to support
mortgage markets by securitizing mortgages originated by savings and loan associations (S&Ls). During the
1970s and 1980s, Freddie Mac was technically a private com- pany, with its equity shares held solely by the
twelve Federal Home Loan Banks (FHLBs) and by S&Ls that were members of the FHLBs. Freddie Mac's
board of directors consisted of the three board members of the Federal Home Loan Bank Board, which
regulated the S&L industry during that time. Freddie Mac was converted in 1989 into a publicly traded
company, also traded on the New York Stock Exchange, with the same special features as apply to Fannie
Mae. A major motivation for the conversion of Freddie Mac to a publicly traded company was the belief that a
wider potential shareholding public would raise the price of the shares held by the then ailing S&L industry and
thus improve the balance sheets of the latter. In its early history, Freddie Mac tended to securitize mortgages,
originated largely by S&Ls, whereas Fannie Mae tended to hold the mortgages that it bought largely from
mortgage banks. By the 1990s, however, the two companies' structures and strategies looked quite similar.
Current Size As of year-end 2003, Fannie Mae had $1,010 billion in assets and Freddie Mac had $803 billion
in assets, making them the second- and third-largest U.S. compa- nies, respectively, on this basis. In addition,
both Fannie Mae and Freddie Mac had significant quantities of mortgage-backed securities outstanding-that is,
net of

mortgage-backed securities carried on their balance sheets. As of year-end 2003, Fannie Mae had $1,300
billion in outstanding mortgage-backed securities, while Freddie Mac had another $769 billion outstanding.
Both Fannie Mae and Freddie Mac have grown rapidly over the past three decades and at a faster clip than the
residential mortgage market as a whole. As Table 1 shows, in 1980, the residential mortgage market consisted
of $1.1 trillion in obligations, of which Fannie Mae and Freddie Mac held or securitized only $78 billion, or
about 7 percent. By contrast, in 2003, these companies held or securitized over $3.6 trillion of the $7.7 trillion
in residential mortgage debt, or about 47 percent. The U.S. Congressional Budget Office (2001) estimated the
involvement of Fannie Mae and Freddie Mac in various slices of the mortgage markets as of 2000. For
example, for fixed-rate single-family mortgages that were eligible to be purchased or securitized by the two
companies (about half of the total residential mortgage market), the two companies accounted for 71 percent
of that slice (through either their securitizations or their portfolio holdings). Special Features of Fannie Mae and
Freddie Mac Fannie Mae and Freddie Mac differ from other U.S. corporations in that they were created by
Congress and maintain exclusive federal charters. These charters, in turn, confer a number of rights and
responsibilities on these companies (U.S. Congressional Budget Office, 1996, 2001; U.S. Department of the
Treasury, 1996; U.S. General Accounting Office, 1996).Fussing and Fuming over Fannie and Freddie: How
Much Smoke, How Much Fire? 163 Some of the advantages that Fannie Mae and Freddie Mac enjoy are as
follows. First, they are exempt from state and local income taxes. Second, the Secretary of the Treasury has
the authority to purchase up to $2.25 billion of Fannie Mae's and Freddie Mac's securities. Third, they issue
"government securities," as classified under the Securities Exchange Act of 1934, which in practice means that
their securities are eligible for use as collateral for public deposits, for purchase by the Federal Reserve in
open-market operations, and for unlimited investment by federally insured depository institutions. A further
implication is that they are exempt from the registration and reporting requirements and fees of the Securities
and Exchange Commission, although Fannie Mae voluntarily registered its stock and Exchange Commission,
although Fannie Mae voluntarily registered its stock with the SEC in March 2003, and they are exempt from the
provisions of many state with the SEC in March 2003, and they are exempt from the provisions of many state
investor protection laws. Fourth, they use the Federal Reserve as their fiscal agent, which means that their
securities are issued and transferred using the same system as U.S. Treasury borrowings. Finally, there is no
defined resolution process in place to deal systematically with insolvency at either Fannie Mae or Freddie Mac;
instead, congressional action is required (Eisenbeis, Frame and Wall, 2004). Fannie Mae's and Freddie Mac's
federal charters also present some disadvan- tages for these companies. First, their activities are restricted to
residential mort- gage finance. Second, they are restricted to the secondary market, which means that they
cannot originate mortgages directly. Third, there is a maximum size of mortgage that they can finance. These
mortgages are usually described as "con- forming" mortgages; larger mortgages are usually described as
'jumbos."2 The size is linked to an annual index of housing prices; for 2005, the limit for a single-family home is
$359,650. Fourth, the mortgages that they finance must have at least a 20 percent down payment or else have
mortgage insurance that is provided either by private firms or the federal government. Fifth, they are subject to
federal safety-and-soundness regulation, including minimum leverage and risk-based cap- ital requirements
and supervisory examinations, by the Office of Federal Housing Enterprise Oversight (OFHEO), an
independent agency within the Department of Housing and Urban Development (HUD). Sixth, they are subject
to "mission oversight" by HUD, which approves new housing finance programs and sets percent-of-business
housing finance goals. Currently, 50 percent of Fannie Mae's and Freddie Mac's business must benefit low-
and moderate-income families, 31 percent must benefit underserved areas, and 20 percent must serve
"special affordable" needs. 2 Other nonconforming mortgages (besides jumbos) are those that do not meet the
credit-quality standards of the two companies. Also, this limit applies only to a single-unit residence; higher
limits apply to two-unit, three-unit and four-unit residences and to multifamily housing. Also, limits for Hawaii,
Alaska and the Virgin Islands are, by law, 50 percent higher.164 Journal of Economic Perspectives A Halo of
Government Support By law, securities of Fannie Mae and Freddie Mac are required to include language that
they are not guaranteed by, or otherwise an obligation of, the federal government. However, Fannie Mae's and
Freddie Mac's special federal charters and the attendant package of special benefits directly lower their
operating costs and have created a "halo" of implied federal government support for the two companies. In
addition, past government actions have contributed to the percep- tion of implied government support. During
the late 1970s and early 1980s, Fannie Mae was insolvent on a market value basis and benefited from
supervisory forbear- ance (U.S. General Accounting Office, 1990; Kane and Foster, 1986). A summa- rizing
phrase for this halo is that the two companies are "government sponsored enterprises" (GSEs).3 enterprises"
(GSEs).3 Evidence suggests that financial markets believe that the federal government Evidence suggests that
financial markets believe that the federal government would come to the rescue of Fannie Mae and Freddie
Mac (and hence their creditors) in the event of financial difficulties. As a result of this perceived implicit
guarantee, Fannie Mae and Freddie Mac can typically borrow at interest rates that are more favorable than
those of a AAA-rated corporation (though not quite as favorably as the rates on government debt), even though
their stand-alone ratings would be about AA- or less. For Fannie Mae and Freddie Mac, empirical studies
suggest that this translates into roughly a 35-40 basis point debt funding advantage, although there is
significant variation in the estimates depending on the credit rating and maturity of the comparison bonds
(Ambrose and Warga, 1996, 2002; Nothaft, Pearce and Stevanovic, 2002). Other studies have found that the
compa- nies enjoy about a 30 basis point advantage in issuing mortgage-backed securities (U.S.
Congressional Budget Office, 1996, 2001; U.S. Department of the Treasury, 1996). The presence of Fannie
Mae and Freddie Mac in the secondary mortgage market influences the primary mortgage market. Most
notably, Fannie Mae's and Freddie Mac's activities result in "conforming" mortgages' carrying lower interest
rates thanjumbo mortgages. Several econometric studies have estimated this effect, and most found the
interest rate differential to be about 20-25 basis points, although the estimates vary depending on the empirical
specification, data sample and time period studied. For an introduction to this literature, see U.S. Congres-
sional Budget Office (2001), McKenzie (2002), Passmore (2003) and Ambrose, LaCour-Little and Sanders
(2004) and the references in these papers. 3 The Federal Home Loan Bank System, which serves as a
wholesale bank for many federally insured depository institutions (banks, S&Ls and credit unions), enjoys a
similar package of favorable features and is similarly described as a GSE. There are also GSEs that serve
agricultural credit markets (Farm Credit System and the Federal Agricultural Mortgage Corporation, or Farmer
Mac) and the student loan market (Student Loan Marketing Association, or Sallie Mae), although the latter is in
the process of privatization under the name SLM Corp. The financial pages of major newspapers often set
aside a separate box of "agency issues" to report the yields on GSE securities-a visible illustration of how they
are treated differently.W. Scott Frame and LawrenceJ. White 165 Fannie Mae and Freddie Mac may bring
other potential benefits to mortgage markets, although these claims are often controversial. For example, one
contro- versy is over whether Fannie Mae and Freddie Mac enhance the stability of the mortgage market by
acting as a large "market maker" in mortgage-backed securities and thereby reducing interest rate volatility in
that market (Gonzalez-Rivera, 2001; Naranjo and Toevs, 2002; Peek and Wilcox, 2003). We will discuss one
counter- argument to this point below--the possibility that the sheer size of these mortgage portfolios creates a
potential for systemic risk in the financial system. Another claim sometimes made is that Fannie Mae and
Freddie Mac can act as a focal point for market-wide standard setting with respect to technology and certain
"best practices." For example, Fannie Mae and Freddie Mac have each developed widely used automated
underwriting systems (known as Desktop Under- writer and Loan Prospector, respectively) that evaluate an
individual loan's credit risk, including whether it meets the companies' purchase requirements. These risk,
including whether it meets the companies' purchase requirements. These systems have greatly reduced the
time and cost of the mortgage origination process. systems have greatly reduced the time and cost of the
mortgage origination process. However, several large lenders that already had similar systems in place
resented the Fannie Mae and Freddie Mac systems, characterizing them as an unwarranted intrusion into the
primary mortgage market. Residential Mortgages: A Primer To appreciate the central role that Fannie Mae and
Freddie Mac play in U.S. residential mortgage finance, a brief tutorial on mortgage finance itself will be useful,
including the process of mortgage securitization. Some Interesting Aspects of Residential Mortgages At one
level, a residential mortgage is a simple debt instrument. The purchaser of a home borrows money to finance
the home purchase. The home serves as the collateral for the loan. The borrower makes monthly payments
that cover the interest on the outstanding principal and the amortization of that principal. The complexity of the
mortgage as a debt instrument arises because of the interactions among three properties of most U.S.
single-family residential mort- gages: lengthy maturities, fixed interest rates and "free" prepayment options.4
First, the term of most mortgages is for 15 or 30 years, with the average term of a new mortgage for a
single-family residence hovering at about 27-28 years over the past decade. Second, fixed-rate mortgages are
more common than adjustable-rate mort- gages, which have been one-quarter or less of the market in the last
6-7 years and exceeded one-third of the market in only a single year during the 1990s. Indeed, adjustable rate
mortgages were relatively unknown before the early 1980s, primarily 4 More detail on the characteristics of
residential mortgages can be found on the website of the Federal Housing Finance Board:
(http://www.fhfb.gov).166 Journal of Economic Perspectives because federal regulation prevented most
depository institutions from originating them. Finally, these long-term, fixed-rate mortgages are generally
prepayable with- out a penalty, in the sense that the borrower can accelerate the repayment of principal or
repay the entire amount at any time, at no additional cost. Though the borrower does not pay an explicit
penalty at the time of repayment, the cost of the option to the lender is incorporated into the contract interest
rate and the fees that the lender charges at the time of origination. A mortgage lender faces two kinds of risks.
First, credit risk bears on whether the lender will be repaid the principal amount that has been lent and the
contracted interest. Second, market risk refers to whether changes in market conditions- primarily interest rate
changes--will affect the value of the mortgage. The credit risk on most single-family residential mortgages is
quite low.5 After all, lenders only originate such loans after screening for adequate household income and a
good credit history. Further, the home itself serves as the collateral for the mortgage in the event of default.
Most lenders require a 20 percent down payment or some form of mortgage insurance. The credit risk losses
on mortgages payment or some form of mortgage insurance. The credit risk losses on mortgages held by
Fannie Mae and Freddie Mac averaged 5.4 basis points annually over the held by Fannie Mae and Freddie
Mac averaged 5.4 basis points annually over the 1987-2002 period, and the losses averaged only 1 basis point
annually for 1999- 2002 (Inside Mortgage Finance, 2003). A fixed-rate debt instrument also creates market risk
for the lender. If interest rates increase, the price of the instrument declines; and if interest rates decrease, the
price of the instrument rises. The longer is the maturity of the instrument, the greater are the associated price
swings. These risks are further complicated by changes in the rate of prepayment. A lower interest rate, which
would benefit the lender of a fixed-rate instrument, makes borrowers more likely to repay their existing
mortgages, either by refinancing the existing mortgage or deciding that the time is right to purchase a new
home. This quickening of the repayment rate deprives the lender of the potential capital gain on the mortgage
that would otherwise occur on a debt instrument that could not be repaid; equivalently, the greater pace of
repayment is occurring just when the lender doesn't want repay- ment, since the lender can then only relend
(or reinvest) the funds at the lower prevailing interest rates. Conversely, a higher interest rate leads to less
prepayment. In this case, the capital loss that the lender would have experienced on a fixed-rate debt
instrument as interest rates increase is compounded by the slackening of the prepayment rate; in essence,
prepayments are slackening just when the lender wishes that they would accelerate. In the specialized
literature, this phenomenon of 5 Two growth areas in residential mortgage lending that are exceptions to this
broad claim are "subprime" and high loan-to-value loans. Subprime loans are those made to borrowers with
material blemishes in their recent credit history. High loan-to-value loans, while generally made to individuals
with especially good credit, have principal amounts equal to or greater than the appraised value of the property
acting as collateral.Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire? 167
additional adverse effects on the mortgage lender from decreases or increases in interest rates is described as
the "negative convexity" of the mortgage instrument. Mortgage Securitization Prior to 1970, mortgages were
largely a nontraded debt instrument.6 The initial lender that originated the loan usually held the loan until it
matured (or was prepayed), collecting interest and principal repayments in the interim. In 1970, Ginnie Mae
issued the first "pass-through" mortgage-backed securities, which cre- ated a claim on an underlying pool of
residential mortgages and meant that security-holders had the right to receive the interest and principal
repayments of the pool as a whole. The Ginnie Mae securities carried the federal government's promise of
timely payment of interest and principal, on top of the guarantees issued by the FHA and the VA on the
underlying mortgages. For the first time, the claim on a stream of mortgage payments could be readily traded.
A number of aspects of mortgage-backed securities are worth noting. First, securitization greatly widens the
potential market for the ultimate financing of residential mortgages. Anyone who buys the security directly or
indirectly (for example, through a mutual fund or pension fund) is, in essence, providing the mortgage
financing. mortgage financing. Second, investors in mortgage-backed securities are in a poor position to
assess Second, investors in mortgage-backed securities are in a poor position to assess the credit risk as to
what proportion of the individual mortgages in the underlying pool will be repaid on schedule, so they require
some assurance on these credit risks. Ginnie Mae, Fannie Mae and Freddie Mac offer direct guarantees with
respect to these repayment rates when they issue such securities. "Private-label" securitiza- tions offer other
kinds of reassurance: for example, private financial guarantees; "overcollateralization," in which a security
issuer pledges assets to back the securi- tization in an amount that exceeds the face value of the securities
being issued; or structuring the securities with senior and subordinated tranches, such that credit losses are
first absorbed by more subordinate securities up to certain values. Third, mortgage-backed securities holders
are not protected from the market risks associated with holding long-term, fixed-rate, prepayable mortgages.
The holder of a simple "pass-through" mortgage-backed security (described above) experiences the same
effects of interest rate changes-including the effects of prepayments-as does the owner of an otherwise similar
unsecuritized pool of mortgages. Fourth, the securitization process creates opportunities for "slicing and dicing"
the cash flows in ways that allow the risks to be better allocated among capital markets participants according
to their preferences (Fabozzi, 2001). The "senior/ subordinated" structure noted above is one such method. As
another example, the cash flows from a mortgage pool can be divided into a "principal-only" security and 6 As
was mentioned above, an exception to this pattern involved originations by mortgage banks, which
immediately sold the mortgages to Fannie Mae (which then held the mortgages in its portfolio).168 Journal of
Economic Perspectives an "interest-only" security, where the former has characteristics that heighten
interest-rate risks, while the latter (at least for modest changes in interest rates) ameliorates them.7 More
elaborate multiple-layer securities, in which some inves- tors have more buffering from early prepayment and
others have less, can also be created from Fannie Mae or Freddie Mac pass-through securities and are
described as "collateralized mortgage obligations" (CMOs) or "real estate mortgage invest- ment conduits"
(REMICs). Trends in Residential Mortgage Finance The structure of residential mortgage markets is
substantially different today than it was in 1970. At that time, the dominant pattern was as follows: The financial
institution-typically a savings and loan or a savings bank-that originated a fixed-rate mortgage loan also held it
in its portfolio, and the same financial institution collected the monthly payments and dealt with delinquencies.
The funding for the loan was provided by the institution's deposits, which were insured by the federal
government, through the Federal Savings and Loan Insurance Corporation (for S&Ls) or the Federal Deposit
Insurance Corporation (for com- mercial banks). As Table 2 shows, in 1970 savings and loan institutions held
over 56 percent of outstanding single-family mortgages, and commercial banks and savings and loans together
held over 70 percent. By contrast, the typical pattern today is for mortgage originators to share some or all of
the risks associated with fixed-rate residential mortgage loans with the secondary market. Depository
institutions typically do this by securitizing their conforming mortgages with Fannie Mae or Freddie Mac and
their FHA- and VA-insured loans with Ginnie Mae. The resulting mortgage-backed securities carry an
assurance as to the timely payment of principal and interest, which is backed by a full-faith-and-credit
guarantee of the federal government (Ginnie Mae) or an implied federal guarantee (Fannie Mae and Freddie
Mac). The originator will elect either to hold or to sell the mortgage-backed security, although it may continue to
"service" the underlying loans by collecting monthly payments and dealing with delinquencies. Nondepository
mortgage originators, such as mortgage banks, tend to sell their mortgages outright-often to Fannie Mae or
Freddie Mac. Only adjustable rate mortgages or those fixed-rate mortgages that exceed the

conforming loan limits ('jumbos") or that do not meet certain underwriting criteria are likely to be held in the
originator's portfolio (if the originator is a depository institution) or securitized in a "private label" offering. As
Table 2 also shows, as of year-end 2000, the share of "whole loan" single-family mortgages held by banks and
savings and loans had plummeted to below 30 percent, despite an increase in commercial banks' share of
single-family mortgage mortgages between 1970-2000. However, if one were also to include the banks' and
savings and loans' holdings of mortgage-backed securities (and thus the depositories' exposure to
mortgage-related market risk), their share would rise to slightly over 40 percent. This vertically dis-integrated
structure allows for greater specialization among institutions with respect to mortgage originations, collecting
payments, dealing with delinquent loans, funding, liability issuance and guarantees. Why the Trend to
Securitization and Dis-Integration of Mortgage Markets? Technological advancements-especially improved and
lower-cost data pro- cessing and telecommunications-have undergirded both the expansion of the
securitization process and division of the market into many interlocking providers. Loan originators are able to
gather information about prospective borrowers, analyze it, make judgments about who to lend to and transmit
that information and170 Journal of Economic Perspectives those judgments to others-notably, securitizers and
investors-in ways and over distances that weren't possible in the 1970s. Regulation, however, has also
contributed to the expanded role of Fannie Mae and Freddie Mac in residential mortgage markets, in at least
two ways. First, since 1988, the regulatory risk-based capital (net worth) requirements that apply to banks and
savings and loans have included a lower requirement of 1.6 percent for holding mortgage-backed securities
issued by Fannie Mae and Freddie Mac, compared with the 4 percent requirement for holding whole
(unsecuritized) residential mortgage loans. At first blush, since risk-based capital requirements for whole-loan
mortgages are at the same level as the minimum "leverage" requirements for an adequately capitalized
depository institution (a 4 percent ratio of a depository's overall capital to assets), there would seem to be little
market impact from these risk-based capital charges. However, in cases where a depository institution holds a
diversified loan portfolio that includes higher-risk loans requiring capital levels above the minimum leverage
requirements, its portfolio may be bound by risk-based capital require- ments. So at the margin, the lower
capital requirements for mortgage-backed securities would strongly encourage the institution to substitute
mortgage-backed securities for "whole" mortgage loans. Frame and White (2004b) discuss this "regulatory
capital arbitrage" in greater detail. Second, Fannie Mae and Freddie Mac are required to hold at least 2.5
percent capital against mortgages (or their own mortgage-backed securities) that they retain in their portfolios.
At first glance, this would seem to put such portfolio retention at a capital cost disadvantage as compared with
depositories' holdings of mortgage-backed securities (at 1.6 percent). But in comparison with depositories
mortgage-backed securities (at 1.6 percent). But in comparison with depositories that are bound by the 4
percent minimum leverage requirement (such as savings that are bound by the 4 percent minimum leverage
requirement (such as savings and loans that tend to specialize in mortgage lending), the purchases by Fannie
Mae and Freddie Mac for their own portfolios would have a capital cost advantage. Strategic management
decisions have also been an influence. When Freddie Mac became a publicly traded company in 1989 and
was freed from the constraints that had previously been imposed by the Federal Home Loan Bank Board, its
management soon realized that its favorable borrowing rates provided an excellent opportunity to expand its
income by earning a spread on the differ- ence between mortgages that it held in portfolio and its favorable
borrowing rates. Though Fannie Mae was chastened and restrained by its near-insolvency in the early 1980s,
by the 1990s, its management had also adopted this expan- sionist mentality. Ironically, Fannie Mae and
Freddie Mac did not expand as dramatically in the 1970s and 1980s, when their position as national operators
in mortgage markets should have given them a comparative advantage vis-a-vis their depository rivals who
were restrained by state and federal limitations on interstate branching. Appar- ently, it took technological and
regulatory changes, supplemented by some strate- gic management decisions, to bring about their
expansion.Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire? 171 The Issues
The federal charters for Fannie Mae and Freddie Mac, and particularly the implied federal guarantee of their
financial obligations, raise the central policy issue. On one side, the implied guarantee on Fannie Mae's and
Freddie Mac's financial obligations allows the federal government to reduce mortgage interest rates for most
residential mortgages by about 20-25 basis points-without an annual appropriation. On the other side, this
policy creates a contingent liability for taxpayers in the event that either enterprise becomes insolvent and the
govern- ment elects to provide financial assistance, as well as causing additional distortions in the housing
market. These tradeoffs involving Fannie Mae and Freddie Mac can then be parsed into five related issues: a)
how the companies' activities mesh with other public policies that encourage the construction and consumption
of housing; b) the appropriate safety-and-soundness regulatory structure; c) the systemic risks that may flow
from the size of the companies; d) the effect of the companies' activities on allocative efficiency; and e) the
consequences of the two companies for efficient market structures. Encouragements for Housing and
Macroeconomic Efficiency U.S. public policy, at all levels of government, encourages the construction and
consumption of housing. The largest incentives pertain to income tax advantages: the exclusion of the implicit
income from housing by owner-occupiers, while allowing the deduction of mortgage interest and local real
estate taxes. Additional tax encouragements include the exemption of much owner-occupied housing from
capital gains taxation and accelerated depreciation on rental housing. Direct provision of rental ("public")
housing is another significant program. In terms of housing finance, some government programs operate
directly, like the mortgage insurance provided by FHA and VA (which allows lower down the mortgage
insurance provided by FHA and VA (which allows lower down payments) and the securitization of associated
mortgages by Ginnie Mae. Other payments) and the securitization of associated mortgages by Ginnie Mae.
Other programs support housing indirectly: federal deposit insurance for depository institutions whose
portfolios contain some residential mortgages, savings and loan charters with mandates to invest in residential
mortgages, and the Federal Home Loan Bank System-originally created by the federal government in 1932 as
a "wholesale" bank that would make low-cost loans to S&Ls. Federal sponsorship of Fannie Mae and Freddie
Mac are another indirect form of support for housing finance and hence housing consumption. The motives
underlying these public policy actions toward housing are diverse. One motive is to assist the middle class with
a major household expenditure. Another motive is to support revenues and employment in residential
construction, sales, and complementary industries. Yet another motive is that homeownership can be viewed
as a way of encouraging households to save (at least so long home values do not decline or other offsetting
reductions in saving or increases in borrowing don't offset the value of home equity). But for most economists,
the172 Journal of Economic Perspectives strongest arguments for government support of housing involve
either a form of in-kind redistributions of income toward lower-income households or the claim that
homeownership has positive externalities. For example, an owner is likely to care more about a residence and
the surrounding neighborhood than is an absentee landlord, which can result in positive externalities including
the external appearance of property, greater watchfulness leading to greater public safety and support for local
public goods. A modest but growing empirical literature provides some documentation for these positive
externalities for neighborhoods and even positive effects on owner-occupier families themselves (Green and
White, 1997; DiPasquale and Glaeser, 2002; Aaronson, 2000, and the references therein). If redistribution to
those with lower income or the positive externalities from a higher rate of homeownership are the goals, then
the logical policy would encourage low- and moderate-income households, who may be on the margin
between renting and owning, to become first-time home buyers. Such programs might aim to reduce down
payments, since the size of down payment can be a binding constraint for low-income households (Linneman
and Wachter, 1989; Quercia, McCarthy and Wachter, 2003), or to reduce monthly payments. However, most
housing programs are broad-based efforts that encourage more housing construction and consumption
throughout the income and social spectrum. For example, the income tax benefits from homeownership
operate as exemptions and deductions, which means that they tend to favor disproportionately higher-income
households in higher marginal tax brackets (Rosen, 1979; Gervais, 2002). Federal sponsorship of Fannie Mae
and Freddie Mac is of this broad-based nature. In 2002, the conforming loan limit for Fannie Mae and Freddie
Mac was $300,700. In that same year, according to the Federal Housing Finance Board, the median price of a
new home that was sold was $187,600, and an 80 percent mortgage on that sale price would have been
$150,080. Thus, the conforming loan limits allow Fannie Mae and Freddie Mac to purchase residential
mortgage loans limits allow Fannie Mae and Freddie Mac to purchase residential mortgage loans that are far
beyond the range that would encompass the low- or moderate-income, that are far beyond the range that
would encompass the low- or moderate-income, first-time buying household. Fannie Mae and Freddie Mac are
required to meet percent-of-business housing goals established by HUD involving annual purchases of loans
involving a) households with less than median incomes; b) underserved areas, such as low-income and
high-minority census tracts; and c) very low income households and low-income households living in
low-income areas. Nevertheless, the bulk of the mortgage purchases by the two companies have not involved
the groups that ought to be the target of homeownership-encouraging activities (U.S. Office of Management
and Budget, 2004). While some research has found that Fannie Mae and Freddie Mac have recently increased
the supply of mortgage credit available to low- and moderate-income households (Ambrose and Thibodeau,
2004), it does not appear that the companies' activities have appreciably affected the rate of homeownership in
the United States (Feldman, 2002; Painter and Redfearn, 2002; Freeman, Galster and Malega, 2003). Such
broad-based encouragements for housing imply that most beneficiariesW. Scott Frame and LawrenceJ. White
173 would have bought anyway, and the marginal effects are largely to cause them to buy larger and
better-appointed homes, on larger lots, and/or to buy second homes. In turn, this broad-based encouragement
means that the United States has invested in an inefficiently large housing stock, although the empirical
literature that attempts to measure the magnitudes of these broad social consequences is surprisingly small. In
one recent study, Gervais (2002) finds that the taxation of the implicit rents on owner-occupied housing
(accompanied by a compensating ad- justment in tax rates) could cause general consumption levels to
increase by almost 5 percent. Taylor (1998) finds that overinvestment in housing persisted during 1975-1995
and estimates the overinvestment in housing at over $220 billion per year (or $300 per month for each
owner-occupied home) for the late 1990s- consistent with prior research by Mills (1987a, b). These results can
be summarized bluntly. The United States has too much housing (and not enough of other goods and
services), and federal sponsorship of Fannie Mae and Freddie Mac exacerbates this problem. Moreover,
Fannie Mae and Freddie Mac do not do an especially good job of focusing on the low- and moderate-income
first-time buyer, where the social argument for support of home- ownership is strongest. Safety and Soundness
The implicit guarantee of Fannie Mae's and Freddie Mac's obligations suggests that attention be paid to the
companies' financial health. How could either enterprise become insolvent? One way is if the credit losses
mushroomed on the mortgages they guaranteed or held outright. This would occur if homeowners could not
repay their mortgages and the prices of housing fell below outstanding loan values. Another-and perhaps more
likely-way is if they failed to hedge their market risks adequately, and the value of their mortgage portfolios fell
below the values of their outstanding debt obligations. This happened to Fannie Mae, as well as to thousands
of savings and loans, in the early 1980s. What is the magnitude of this contingent liability to the federal
government? One way to answer this question is to consider how much the government poten- One way to
answer this question is to consider how much the government poten- tially would have to pay to a third-party
guarantor who would have the same tially would have to pay to a third-party guarantor who would have the
same probabilistic-contingent obligation to make whole the holders of Fannie Mae or Freddie Mac debt and
mortgage-backed securities in the event that one of them failed. Such estimates are approximated by the gross
benefits accruing to Fannie Mae and Freddie Mac from the implied guarantee in terms of both of the compa-
nies' debt and their mortgage-backed securities.8 A "back-of-the-envelope" calcula- tion of this can be
constructed using year-end 2003 data on their outstanding debt 8 Recall that the gross benefits from the
implied guarantee are simply the differential between the interest rates that the creditors of
government-sponsored enterprises actually demand (given their belief that the federal government would be
likely to bail them out) and what they would require if the two companies were wholly divorced from the federal
government.174 Journal of Economic Perspectives and mortgage-backed securities, coupled with estimates of
the interest rate advan- tages that the two companies enjoy (40 basis points on debt and 30 basis points on
mortgage-backed securities) as a result of implied government support, values for growth of portfolio and
mortgage-backed securities (4 percent),9 a discount rate (5 percent, based on long-term Treasury bond yields)
and a time horizon (25 years). These numbers suggest an estimated contingent liability borne by the federal
government of approximately $288 billion. The implied federal guarantee of Fannie Mae's and Freddie Mac's
financial obligations create a "moral hazard" problem. Because of the implied guarantee, creditors do not
monitor the firms' activities as closely as they otherwise would. As a consequence of this reduced monitoring,
the managements of Fannie Mae and Freddie Mac can engage in activities that involve greater risk (with
greater liability consequences for the government), since the companies' owners will benefit from the "upside"
outcomes while being buffered (because of the limited liability of corporate owners) from the full consequences
of large "downside" outcomes. Safety-and-soundness regulatory oversight is one way to deal with insufficient
market monitoring and discipline. However, in the case of Fannie Mae and Freddie Mac, the case for such
regulation must be more nuanced. The federal guarantee itself is implicit and based on expectations, rather
than a legally binding obligation of the government. The presence of safety-and-soundness oversight likely
rein- forces such expectations, and it is thus unclear whether safety-and-soundness regulation for Fannie Mae
and Freddie Mac actually reduces taxpayer exposure (Frame and White, 2004a; Greenspan, 2004). The Office
of Federal Housing Enterprise Oversight (OFHEO), within the Department of Housing and Urban Development
(HUD), is the safety and sound- ness regulator for Fannie Mae and Freddie Mac. OFHEO is authorized to set
risk-based capital standards, conduct examinations and take enforcement actions if unsafe or unsound
financial or management practices are identified.'0 However, OFHEO has been criticized for a perceived lack
of effectiveness, including the lengthy delays that the regulator experienced in issuing and finalizing its
risk-based capital regulation for Fannie Mae and Freddie Mac (U.S. General Accounting Office, 1997). More
recently, Treasury Secretary John Snow (2003) remarked that Office, 1997). More recently, Treasury Secretary
John Snow (2003) remarked that there is a "general recognition that the supervisory system for the housing
GSEs there is a "general recognition that the supervisory system for the housing GSEs 9 Though the overall
mortgage market has grown at an average annual rate of 8.5 percent over the past decade, this rate could not
be sustained indefinitely, nor could the even faster growth of Fannie Mae and Freddie Mac. Instead, we have
assumed a growth rate that would be roughly equal to the growth of nominal U.S. GDP. At the other extreme, if
the levels of the two portfolios and the mortgage-backed securities were to be frozen at year-end 2003 levels,
the contingent liability would be "merely" $183 billion. 10 Prior to the creation of OFHEO in 1992, the
Department of Housing and Urban Development (HUD) maintained exclusive regulatory oversight
responsibilities over Fannie Mae and (for 1989-1992) Freddie Mac. Prior to the passage of the Financial
Institutions Reform, Recovery and Enforcement Act of 1989, Freddie Mac was the responsibility of the Federal
Home Loan Bank Board.Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire?
175 neither has the tools, nor the stature, to effectively deal with the current size, complexity, and importance
of these enterprises." Most important, OFHEO cur- rently lacks the power to place an insolvent
government-sponsored enterprise into receivership. A number of legislative proposals were introduced in
Congress during 2003 to enhance the safety and soundness regulation of Fannie Mae and Freddie Mac
(Frame and White, 2004a). These proposals would move the safety-and-soundness regulator for Fannie Mae
and Freddie Mac out of Housing and Urban Develop- ment (where the culture is more focused on housing) and
into either the Treasury (where the culture is more focused on safety and soundness) or to create a
freestanding agency outside the executive branch. This relocated regulatory agency might also be given some
additional powers. For example, it might have the ability to levy fees on Fannie Mae and Freddie Mac to fund
itself, thus removing the agency from the vagaries of annual budgetary appropriations. It would have a stronger
ability to set and revise the minimum capital requirements that the two companies must meet, as well as to
regulate new programs or new activities. Finally, the new agency might have the power to appoint a receiver
that could liquidate or otherwise dispose of either Fannie Mae's or Freddie Mac's assets in the event that one
of them became insolvent. At the time that this article was completed in fall 2004, no definitive legislative action
had been taken. Systemic Risk In recent testimony before Congress, Federal Reserve Chairman Greenspan
(2004) suggested that Fannie Mae and Freddie Mac may pose "systemic risks" to the U.S. economy. That is, if
one of the companies became financially distressed, enough harm to the overall financial system could be
caused such that a nontrivial reduction in general economic activity would result." Such concerns generally
begin with the observations that these companies are large, highly leveraged and focused on a particular asset
class that they dominate. As noted above, as of year-end 2003, Fannie Mae and Freddie Mac were the second
and third largest U.S. companies measured by assets. In terms of financial leverage, Fannie Mae and Freddie
Mac operated with ratios of total capital to total assets of 3.4 percent and 3.9 percent, respectively, as of that
same date. (By contrast, FDIC-insured deposi- tory institutions maintained a ratio of total capital to total assets
of 9.2 percent on December 31, 2003.) Finally, about 86 percent of the combined balance sheet of December
31, 2003.) Finally, about 86 percent of the combined balance sheet of Fannie Mae and Freddie Mac
constitutes mortgage-related assets. Almost 50 per- Fannie Mae and Freddie Mac constitutes
mortgage-related assets. Almost 50 per- cent of all the credit risk and 20 percent of all market risk associated
with U.S. residential mortgage assets are held by the two companies. The U.S. Office of 1 The discussion
below focuses on systemic risks emanating from either (or both) Fannie Mae or Freddie Mac. Fahey (2003)
and U.S. Office of Federal Housing Enterprise Oversight (2003) suggest that because of their implicit
government guarantees, the companies might also act as a source of strength to financial markets in the face
of external shocks.176 Journal of Economic Perspectives Federal Housing Enterprise Oversight (2003)
provides a detailed discussion of systemic risk as it may pertain to Fannie Mae and Freddie Mac. Concerns
about the systemic consequences of Fannie Mae and Freddie Mac have focused on the concentration of
market risk within the two companies. Fannie Mae and Freddie Mac do hedge these risks in their portfolios in
various ways, thereby distributing the market risk into the broader capital market. One way they do this is by
issuing "callable debt," so that if interest rates fall and a surge of prepaying home mortgage occurs, Fannie and
Freddie can refinance their existing debt as well. The companies also use derivative financial instruments, like
interest- rate swaps, to reduce their exposure to interest rate risk. Fannie Mae and Freddie Mac rely heavily on
"dynamic hedging," whereby they rebalance their portfolios in response to changing interest rates that
influence expected prepayment behavior (U.S. Office of Federal Housing Enterprise Oversight, 2003; Jaffee,
2003). A specific area of systemic concern has been the effect of portfolio rebalancing by Fannie Mae and
Freddie Mac on fixed-income markets. For example, a decline in the general level of interest rates often leads
to increased prepayment risk, which in turn reduces the duration of mortgage-related assets. Holders of these
assets, if they would like to maintain the original duration of their portfolios, would then have to purchase other
longer-term assets to add duration. Increased demand for these longer-term assets would increase the price of
these assets, or equivalently reduce the interest rates on them further. Perli and Sack (2003) present statistical
evidence that mortgage-related hedging significantly influences the behavior of the 10-year swap rate,
although their analysis is not focused on Fannie Mae and Freddie Mac specifically. The U.S. Office of Federal
Housing Enterprise Oversight (2003) notes several conditions that make an economy vulnerable to financial
sector shocks, including weak market discipline of institutions and poor public disclosure. "Market disci- pline"
refers to the ability of investors and creditors to track the changing financial condition and risk of firms and
securities, to price securities accordingly and, through pricing, to influence the actions of management (Bliss
and Flannery, 2001). Consistent with the presence of some market discipline of Fannie Mae and Freddie Mac,
Seiler (2003) finds that the share prices and debt yields of these companies respond to new information about
their respective financial risks. Fannie Mae and Freddie Mac have taken steps to strengthen their public
disclosure through a set of six voluntary initiatives announced in 2000: a) to issue subordinated debt; b) to
meet certain liquidity standards; c) to enhance credit-risk subordinated debt; b) to meet certain liquidity
standards; c) to enhance credit-risk disclosures; d) to enhance interest rate disclosures; e) to obtain annual
credit disclosures; d) to enhance interest rate disclosures; e) to obtain annual credit ratings; and f) to
self-implement and report their regulatory risk-based capital levels. (This sixth initiative was rendered obsolete
in 2002, when OFHEO's risk- based capital standard became effective.) Also, in 2002 both Fannie Mae and
Freddie Mac agreed to register their common stock with the Securities and Ex- change Commission, although
at the time of this writing only Fannie Mae has followed through. These steps all seem headed in the right
direction, althoughW. Scott Frame and Lawrence J. White 177 some improvements also seem possible (Frame
and Wall, 2002; Jaffee, 2003). A more direct approach to reducing systemic risk associated with Fannie Mae
and Freddie Mac would be to limit their debt issuance, thereby capping the size of their respective balance
sheets (Greenspan, 2004). Two other arguments about systemic risk related to Fannie Mae and Freddie Mac
have been discussed. One is that the companies have seemingly large expo- sures to a small number of
derivatives counterparties. Fannie Mae and Freddie Mac are significant end-users of interest rate derivatives,
and together the notional amount of these instruments outstanding as of year-end 2001 was $1.6 trillion for the
two companies. Moreover, as of the same date, five counterparties accounted for about 59 percent of their
over-the-counter derivatives. However, the notional amounts of derivatives often bear little direct relationship to
the actual credit exposure; as a simple example, an option to borrow $100 million at a certain fixed rate of
interest six months from today has a notional value of $100 million- although the price of the actual option is
much lower. Moreover, counterparties in a derivatives trade are required to post collateral if their net exposure
exceeds certain limits, with lower-rated counterparties posting proportionately more collat- eral. Indeed, U.S.
Office of Housing Enterprise Oversight (2003) reports that as of year-end 2001, the net uncollateralized
exposures were only $110 million for Fannie Mae and $69 million for Freddie Mac. In the event of counterparty
default, however, there is "rollover risk" to the extent that Fannie Mae and Freddie Mac find it difficult or
particularly expensive to replace their hedging positions (Jaffee, 2003). An introduction to derivatives and their
uses and misuses in this journal can be found in Stulz (2004). The other argument is that, under current
regulations, federally insured depository institutions can make unlimited investments in the obligations of
Fannie Mae and Freddie Mac. However, as illustrated in Frame and Wall (2002), although a large number of
banks hold such obligations in amounts that exceed their net worth (just over 50 percent as of year-end 2000),
most of these institutions are very small (over 95 percent as of year-end 2000). Further, in the event of
financial distress at either Fannie Mae or Freddie Mac, the losses incurred by mortgage- backed securities
investors would likely be minimal, given that the securities are collateralized by mortgages with very low
historic loss rates. Kulp (2004) assesses the exposure of FDIC-insured institutions to privatization of Fannie
Mae and Freddie Mac and finds minimal impact, although that analysis does not consider the impact in the
case of financial distress at either or both of the companies. Allocative Efficiency The benefits embedded in the
federal charters of Fannie Mae and Freddie Mac The benefits embedded in the federal charters of Fannie Mae
and Freddie Mac act as a barrier to entry in the secondary conforming mortgage market (Goodman act as a
barrier to entry in the secondary conforming mortgage market (Goodman and Passmore, 1992; Hermalin and
Jaffee, 1996). In that market, Fannie Mae and Freddie Mac can be characterized as duopolists. But instead of
raising prices, Fannie Mae and Freddie Mac cause mortgage interest rates to be below those that178 Journal
of Economic Perspectives the private market would otherwise provide. For this reason, Carlton, Gross and
Stillman (2002) conclude that the two companies do not raise antitrust concerns. However, an examination of
market power in the context of a government subsidy should not offer comparisons with an unsubsidized
market, but instead should ask whether the subsidy is completely passed through by competing firms to
customers. Some theoretical research has examined various equilibrium outcomes arising from interactions
between a perfectly competitive primary mortgage market and a less than perfectly competitive secondary
mortgage market (for example, Gan and Riddiough, 2004; Passmore, Sparks and Ingpen, 2002; Heuson,
Passmore and Sparks, 2001; Passmore and Sparks, 2000). Such studies examine issues related to mortgage
guarantee pricing as well as the distribution of mortgage credit risk (by risk classification) between mortgage
originators and Fannie Mae and Freddie Mac. The empirical evidence suggests that Fannie Mae and Freddie
Mac do retain some portion of their federal benefits and hence are not acting in a perfectly competitive manner.
One piece of casual evidence is the extraordinary profitability of these two firms. For the years 1998-2003, for
example, Fannie Mae earned an average return on equity of 32.6 percent while Freddie Mac earned an
average of 28.3 percent. By contrast, the industry return on equity for all FDIC-insured commercial banks for
the same six years was 13.6 percent.'2 A second piece of evidence is from studies of using Fannie Mae and
Freddie Mac as conduits for a mortgage interest rate subsidy. Feldman (1998) reviews the various
approaches, while U.S. Congressional Budget Office (2001, 2004) and Passmore (2003) offer more recent
analyses. For example, the U.S. Congressional Budget Office (2004) estimated that in 2003 the two
companies received gross benefits of $19.6 billion accruing from their federal charters, of which they passed
through $13.4 billion to homebuyers through lower mortgage rates and retained $6.2 billion for their
shareholders. Using a simulation exercise, Passmore (2003) estimates the median after-tax present value of
Fannie Mae's and Freddie Mac's net federal benefits at $72 billion, accounting for 60 percent of the companies'
combined market capi- talization. Outside analyses sponsored by Fannie Mae disputes various assumptions
and research methods used in these studies (for example, Toevs, 2001; Greene, 2004; Blinder, Flannery and
Kamihachi, 2004). Of course, if one believes that broad-brush public policies encourage too much housing
investment and that the activities of Fannie Mae and Freddie Mac exac- erbate this problem, then the exercise
of market power by these firms will improve allocative efficiency in the economy. 12 For the 15 years
1989-2003, Fannie Mae averaged 28.9 percent, while Freddie Mac averaged 24.9 percent. An alternative
profitability ratio, return on assets (ROA), is substantially lower for Fannie Mae and Freddie Mac than that for
commercial banks. The primary reason for this is that Fannie and Freddie are far more leveraged. As an
indicator of likely rents from less-than-completely-vigorous Freddie are far more leveraged. As an indicator of
likely rents from less-than-completely-vigorous competition, return on equity is the superior
measure.competition, return on equity is the superior measure.Fussing and Fuming over Fannie and Freddie:
How Much Smoke, How Much Fire? 179 Institutions for Greater Market Efficiency As an historical matter,
Fannie Mae and Freddie Mac have surely enhanced the liquidity of mortgage loans, improved the geographic
diversification of mortgage credit risk, and nationally integrated mortgage markets. Further, the presence of
Fannie Mae and Freddie Mac and their implied guarantees may well have been important for the innovation
and development of mortgage securitization in the 1970s and 1980s. Nevertheless, most of these benefits can
now be achieved as a result of geographic deregulation of banking, which has allowed large, nationwide
mortgage originators to emerge. Mortgage securitization is now a well-established technology of finance that
does not require the special status of Fannie Mae and Freddie Mac. So do Fannie Mae and Freddie Mac still
provide a necessary institu- tional underpinning for a more efficient mortgage market in the current economic
environment? Because of their special status, Fannie Mae and Freddie Mac can issue blanket credit-loss
guarantees on an entire pool of loans as well as avoid the costs of having their securities rated by rating
agencies or registered with the Securities and Exchange Commission. In contrast, private-label
mortgage-backed securities often have a structure that involves creating different levels of seniority of debt,
obtaining securities ratings from rating agencies like Moody's or Standard & Poor's and registering with the
Securities and Exchange Commission-all of which involve transactions costs. Further, investors in the senior
mortgage-backed securities follow the credit performance of the underlying loans, which results in monitoring
costs. In this way, the presence of Fannie Mae and Freddie Mac (and their special halo) might eliminate
significant transactions costs (Woodward, 2004). However, these transaction costs are actually shifted rather
than eliminated: investors believe that they are shielded from credit risk not only by Fannie Mae and Freddie
Mac, but also ultimately by taxpayers. Another argument is that the new-era securitization process is an
inherently more efficient way of providing mortgage finance and that the expansion of Fannie Mae and Freddie
Mac (with their implicit federal guarantee) at the expense of depositories' holdings of residential mortgages
(supported by the depositories' explicit federal deposit insurance) is evidence of this superior efficiency (Van
Order, 2000a, b; 2001). Three potential counterpoints come to mind here. First, securitization is a widely used
technology of finance in the United States: it permeates consumer credit markets (mortgages, credit cards,
auto loans) and is used by both depository and nondepository financial institutions. Second, as dis- cussed
earlier, an important reason why depository institutions securitize mortgages with Fannie Mae and Freddie Mac
rather than holding them in their portfolios is the differential treatment of these assets for purposes of required
regulatory risk-based capital. Finally, it is marginal debt funding costs that matter, rather than average costs.
While these marginal and average costs are probably roughly equal for Fannie Mae and Freddie Mac (that is,
they face a perfectly elastic supply of for Fannie Mae and Freddie Mac (that is, they face a perfectly elastic
supply of loanable funds), banks likely face a rising marginal cost curve as they tap intoloanable funds), banks
likely face a rising marginal cost curve as they tap into180 Journal of Economic Perspectives non-core
deposits or borrow money from wholesale lenders (like the Federal Home Loan Banks) or the capital markets.
Hence, the extent to which the dramatic changes in the structure of U.S. residential mortgage markets are
efficiency-driven rather than regulation-driven remains unclear.'3 Finally, there is no assurance that the current
organizational structures for Fannie Mae and Freddie Mac are the most efficient. Since the Congress has
issued only two charters of this particular kind, no competitive processes exist to reward more efficient firms
and winnow less efficient firms. The market for corporate control also cannot operate effectively, since the two
companies' large sizes and special status likely make them immune to a takeover by a firm or an investor
group. What Is to Be Done? First-Best There seems no strong efficiency reason for preserving the existing
structure of Fannie Mae and Freddie Mac. They mostly just add to an already excessive encouragement for
housing in the United States, using an implied guarantee that (to the extent that it would be honored) creates a
contingent liability for the U.S. government. Thus, a complete privatization of the two companies would be the
first-best outcome. In this vision, the two companies would no longer enjoy any special privileges, but also
would no longer be restricted to their current narrow slice of the financial world. The consequence of such a
step for residential mort-gage markets would be modest: Mortgage rates would probably rise by about 20-25
basis points (ceteris paribus). Because it appears that the United States already builds and consumes too
much housing, this would be a move in the right direction. Instead of backing a broad subsidy to housing
through Fannie Mae and Freddie Mac, the federal government ought to focus on assisting first-time home
buyers with low and moderate incomes (Calomiris, 2001; White, 2003). Second-Best The complete
privatization of Fannie Mae and Freddie Mac seems an unlikely outcome in the current political environment.
Accordingly, second-best measures should be considered. One useful step would be for government officials
to state clearly, whenever the subject comes up, that the federal government does not guarantee the debt of
13 As a related matter, whenever either of the two firms has expanded slightly in "horizontal" (sub-prime
lending) or "vertical" (providing underwriting software to mortgage originators) directions-or even publicly
contemplated such moves-critics have complained that the two companies' ability to expand arises solely from
the low-cost funding that they enjoy from the implicit guarantee and not because of any inherent efficiency
advantage.
W. Scott Frame and LawrenceJ. White 181 Fannie Mae or Freddie Mac and will not bail them (or their
creditors) out. No presidential administration has explicitly made such a statement. More typical are carefully
crafted comments that reiterate that the federal government is not re-quired to bail out Fannie Mae or Freddie
Mac, but fall short of flatly stating that the government will not do so (for example, Mankiw, 2004). One step
toward separat-ing the federal government from Fannie Mae and Freddie Mac has recently occurred. Five of
the 18 board members of each company were historically ap-pointed by the president; but in 2004, the Bush
administration announced that it would cease appointing such members. Second, the enterprises should be
forced to focus more on the lower end of the housing market. The loan limit for a conforming mortgage might
be frozen at its current level of $359,650 for some years. The Department of Housing and Urban Development
might strengthen the affordable housing goals that it sets for Fannie Mae and Freddie Mac. Indeed, in the fall
2004 HUD revised these goals in a way that should result in a marked increase in targeted lending. Third, the
safety-and-soundness regime should be strengthened so that it is more comparable to that of the federal
banking agencies. This step should include giving OFHEO or its successor a) responsibility for the approval of
new programs and other activities; b) the discretion to set both minimum and risk-based capital requirements;
and c) receivership authority. While the presence of a safety-and-soundness regulatory regime likely reinforces
the market perception of an implied guarantee, stronger oversight should serve to reduce taxpayer exposure.
The policy issues raised by Fannie Mae and Freddie Mac are complex and increasingly important as these
institutions grow and become a more pervasive influence on the financial sector. Although the first-best path of
privatization may well be politically unrealistic, we believe that some constructive second-best measures
deserve serious consideration.

Real Estate and Economies of Scale:


The Case of REITs
Brent W. Ambrose,​∗​​Michael J. Highfield​∗∗​a
​ nd Peter D. Linneman​∗∗∗
Building on past research in the economies-of-scale debate, we test for 
scale economies in real estate investment trusts (REITs) by examining growth 
prospects, revenue and expense measures, profitability ratios, systematic risk 
and capital costs. Overall, we find that large REITs are increasing growth 
prospects while succeeding at lowering costs, leading to a direct relationship 
between firm profitability and firm size. Additionally, we find an inverse relationship 
between equity betas and firm size, and for all cost of capital measures we 
find significant scale economies. Further evidence from the stochastic frontier 
analysis suggests efficiency opportunities appear possible through continued 
growth and consolidation in REITs. 
The phrase “economies of scale” simply implies that efficiency in production
and operations increases with size. Historically, firms in various industries often
expand and consolidate in an effort to capture these efficiency gains. Assuming
that economies of scale are available in the real estate industry, publicly traded
real estate investment trusts (REITs) are excellent tools to take advantage of
these efficiency opportunities because, unlike private real estate investors, REITs
are not equity capital constrained. Market evidence generally supports the
idea that scale economies are available to REITs; after all, investment in incomeproducing
real estate has grown tremendously over the past decade and REITs
have enjoyed most of the growth in this industry. If economists and market
analysts are correct and economies of scale exist in real estate, then REIT costs
should increase at a decreasing rate and efficiency gains should be reflected in
higher returns.
While the argument for economies of scale in commercial real estate continues
to gain momentum, disagreements about the concept of scale economies in real
estate continue to exist. Against this backdrop, this article examines the case for

scale economies in REITs on a more complete level than ever attempted before.
Recognizing that a serious limitation of the earlier studies of REIT economies of
scale is the inability to separate size-related advantages versus a period of rapidly
expanding, strong markets, we obtain 1,508 REIT year observations using a
sample of 187 equity REITs trading in U.S. markets between January 1990
and December 2001. Thus, our analysis covers an 11-year period that includes
a full market cycle of significant market expansion followed by contraction.
Using this relatively large data set, we test for economies of scale in REITs
by examining growth prospects, revenue and expense measures, profitability
ratios, systematic risk and cost of capital measures.
In addition to the size and time span of our data set, we also incorporate newsreported
information on merger activity into the analysis of economies of scale.
This is important as the costs of integrating a merger occur in the first year
or so, while efficiencies are realized largely subsequently. In the following
section, we examine the background of consolidation and economies-of-scale
arguments in real estate while defining our expectations. Next we discuss the
data and hypotheses. This is followed by a discussion of our empirical results
and conclusion.
Background
A Brief History of REIT Consolidation
Following banking deregulation in the 1980s, real estate investment, which
was already heavily debt financed, surged through the use of debt provided by
banks and savings and loans. However, the savings and loan crisis in 1989–
1990 resulted in a curtailment in debt financing for real estate, forcing many
industry leaders to turn to public capital markets. Some observers argued that the
real estate industry would have to follow the example of other capital-intensive
public firm-dominated industries and enter a period of significant consolidation,
with publicly traded companies leading the consolidation effort (​e.g​., Linneman
1997, 2002).​1
Since 1994 industry watchers have routinely predicted a wave of consolidation
in the industry.​2 ​The period of 1997–1999 was a particularly noticeable
See Ambrose, Highfield and Linneman (2000) for an overview of REIT consolidation.
1​
See Campbell, Ghosh and Sirmans (2001) for a discussion of the REIT merger and
2​
acquisition activity during the 1994 to 1998 period.
Real Estate and Economies of Scale ​325 
consolidation period in almost every property sector.​3 ​Then, while the dotcom
bubble was bursting in early 2000 and investors finally abandoned overvalued
companies with little-to-no tangible assets, real estate stood out as a relatively
strong and stable investment. In fact, REITs averaged a 26% return for the year,
and 2000 was the first year for REITs to outperform both the Nasdaq and DJIA.
Thus, with the increase in funds and popularity, REITs again consolidated.
While the rate over the past 3 years has not been as substantial as the 1997–
1999 period, consolidation has continued.​4 ​In fact, 2001 was the third-busiest
year for REIT and REOC merger and acquisitions activity, falling behind 1997
and 1998, respectively. Interestingly, while mergers and property acquisitions
continue on a monthly basis, research on these topics has been mixed.
In an early study, Allen and Sirmans (1987) examined acquirer returns from
REIT mergers during the period of 1977 to 1983, and they found significantly
positive REIT abnormal returns in reaction to merger announcements.
McIntosh, Officer and Born (1989) followed up with an examination of returns
for REIT merger targets during the period of 1969 to 1986. Again, they
found significantly positive returns. Overall, evidence from early research is
consistent with the notion that market participants believe that these mergers
would allow larger REITs to achieve economies of scale through better asset
utilization. However, as noted by Ling and Ryngaert (1997), REITs changed
significantly in the late 1980s and early 1990s. Thus, to see if the regime has
changed, Campbell, Ghosh and Sirmans (2001) examined REIT mergers during
the period of 1994 to 1998. In general, they found that acquirer returns
are slightly negative while target returns are significantly positive. While the
3​ For example, in September 1997, Equity Office Properties (EOP) announced a
$4 billion merger with Beacon Properties that added 18.8 million square feet of property
to EOP. The combined holding of 33.4 million square feet of office space made EOP
the largest office owner in the United States, with 245 properties in 21 states and the
District of Columbia. In another transaction, in April 1998 Security Capital Pacific Trust
of Denver announced its acquisition of Security Capital Atlantic Inc. for $1.6 billion,
creating the third-largest apartment REIT in the country, Archstone Communities, with
90,166 apartments and a total expected investment of $5.6 billion in apartment communities.
Another example of REIT consolidation was the September 1998, $5.8 billion
acquisition of Corporate Property Investors by Simon Property Group. At the completion
of the merger, Simon held 241 properties in 35 states, and a staggering $1.3 billion
EBITDA. In addition, in October 1999, Equity Residential Properties Trust acquired
Lexford Residential Trust in a merger valued at about $732.8 million.
4 ​In February 2000, EOP announced a $4.6 billion merger agreement with Cornerstone
Properties, and in late February 2001, EOP announced a $7.2 billion acquisition of
Spieker Properties, Inc. At the time the EOP and Spieker merger was the largest REIT
merger and acquisition transaction in history until the December 2001 $8 billion takeover
of Security Capital Group byGECapital became the largest REIT merger and acquisition
transaction in history.
326 ​Ambrose, Highfield and Linneman 
positive return for target firms is consistent with the scale economies argument,
the negative return to acquirer firms is not driven by diseconomies of
scale. Instead, because REITs often obtain significant geographical diversification
through mergers, these diversifying mergers can limit opportunities for
economies of scale. Thus, the authors explain that while diversification of all
kinds was beneficial to REITs in the 1970s and 1980s, geographical diversification
is not beneficial to the modern fully integrated REIT because it may
limit economies-of-scale opportunities.
Interestingly, McIntosh, Liang and Thompkins (1991) find evidence of a “smallfirm
effect,” that is, small REITs earn higher average rates of return than large
firms after accounting for risk. Using REIT returns from 1974 to 1988, they
find that although small REITs earn higher returns than large REITs, they are
no more risky than large REITs. While the “small-firm effect” contradicts the
scale economies argument that efficiency gains should be reflected in higher
returns, other studies that examined the impact of announcements concerning
property acquisitions on REIT share prices found insignificant wealth effects
for either sale or purchase transactions. For example, McIntosh, Ott and Liang
(1995) conclude that REITs do not experience significant wealth effects from
the announcement of either acquisition or divestment of properties. Unlike
McIntosh, Liang and Thompkins (1991), who find evidence against economies
of scale, the results of McIntosh, Ott and Liang (1995) find evidence neither
dismissing nor supporting scale economies. As a result, the early evidence
appeared to suggest that significant consolidation of property assets had not
clearly created significant gains in shareholder wealth, but research had also
not eliminated the hope for such gains.
A Brief History of REIT Economies of Scale Research
Unfortunately, as was the case for banking and other industries in the early
phases of their consolidation, it is extremely difficult to identify the presence
of economies of scale in the real estate industry. This problem arises for two
main reasons. First, given the relatively similar size of most REITs and their
recent integration, the statistical technology available to accurately measure
economies of scale is not sufficiently precise to fully capture cross-sectional
variations. For example, Mester (1996) notes that an implicit assumption in
the studies of economies of scale is that all firms in the study have access
to the same cost frontier and should be using the same technology. Second,
the effort required by growing firms to capture scale economies is difficult
and time consuming, with the pain of integration generally occurring prior to
the realization of the benefits. Thus, exploring cross-sectional variations in the
presence of significant merger and acquisition activity understates the benefits of
scale. Moreover, the market is not static as the consolidation activities described
Real Estate and Economies of Scale ​327 
above have been almost continuous in the real estate industry. As leading firms
merge and achieve competitive advantages, their competitors respond, making
it difficult to capture the effect of scale economies cross-sectionally.
Research from the 1980s and early 1990s focused on the set of very small REITs
that existed from the early 1970s and 1980s, which bear little resemblance to
today’s fully integrated REITs. Not surprisingly, limited statistical evidence
of scale economies exists based on data from the 1970s and 1980s, a period
when debtwas plentiful and the largest players were small by today’s standards.
For example, in the late 1970s and early 1980s the average equity REIT had a
market capitalization of only $28 million, but in 1990 the average equity REIT
had an inflation-adjusted market capitalization of $95 million. Furthermore,
regulations during this earlier period (such as shareholder concentration rules)
severely restricted the ability of REITs to raise sufficient capital to expand
and capture any meaningful economies of scale. Thus, it is not surprising that
researchers using REIT data from the same period find positive stock price
reaction to announcements of asset sales and attribute this to the belief that
scale economies do not exist for REITs, as these companies had no scale.
Research from the late 1990s and early 2000s utilized data from the 1980s and
early 1990s. The research in this period suggests that scale economies exist, at
least for larger REITs.​5 ​These more recent studies attempt to isolate the effect of
economies of scale in REIT expenses, revenue growth and capital costs and build
on the hypothesis that larger REITs have higher earnings growth potential.​6 ​For
example, evidence indicates that the nondiscretionary component of general
and administrative (G&A) expense increases at a decreasing rate as REIT size
increases, and other evidence indicates that scale economies exist in REIT
management costs.​7 ​However, the studies that examine various REIT expense
items (G&A, interest expense, management fees, operating expenses) find that
economies of scale are most present in smaller expense items, suggesting that
while economies of scale exist, the gains from realizing these economies may
be insufficient to lead to massive consolidation in the REIT industry.​8
Ambrose ​et al​. (2000) compared REIT income growth and profitability relative
to changes for the market to explore economies of scale using data from the
5​ See Bers and Springer (1997), Capozza and Seguin (1998) and Ambrose and Linneman
(2001).
6 ​See Zell (1997).
7 ​See Bers and Springer (1997, 1998) and Capozza and Seguin (1998).
Yang (2001) presents evidence for nonlinear economies of scale suggesting that diseconomies
8​
of scale may exist for large REITs.
328 A​ mbrose, Highfield and Linneman 
1990s. The results indicate that small REIT net operating income (NOI) growth
rates exceed average growth rates in the markets in which they held properties,
and thus small REITs appear to be generating revenue and operating economies.
However, this does not seem to be the case for the largest REITs. Their findings
indicate that NOI gains, relative to the market, were large prior to 1996, but
are no longer so, with REITs at the end of the 1990s outperforming the market
primarily via revenue enhancement, not cost reduction. Thus, the results from
the Ambrose ​et al​. (2000) study call into question the ability of large REITs to
generate sufficient economies of scale based on income growth. However, this
conclusion must be interpreted with caution because the study was based on a
small sample of residential REITs.
Additional research has tested for economies of scale in REIT capital costs,
improving on previous studies by examining REITs that invest in multiple
property segments (residential, industrial/office and retail) and focusing on the
primary driver of REIT expansion, namely capital. Because REITs are very
capital intensive and the primary source of REIT expansion lies in their ability
to access capital, significant consolidation may be motivated by scale economies
in capital costs. Based on capital costs for equity REITs from 1997 and 1998,
the evidence indicates that REITs realized significant scale economies with
respect to capital costs. Although all REITs appear to generate scale economies
in capital costs, the results from this study show that the scale economies in
capital for large REITs are almost twice as large as the scale economies for
small REITs. As argued by Linneman (1997), the natural implication is that
large REITs are in a position to utilize their economies of scale in capital
costs—their main input cost—to further consolidate the real estate industry.
In addition to the problems inherent to identifying economies of scale in rapidly
changing industries, controversy exists regarding the technology employed in
estimating economies of scale. Estimation of economies of scale for various
industries and firms has a long history within the general finance and economics
literature. In particular, research on economies of scale in the banking
literature is extensive given the natural questions regarding size and efficiencies
in a highly regulated industry. As a result, the banking literature contains
numerous studies that demonstrate the relative merits of various methods of
measuring scale efficiencies. For example, Berger and Humphrey (1997) catalog
130 studies of financial institution economies of scale using a variety of data
and estimation techniques. In an attempt to bring order and clarity to the variation
in results reported in these studies, Berger and Mester (1997) conducted an
exhaustive comparison of the multiple efficiency concepts and differing econometric
measurement methods using a large data set containing over 5,000 U.S.
commercial banks. Their study notes that the most common estimation methods
involve both nonparametric techniques (data envelopment analysis [DEA]
Real Estate and Economies of Scale ​329 
and free disposable hull analysis) and parametric methods (stochastic frontier
approach, thick frontier approach and the distribution free approach). Berger
and Mester (1997) note that the nonparametric techniques have a number of
significant drawbacks, which lead to findings of lower efficiency means than
reported by the parametric methods. They also note that the parametric stochastic
frontier approach requires explicit and arbitrary distributional assumptions
regarding the components of the error term. Furthermore, Berger and Mester
(1997) discuss the choice of the functional form for the cost and profit functions
when estimating efficiency via one of the parametric methods. Although they
note that the translog form is popular, they indicate that other more flexible functional
forms may provide a better fit to the data. However, the results of their
comparison indicate that “choices made concerning efficiency measurement
usually make very little difference” (p. 897).
Integral to the discussion of estimation technology is the controversy regarding
how to measure economies of scale in REITs. Most empirical studies
of scale economies have focused on industries with readily identifiable and
quantifiable outputs. For example, economists have studied scale economies
in such diverse industries as brewing, where the output is quantified as barrels
or gallons of beer (Tremblay and Tremblay 1988); steel, where output is gross
tonnage of steel produced (McCraw and Reinhardt 1989); electrical utilities,
where output is measured in kilowatts-hours (Christensen and Greene 1976);
banking, where output is measured in terms of asset dollars (Noulas, Ray and
Miller 1990, Mullineaux 1978); and railroads (Caves, Christensen and Swanson
1981), shipping (Jansson and Shneerson 1978) and airlines (Borenstein
1991, Kim and Singal 1993), where output is measured in terms of freighttons
or passenger-miles hauled. The overriding feature across these industries
is that the firms produce essentially a homogenous product with readily identifiable
input factors necessary for production. REITs, however, invest in real
estate assets and derive profits through leasing space in these assets. Unfortunately,
real estate is not homogenous, and this creates difficulties in quantifying
firm output. For example, several studies have proxied REIT output
as total assets because it has the advantage of value-weighting the real estate
investment.​9 ​Because total assets are recorded at book value, this creates difficulties
in comparing firms that may have acquired their assets at different
points in time. Other studies have suggested proxying output as total square
feet available for lease since this measure closely proxies the physical output
measured in other industries. However, this has the drawback of not recognizing
the inherent heterogeneity in real assets (​i.e​., location, product type and
quality).
See Anderson ​et al​. (2002).
9​
330 ​Ambrose, Highfield and Linneman 
As a result of these problems, we focus on a simple metric of scale efficiency.
Our analysis, in the spirit of Altinkihc and Hansen (2000), estimates the effect
of firm size across multiple dimensions of revenue and cost parameters. In
order to capture the possibility that firm cost and profitability factors follow the
traditional U-shaped curve with respect to firm size, we include in our regression
analysis the natural log of total capitalization. However, in an effort to link
our simple efficiency measure with the prevailing literature, we also report an
analysis of REIT scale efficiency through stochastic frontier estimation of the
translog cost function.
Data
We examine a sample of 187 REITs trading on the Nasdaq, New York Stock
Exchange or American Stock Exchange from January 1990 through December
2001. The sample is restricted to REITs with financial data available from
the SNL REIT Datasource and monthly returns available from the Center for
Research in Securities Prices (CRSP) database. In addition to the SNL REIT
Datasource and CRSP data, we also used SNL Interactive and the Dow Jones
News Service to examine all REIT-related press releases from January 1988
through December 2001. From these press releases we compiled a listing of
historical mergers and the size of those mergers.
The summary statistics for our primary variables of interest are showninTable 1.
Because several variables commonly used in REIT research do not have a universal
and undisputed definition, it is important to clarify variable measurement.
First, we define total capitalization as the market value of common equity outstanding
plus the value of preferred shares plus the book value of debt.We then
examine measures of REIT growth prospects including implied capitalization
rates (​ICR​) and payout ratios. The ​ICR ​is rental net operating income (​NOI​) as
a percentage of average real estate value providing a rough proxy for pricing
REIT assets.​10 ​That is, the ​ICR ​is effectively a going-in rate of return for investors:
The higher the ​ICR​, the more the assets are “discounted” when sold
on a per share basis, and vice versa. This implies that lower ​ICR​s indicate a
market premium while higher ​ICR​s indicate a market discount on the value of
REIT assets. The payout ratio is the cash dividend per share of common stock
as a percentage of funds from operations (​FFO)​ per share. Because capital is
costly, low payout ratios encourage growth.

To examine REIT revenue and expenses we include net operating income (​NOI​)
as a percentage of sales, rental revenue as a percentage of sales and general
and administrative (G&A) expenses as a percentage of sales. If economies of
scale are evident in REITs, then we would expect to find that both revenue
measures increase while the overhead costs fall as a proportion of revenue as
size increases.
We evaluate REIT profitability using return on equity (​ROE​) and funds from
operations yield (​FFO Yield​). ​ROE ​is defined as net income as a percentage
of average equity. Assuming that consolidation and growth leads to revenue
enhancement, we should find an expansion in net income relative to
increases in equity providing an increase in ​ROE​. We define ​FFO Yield ​as
funds from operations as a percentage of the REIT’s market price per share
of common equity.​11 ​In the presence of scale economies, we should find that
ROE ​and ​FFO Yield ​provide similar results; that is, profitability increases with
size.
Due to possible variations in risk across different firms, property types or organizational
structures, we estimate each REIT’s equity beta, a measure of
systematic variation in returns relative to the market, using the Capital Asset
Pricing Model (CAPM) framework. If economies of scale are present, we
should expect to find lower systematic risk as firm size increases.
Using CRSP we obtain the monthly returns for each REIT in the sample and
the CRSP value-weighted market index. We use the 3-month T-Bill secondary
market rate as a proxy for the risk-free rate.​12 ​After converting the T-Bill yearly
rate to a monthly rate, we estimate REIT equity betas using the market model:
Ri​ ​,​t ​= ​ai​ ​+ ​bi​ ​Rm
​ ​,​t ​+ ​ei​ ​,​t​, ​(1)
where ​Ri​ ​,​t ​and ​Rm ​ ​,​t ​represent the monthly returns for REIT ​i ​and the market
portfolio in excess of the risk-free rate for the 24 prior months, ​αi​ ​is the regression
intercept, ​βi​ ​is the estimated equity beta for REIT ​i ​and ​εi​ ​,​t ​is the standard
error term.​13
11 ​As defined by SNL Datasource, funds from operations (​FFO ​is typically derived by
taking GAAP net income, excluding gains and losses from sales of properties and debt
restructuring, and adding back real estate depreciation expenses.
12 ​T-Bill rates were obtained from the FRED​_ ​database at the Federal Reserve Bank of
St. Louis (http://research.stlouisfed.org/fred/data/irates/tb3ms).
13 ​For example, December 2001 betas are estimated by regressing the REIT returns less
the risk-free rate against the CRSP value-weighted market index less the risk-free rate
for the period from January 2000 to December 2001.
Real Estate and Economies of Scale ​333 
We also examine the relationship between a REIT’s cost of capital and its size.
We calculate each REIT’s weighted average cost of capital (​WACC​) as follows:
WACC ​= ​k​d
_
TD
TC
_
+ ​k​p
_
PE
TC
_
+ ​k​e
_
CE
TC
_
, ​(2)
where ​TC ​= ​TD ​+ ​PE ​+ ​CE ​and ​kd​ ​, ​kp​ ​and ​ke​ ​are the cost of debt (​TD​),
preferred equity (​PE​) and common equity (​CE​), respectively. The cost of debt
and preferred equity are estimated as the ratio of total interest expense to book
value of debt and the ratio of preferred dividends to book value of preferred
stock, respectively. The cost of equity is estimated via the CAPM using the
beta calculated in (1). It is intuitive that having a capital cost advantage in a
capital-intensive industry such as real estate should lead to a true competitive
advantage. In effect, a REIT with lower capital costs can hire better talent,
charge lower rents, and buy more expensive properties while still financially
outperforming competitors with a high cost of capital.
Next we calculate the return on capital (​ROC​) and economic value added spread
(​EVA_​ ​Spread​) for each REIT. ​ROC ​is calculated by dividing ​NOI ​by capital
employed, and ​EVA_​ ​Spread ​is defined as net operating profit after taxes minus
the capital charge, where the capital charge is the REIT’s ​WACC ​multiplied
by capital employed.​14 ​In the presence of economies of scale we should
find a positive relation between total capitalization and both ​ROC ​and ​EVA​_
Spread​.
We also control for growth, leverage, industry, time and organizational structure
effects in our regression analysis. With regard to growth rates, asset growth is
the growth in the book value of total assets over the previous year, and ​FFO
Growth ​is the growth in ​FFO ​over the previous year. To control for leverage
effects we include the book value of total debt, expressed as a percentage of the
total capitalization of the REIT in dollar terms (​Total Debt/Total Cap​), and the
ratio of the book value of short-term debt to the book value of long-term debt
(​ST Deb/LT Debt​).
We control for industry effects through binary variables based on the
self-reported property focus of the REIT: ​Recreation,​ ​Restaurant​, ​Healthcare​,
Retail​, ​Industrial​, ​Residential​, ​Self Storage​, ​Hotel​, ​Office ​and ​Other/
Diversified​. Although all of the firms are publicly traded, most have a specific
property focus (such as hotels, apartments or self-storage facilities, ​etc​.),
See Stewart (1991), Walbert (1994) and O’Byrne (1996) for a detailed discussion of
14 ​
EVA​_ ​calculations.
334 A
​ mbrose, Highfield and Linneman 
with each sector effectively a separate industry with its own operating and competitive
dynamics. For example, Table 2 shows that recreation REITs typically
have the smallest total capitalization, approximately $358 million, while office
REITs have the largest market capitalization, approximately $1.6 billion.With
regard to growth prospects, residential REITs post the lowest ​ICR ​at 9.7%,
while hotel REITS have the highest average ​ICR ​at 12.8%. ​FFO Yields ​range
from 6.6% for restaurants, to a high of 10.2 for self-storage REITs. Looking
at revenue and expense measures, diversified REITs have the lowest ​NOI ​to
revenues ratio, 57.9%, and healthcare REITs have the highest ​NOI ​to revenues
ratio. The rental revenue to total revenue varies from 54.9 for hotels to 95.7
for self-storage REITs. While maximizing rental revenue, self-storage REITs
also minimize general and administrative (G&A) expenses as a percent of total
revenue at 3.7%, reflecting the fact that the costs of managing cubic space
is minimal. Lastly, regarding profitability, restaurants have the lowest ​ROE
(​−0​.7%) and highest payout ratio (134.7%), while residential and retail REITS
have the highest ​ROE ​(11.5%). Self-storage REITs provide the lowest payout
ratios among the groups considered.
Finally, we control time and organizational structure effects through a set of
binary variables reflecting self-managed and self-advised firms interacted with
the observation year. As shown in Table 3, after adjusting for inflation, during
the sample period the total capitalization for an average REIT increased at
a compound annual rate of approximately 22% (from $194 million in 1990
to $1,683 million in 2001). Table 4 displays the variation across operating
structures.
Methods and Results
Regression Analysis
The information in Tables 2, 3 and 4 reveals notable differences across property
types, time and organizational structures. So, are changes in growth prospects,
revenues and expense measures, profitability measures, systematic risk and
capital costs due to economies of scale or is it simply property focus, time or
organizational structure that drives these accounting and financial performance
measures? To answer this question we estimate multivariate regressions using
a random effects model with unbalanced panels.​15

Growth Prospects
Table 5 provides the multivariate regression results for the impact of size
on growth prospects controlling for asset growth, FFO growth, industry effects,
time and organizational structure. Overall, the results show evidence of
economies of scale. For the ​ICR ​regression, we find a negative and significant coefficient
for firm size, and a significantly positive coefficient for the quadratic
effect, indicating that as REIT total capitalization increases there is a corresponding
nonlinear decrease in ICRs.​16 ​The results indicate that the presence
of value-generating benefits obtainable by increasing size because the market
places a premium on larger REITs in the form of higher asset prices. In addition
to size, other factors contribute to the determination of implied capitalization
rates. We find that higher asset growth rates lower implied capitalization rates,
but higher debt usage has the opposite effect.
In addition to lower implied capitalization rates, we find evidence that firm
size affects payout ratios in a similar, nonlinear fashion. The regression results
indicate that larger firms have higher payout ratios. As expected, we find that
higher debt ratios negatively affect payout ratios and payout ratios appear to
vary across property types. These results suggest diminishing returns to scale
with respect to retained earnings. While this issue as a whole is driven by
dividend discipline of the board rather than operating or capital market issues,
firms that lower payout ratios are effectively lowering their cost of capital by
using retained earnings in place of the more expensive capital markets. As a
result, smaller firms, with lower payout ratios, appear to be capitalizing on the
ability to utilize retained earnings to fund growth opportunities. However, as
firm size increases, retained earnings are no longer sufficient to fund significant
growth opportunities.
Revenue and Expense Measures
One of the main driving forces behind consolidation in the real estate industry
is the belief that larger REITs should obtain some measure of efficiency gains
in improving profit margins by increasing revenues and lowering expenses.
Estimates of these effects are presented in Table 6.

The ratio of ​NOI ​to total revenue is a popular proxy for firm profitability.
We find that asset growth, FFO growth, total debt ratios and property focus
are significant in determining ​NOI ​as a percentage of total revenue, but we
also find a positive and significant coefficient on firm size, and a statistically
significant, negative coefficient for the quadratic size effect. Thus, firm ​NOI
increases at a decreasing rate as the firm grows larger. Similarly, examining
rental revenue, we find that total debt ratios and property focus are significant
in explaining rental revenue as a percentage of total revenue. Interestingly, we
find no evidence to suggest a relationship between firm size and rental revenue
as a percentage of sales; however, we do find that mergers, in the current year
or previous year, have a negative effect on rental revenue as a percentage of
total revenue. Thus, while larger firms can increase profit margins, most likely
through lower expenses, rental revenue as a percentage of sales is unaffected by
size, but the effects of a recent merger may negatively impact rental revenue.
As mentioned previously, another popular argument for economies of scale
in real estate is that as a REIT grows larger, it should decrease its portion of
G&A expenses as a percentage of revenue. In other words, it can allocate its
G&Aexpenses over a larger asset base. Again, property focus shows significant
explanatory power in determining the ratio of G&A expenses to total revenues,
and the significantly negative coefficient on firm size suggests that larger REITs
are increasing shareholder value by lowering overhead expense ratios. Overall
the evidence here supports the notion that larger firms are better at increasing
revenues while decreasing costs, a true-scale economies competitive advantage
we should expect to be evident in profitability measures.
Profitability Measures
In Table 7 we report the models regarding profitability measures, beginning
with net income to total equity (​ROE​). In general, we find evidence that larger
firms achieve higher returns for shareholders. The positive and significant size
coefficient and the negative and significant quadratic coefficient suggest that
ROE ​increases at a decreasing rate. Again, this result is not surprising given
the findings for size effects on ​NOI ​and overhead costs. We also find strong
evidence that property focus affects ​ROE​.
Next, we consider the effect of size on ​FFO Yield​. Again, we find strong support
for the theory that size influences ​FFO Yield​. The results indicate a nonlinear
effect, with ​FFO Yield ​increasing at a decreasing rate, as total capitalization
increases. As expected, in the presence of scale economies, we should find that
ROE ​and ​FFO Yield ​provide similar results; that is, profitability increases with
size.

Risk and Capital Costs


Using equity betas as a measure the systematic variation in returns for a stock
relative to the market as a whole, Table 8 reports the results of the regression
estimating the impact of REIT size on beta, controlling for growth effects,
capital structure, industry, year and organizational structure effects. The results
indicate that equity betas vary across property focus, butwe also find significant
coefficients for FFO growth and capital structure ratios. In addition, we also find
a statistically significant, negative coefficient on firm size, and a positive, but
insignificant, coefficient on the quadratic of firm size. This suggests that larger
REITs enjoy less systematic variation in stock returns relative to the market.
Also in Table 8, we find a statistically negative, nonlinear relationship between
firm size and the ​WACC​. The evidence presented here suggests that larger
firms enjoy lower costs of capital, but these costs decrease at a decreasing rate.
Interestingly, the significant coefficient on the debt-to-total-capitalization ratio
does not suggest that REITs are enjoying this lower ​WACC ​by increasing size
through debt issuance. Instead, based on the previously presented results, one
could argue that ​WACC ​is declining due to lower costs of equity resulting from
lower payout ratios and lower systematic risk.
Turning to capital costs, Table 9 reports the results of regressions estimating
the impact of REIT size on ​ROC ​and ​EVA_​ ​Spread​. Examining ​ROC​, we find
that property focus, total debt ratios and growth ratios impact REIT return on
capital; however, we also find a statistically significant positive coefficient on
firm size and a negative statistically significant coefficient on the quadratic of
firm size. This suggests that ​ROC ​increases at a decreasing rate and REITs earn
more per dollar in invested capital as they increase in size, but, as suggested by
the negative sign on the total debt ratio, this increase is offset by the costs of
increasing leverage.
Finally, we find that capital structure and property focus does impact ​EVA​_
Spreads​, but firm size is an important part of the equation. In fact, we find that
larger REITs have higher ​EVA_​ ​Spreads​, but again, this relationship increases
at a decreasing rate. This is consistent with Ambrose and Linneman (2001)
and supplies additional evidence of economies of scale in capital costs. That
is, larger firms are less risky, as measured by equity betas, than their smaller
counterparts, and these larger firms enjoy lower costs of capital, as measured by
WACC​, while generating profits in excess of their cost of capital, as measured
by ​ROC ​and ​EVA_​ ​Spread​.
Stochastic Econometric Frontier Analysis
In the spirit of Mester (1996), we provide another test of economies of scale in
REITs using the stochastic econometric frontier model. This model is based on

the assumption that a REIT’s cost will deviate from the industry cost frontier
as a result of random noise and inefficiency. Following Mester (1996), we use
a translog cost function as the functional form, and we estimate the model
using maximum likelihood techniques. After estimation, we calculate the scale
economies measure (​SCL​) where ​SCL ​< ​1 implies scale economies, ​SCL ​=
1 implies constant returns to scale, and ​SCL ​> ​1 implies diseconomies of
scale.​17 ​Table 10 reports the scale economies measure evaluated at the mean
output, input price levels and financial capital cost levels over the entire sample
and size quartiles based on total assets. For the entire sample we find a ​SCL
of 0.988, which implies that a 1.0% increase in the level of output, holding
risk and the quality of the output constant, would lead to a 0.988% increase
in total costs. As shown in Table 10, all size quartiles support the findings

presented above. This suggests that economies of scale continue to exist for
REITs.
Conclusions
REITs have experienced significant growth and received increased attention in
the financial literature during the past decade.With this increased attention and
growth, many experts have raised the possibility of economies of scale in real
estate, and theory suggests that, as REITs have grown and merged, they provide
an almost perfect laboratory for examining any such scale economies.
Building on past research in the REIT economies-of-scale debate, we test for
economies of scale in REITs by examining growth prospects, revenue and expense
measures, profitability ratios, systematic risk and cost of capital measures.
Utilizing REIT property data from the SNL REIT Datasource as well as REIT
and market return data from the CRSP database, we examine differences in
REITs across organizational structures, across time and across property focus.
We then estimate multivariate regression models to determine whether REITs
are gaining economies of scale with respect to firm size.
A serious limitation of the earlier studies of REIT economies of scale is the
inability to separate size-related advantages versus a period of rapidly expanding,
strong markets. Thus, our updated analysis now covers an 11-year period
that includes a full market cycle (significant market expansion followed by contraction),
the importance of which should not be understated. In addition to the
size of our data set, we also improve on other REIT economies-of-scale studies
by using only real dollar amounts, leveraging SNL data with news-reported
information on merger activity and specifically controlling for REIT property
focus.
As a whole, our results suggest that small REITs have available efficiency gains
in the area of growth, and we find strong evidence suggesting that large REITs
are succeeding at lowering costs, specifically G&A expenses, and increasing
profit margins. Thus, it is no surprise that there is a direct relationship between
firm profitability, as measured by return on equity, and firm size.We also confirm
these results with the FFO yield.
With respect to equity betas, we find an inverse relationship between betas
and firm size indicating that as REITs grow larger they find ways of lowering
systematic risk. These findings are supported by the inverse relationship between
REIT size and ​WACC​. In fact, for all cost-of-capital measures we find
significant economies of scale, such as the positive and significant relationship
between firm size and ​ROC ​and ​EVA_​ ​Spreads​. In addition to the regression re​348 
Ambrose, Highfield and Linneman 
sults discussed above, we also estimate a stochastic econometric frontier model
using a translog cost function as the functional form. The results of the scale
economies measure calculated from the efficient frontier suggests that REITs
can lower costs while increasing output for all size classes considered.
Overall, we find continued support for economies of scale in real estate through
growth and consolidation in REITs, but we should note that these results, while
particularly strong, could be underestimated, particularly in the areas of revenue
and expenses. In general, econometric analysis of economies of scale is often
difficult due to “local” data relative to the true scale, the lag of integration
and expansion efficiency as well as the nature of competition. While we have
adjusted for scale issues by using ratios when available, converting all dollar
amounts to real dollars, and controlling for lag effects by incorporating merger,
merger amount and development lags, competition may lead to understated
results in econometric models. Like other industries where economies of scale
abide, competition responds in a manner that erodes competitive advantages.
This means that costs can decline while returns remain constant simply because
all market participants are doing the same thing. Thus, the results presented in
this article are effectively downward biased, but they nonetheless support the
theory of economies of scale in the REIT market.
Furthermore, it should be noted that the old generation of REIT data, dating
back to the 1980s, is of limited relevance because many of those firms were in
their infancy and not operating anywhere near a productive level of efficiency.
During the early and mid-1990s the REIT industry experienced a period of rapid
growth, and by the late 1990s and early 2000s we have seen a market contraction
and slower period of growth. As such, the REIT market has changed and many
of these changes may not become apparent until 5 or 10 years into the future.
Finally, the market has proven that REITs have dramatically increased in size
over the past decade, and they will continue to do so. In 1990 a $300 million
REIT was a large company, but now a $300 million company is one of
the smallest. However, we cannot misinterpret our results as a projection of
doom and gloom for small REITs. As suggested by Stigler (1958), there is
no single, magical, optimal firm size. Just because a REIT is smaller or larger
than our estimates does not mean that it cannot compete. In fact, some small,
well-managed REITs are sustaining competitive advantages over large, poorly
managed REITs. A large, inefficient REIT is simply a wasted opportunity, and
just increasing size will never guarantee success—a point clearly illustrated by
the negative shareholder return for REITs engaging in geographical diversifying
mergers (Campbell, Ghosh and Sirmans 2001). As stated by Linneman
(2002), a large public company is not a “silver bullet” that will solve all problems,
and, moreover, it should not be the goal of all REITs to simply become
Real Estate and Economies of Scale ​349 
larger. The real point here is that economies of scale are visible in REITs, with
part of this effect due to increases in operating efficiency, and the remainder a
reward to risk. As a result, the market has generally forced REITs to expand
and consolidate.

Back to black
The Treasury squashes hopes that the agencies may ever be private again
SINCE 2008 Fannie Mae and Freddie Mac,
America’s two housingfinance
giants, have
been on life support, spared from
insolvency by an intravenous drip of
taxpayer cash. Lately, however, the
companies have shown signs of life: earlier
this month both reported their biggest
profits since being forced into
“conservatorship” four years ago (see
chart).
That has sent a frisson through investors
clutching preferred shares issued back
when the companies minted money by
using their quasigovernmental
status to borrow cheap and buy or guarantee most
residential mortgages in America. Between March and early August, many of Fannie’s old
preferred shares, which now trade over the counter, jumped from around $1.50 to more
than $3 (still a fraction of their $25 par value).
Several factors explain the turn in the companies’ fortunes.
As home prices have stabilised, unemployment has
gradually declined and troubled loans have been
restructured or written off, the two have set aside ever
smaller provisions for loan losses. In the second quarter
Fannie reversed some prior provisions, adding $3 billion to
the bottom line. More importantly, mortgages issued after
2008 now make up more than half of the companies’
portfolios. Thanks to stricter underwriting terms and slowing
homeprice
falls, those mortgages sport far lower loantovalue
ratios and delinquency rates than “legacy” mortgages
issued during the bubble years of 200508.
As a result, both companies are firmly back in the black.
Fannie recorded a $7.8 billion profit in the first half of this
year, compared with a loss of $16.9 billion in all of 2011. Her sibling earned $3.6 billion,
against a loss of $5.3 billion.
Under the terms of the original bailout,
the Treasury invested just enough each quarter in
senior preferred shares to cover the companies’ losses and to keep their net worth above
zero. In return the companies pay the Treasury a 10% dividend on those shares.

Perversely, to distribute those dividends both companies have routinely had to draw even
more cash from the government. But in the second quarter, neither had to. That has
begun to bring down the net cost of the bailout,
from a peak of $151 billion at the end of
2011 to $142 billion now. A decade from now, the administration reckons the tally will be
just $28 billion.
The good news had one unwelcome sideeffect,
however. With profits now exceeding
their dividends, the companies’ net worth began to grow, arousing hope that one day
dividends might resume on their old shares. On August 17th the Treasury drove a stake
through those hopes, announcing that rather than pay a 10% dividend, the companies
would henceforth simply send every penny of profit its way. For those who did not get the
message, the Treasury rammed it home: the move underlined that they “will not be
allowed to retain profits, rebuild capital, and return to the market in their prior form.”
Fannie’s old preferred shares promptly sank back to about $1.
While the companies’ status as public utilities now appears crystal clear, the federal
government’s longterm
role in housing finance is as muddy as ever. In the short run, it is
indispensable. Fannie, Freddie and the Federal Housing Administration, another
government agency, currently back some 90% of newly originated mortgages. In the long
run, Democrats and Republicans agree that Fannie and Freddie should be wound down,
but concur on little else. The Obama administration has proposed several options for a
smaller federal role in backstopping mortgages: the companies’ regulator is exploring
how to draw private insurers into the mortgage market via losssharing
arrangements with
Fannie and Freddie. Mitt Romney and congressional Republicans want to wind both
companies down, but have not specified any remaining role for government. As with
every policy of consequence in America, the fate of Fannie and Freddie must await the
election.

HOUSING, CREDIT MARKETS AND THE BUSINESS CYCLE


Martin S. Feldstein

The housing sector is now (September 2007) at the root of three distinct but related problems: (1)
a sharp decline in house prices and the related fall in home building; (2) a subprime mortgage problem
that has triggered a substantial widening of all credit spreads and the freezing of much of the credit
markets; and (3) a decline in home equity loans and mortgage refinancing that could cause greater
declines in consumer spending. Each of these could by itself be powerful enough to cause an economic
downturn. The combination could cause a very serious recession unless there are other offsetting forces.
In this paper, I discuss each of these and then comment on the implications for monetary policy.
Housing, Credit Markets and the Business Cycle
Martin Feldstein​*
The housing sector is now (September 2007) at the root of three distinct but related
problems: (1) a sharp decline in house prices and the related fall in home building ; (2) a
subprime mortgage problem that has triggered a substantial widening of all credit spreads and
the freezing of much of the credit markets; and (3) a decline in home equity loans and mortgage
refinancing that could cause greater declines in consumer spending. Each of these could by itself
be powerful enough to cause an economic downturn. The combination could cause a very
serious recession unless there are other offsetting forces. In this paper, I discuss each of these
and then comment on the implications for monetary policy .
Falling House Prices
Robert Shiller (2007) presents evidence of a sharp surge in house prices after the year
2000. More specifically, national indexes of real house prices., real rents and real construction
costs moved together for 25 years until the year 2000. After that, while construction costs and
rents continued to move in parallel, real house prices then rose rapidly so that by 2006 they were
70 percent higher than equivalent rents., driven in part by a widespread popular belief that
houses were an irresistible investment opportunity. How else could an average American family
buy an asset appreciating at 9 percent a year , with 80 percent of that investment financed by a
mortgage with a tax deductible interest rate of 6 percent, implying an annual rate of return on the
initial equity of more than 25 percent?
But at a certain point home owners recognized that house prices – really the price of land
– wouldn’t keep rising so rapidly and may decline. That fall has now begun, with a 3.4 percent
decline in housing prices over the past 12 months and an estimated 9 percent annual rate of
decline in the most recent month for which data are available (a Goldman-Sachs estimate for
June 2007.) The decline in house prices accelerates offers to sell and slows home buying,
causing a rise in the inventory of unsold homes and a decision by home builders to slow the rate
of construction. Home building has now collapsed, down 20 percent from a year ago, to the
lowest level in a decade.
Edward Leamer (2007) explained that such declines in housing construction were a
precursor to 8 of the past 10 recessions. Moreover, major falls in home building were followed
by a recession in every case except when the Korean and Vietnam wars provided an offsetting
stimulus to demand..
Why did home prices surge in the past 5 years? While a frenzy of irrational house price
expectations may have contributed, there were also fundamental reasons. Credit became both
cheap and relatively easy to obtain. When the Fed worried about deflation it cut the Fed funds
rate to one percent in 2003 and promised that it would rise only very slowly. That caused
medium term rates to fall, inducing a drop in mortgage rates and a widespread promotion of
mortgages with very low temporary “teaser” rates.
Mortgage money also became more abundant as a result of various institutional changes
as Ben Bernanke (2007), Ned Gramlich (2007) , and Richard Green and Susan Wachter (2007)
explained. Subprime mortgages were the result of legislative changes (especially the
Community Reinvestment Act) and of the widespread use of statistical risk assessment models
by lenders,. In addition, securitization induced a lowering of standards by lenders who did not
hold the mortgages they created. Mortgage brokers came to replace banks and thrifts as the
primary mortgage originators. All of this had been developing since the 1990s but these
developments contributed to the current mortgage problems when rates fell after 2000.
If house prices now decline enough to reestablish the traditional price-rent relation​1 ​,

there will be serious losses of household wealth and resulting declines in consumer spending.
Since housing wealth is now about $21 trillion, even a 20 percent nominal decline would cut
wealth by some $4 trillion and might cut consumer spending by $200 billion or about 1.5 percent
of GDP. The multiplier consequences of this could easily push the economy into recession.
A 20 percent national decline would mean smaller declines in some places and larger
declines in others. A homeowner with a loan to value ratio today of 80 percent could eventually
find himself with a loan that exceeds the value of his house by 20 percent or more. Since
mortgages are effectively non-recourse loans, borrowers can walk away with no burden on future
incomes. While experience shows that most homeowners continue to service their mortgages
even when the loan balances slightly exceed the value of their homes, it is not clear how they
would behave if the difference is substantially greater. The decision to default would be more
likely if house prices are expected to fall further. .
Once defaults became widespread, the process could snowball, putting more homes on
the market and driving prices down further. Some banks and other holders of mortgages could
see their highly leveraged portfolios greatly impaired. Problems of illiquidity of financial
institutions could become problems of insolvency.
Widening Credit Spreads
I turn now to the second way in which the housing sector is affecting our economy: the
impact of subprime mortgages on credit spreads and credit availability.
For several years now, informed observers have concluded that risk was underpriced in
the sense that the differences in interest rates between U.S. Treasury bonds and riskier assets
(i.e., the credit spreads) were very much smaller than they had been historically.
Some market participants rationalized these low credit spreads by saying that financial
markets had become less risky. Better monetary policies around the world have reduced
inflation and contributed to smaller real volatility. Securitization and the use of credit derivatives
were thought to disperse risk in ways that reduced overall risk levels. Most emerging market
governments now avoid overvalued exchange rates and protect themselves with large foreign
Housing, Credit Markets & the Business Cycle.092307 ​-4-
exchange reserves. There was also the hope based on experience that the Federal Reserve would
respond to any financial market problems by an easing of monetary policy.
Many of us were nevertheless skeptical that risk had really been reduced to the extent
implied by existing credit spreads. It looked instead like the very low interest rates on high grade
bonds were incenting investors to buy riskier assets in the pursuit of yield. Many portfolio
managers were enhancing the return on their portfolios by selling credit insurance – i.e., by using
credit derivatives to assume more risk – and by using credit to leverage their investment
portfolios on the false assumption that the basic portfolio had relatively small risk. Investors
took comfort from the apparent risk transfer in structured products. And less sophisticated
investors were buying such structured products without actually recognizing the extent of the
risk.
Most of the institutional investors who thought that risk was mispriced were nevertheless
reluctant to invest based on that view because of the cost of carrying that trade. Since virtually
all such institutional investors are agents and not principals, they could not afford to take a
position that involved a series of short term losses. They would appear to be better investment
managers by focusing on the short term gains that could be achieved by going with the herd to
enhance yield by assuming increased credit risk.
But these investors also shared a widespread feeling that the day would come when it
would be appropriate to switch sides, selling high risk bonds and reversing their credit derivative
positions to become sellers of risk. No one knew just what would signal the time to change.
It was the crisis in the subprime mortgage market that provided the shock that started the
wider shift in credit spreads and credit availability.
Subprime mortgages are mortgage loans to high risk borrowers with low or uncertain
incomes, high ratios of debt to income, and poor credit histories. These are generally floating
rate mortgages, frequently with high loan-to-value ratios and very low initial “teaser” rates. A
realistic assessment would imply that the borrowers would have trouble meeting the monthly
payments once the initial teaser rate period ended and the interest rate rose to a significant
premium over the rates charged to prime (i.e., low risk) borrowers.
Borrowers with subprime credit ratings nevertheless took these adjustable rate loans with
low teaser rates because they wanted to get in on the house price boom that was sweeping the
2​This reflected in part the use of data on borrower experience in recent years in which

house prices were rising and interest rates declining.


Housing, Credit Markets & the Business Cycle.092307 ​-5-
country. Some of them hoped on the basis of recent experience that market prices would rise
enough by the time that they had to face higher interest rates that they could refinance with a
lower loan to value ration and therefore a lower interest rate. Many of those who originated the
loans were mortgage brokers who sold them almost immediately at a profit to the financial
market and therefore did not care about the ability of the borrowers to service their debt..
The sophisticated buyers of the subprime loans could then bundle them into large pools
of mortgages and sell participation in that pool. Often the pool was “tranched” to offer different
degrees of risk to different buyers. In a simple case, the highest risk tranche might represent the
first 10 percent of the mortgages to default and would carry a correspondingly high interest rate.
Buyers of the next tranche would incur losses only if more than 10 percent of the mortgages
defaulted. The highest quality tranche, which would incur losses only after 90 percent of the
mortgages had defaulted, was regarded as so safe that the rating agencies would give it a better
than AAA rating even though all of the underlying assets were subprime mortgages.
In retrospect, the riskiness of individual tranches was often underestimated by the rating
agencies and by those who bought the participation in the risk pool.​2 ​These were nevertheless
combined with other more traditional bonds and commercial paper in structured notes and even
in money market mutual funds that had high ratings and attractive yields.
This was clearly an accident waiting to happen. The subprime problem unfolded quickly
with very high default rates on subprime loans.
Because subprime mortgages are a relatively small fraction of the total mortgage market
and therefore an even smaller fraction of the total global credit market, many experts and
government officials initially claimed that the subprime problem would have only a very limited
effect on capital markets and the economy.
But the subprime defaults and the dramatic widening of credit spreads in that market
triggered a widespread flight from risk, widening credit spreads more generally and causing
price declines for all risky assets. When those risky assets were held in leveraged accounts or
Housing, Credit Markets & the Business Cycle.092307 ​-6-
when investors had sold risk insurance through credit derivatives, losses were substantial.
As credit spreads widened, investors and lenders became concerned that they did not
know how to value complex risky assets. Credit ratings came under suspicion when failures
exceeded levels associated with those official credit ratings. A result was a drying up of credit
for risky investments, including private equity acquisitions.
Loans to support private equity deals that were already in the pipeline could not be
syndicated, forcing the commercial banks and investment banks to hold those loans on their own
books. Banks are also being forced to honor credit guarantees to previously off-balance-sheet
conduits and other back-up credit lines. These developments are reducing the capital available
to support credit of all types. One result has been that hedge funds have been forced to sell
stocks (or buy back short positions) because they could not obtain credit to maintain their
portfolios.
It will of course be a good thing to have credit spreads that correctly reflect the actual
risks of different assets. But the process of transition may be very costly to the overall economy.
Declining Mortgage Credit for Consumer Spending
This brings me to the third way in which the housing sector now contributes to the
adverse outlook of the American economy: the potential for a substantial decline in consumption
in response to lower home equity withdrawals through home equity loans and mortgage
refinancing. This channel is in addition to the effect of reduced wealth caused by a fall in house
prices.
An important feature of the US mortgage system is that most borrowers can repay at any
time without penalty. When interest rates fall, the borrower can replace the existing mortgage
with a new one at a lower interest rate. If the value of the property has increased since the
existing mortgage was obtained, refinancing also provides an opportunity to withdraw cash –
the so-called mortgage equity withdrawal (or MEW).
Starting in 2001, the combination of lower mortgage rates and the rapid rise in house
prices led to widespread refinancing with equity withdrawals, a practice heavily promoted by
banks and mortgage brokers. Someone who obtained a mortgage at 7.7 percent in 1997 could
refinance at a 5.8 percent rate in 2003 and extract substantial cash at the same time.
Housing, Credit Markets & the Business Cycle.092307 ​-7-
A massive amount of such refinancing and equity withdrawal occurred. In 2005, 40
percent of existing mortgages were refinanced. The Flow of Funds data imply that mortgage
equity withdrawals between 1997 and 2006 totaled more than $9 trillion, an amount equal to
more than 90 percent of disposable personal income in 2006.
This new borrowing was used to pay down other non-mortgage debts, to invest in
financial assets, and importantly to finance additional consumer spending.
There is a vigorous professional debate about the extent to which MEWs did lead to
additional consumer spending, (Frederick Mishkin (2007) , John Muellbauer (2007)). Alan
Greenspan and James Kennedy (2004) , in Federal Reserve Bank research paper, concluded
from an analysis of survey data that substantial fractions of the MEW funds were used to finance
home improvements or general consumption. It is significant in this context that home
improvements would generally be treated in the national income accounts as a form of consumer
spending rather than investment.
Mishkin and others are skeptical about the effect of mortgage equity withdrawals on
consumer expenditures, pointing out that individuals may choose to undertake mortgage
refinancing simply because they want to increase their spending or undertake home
improvements. While that may be true in some cases, I believe that the combination of rapidly
rising home prices that more than doubled the value of owner occupied housing between 1999
and 2006 – an increase of more than $10 trillion dollars – and the substantial fall in interest rates
were the primary drivers of the large rise in mortgage equity withdrawals. I believe that it was
the availability and low cost of mortgage equity withdrawals that caused the increased consumer
outlays.
Muellbauer notes that the relatively long time series evidence on the relation between
mortgage equity withdrawals and consumer spending is inconclusive, with some studies pointing
to substantial effects of mortgage equity withdrawal and others the opposite. I am quite skeptical
about the relevance of this evidence because variations in national home values only became
substantial after the year 2000.
Some economists argue on theoretical grounds that MEW should not change consumer
spending, since consumption should be a function only of income (including expected future
income), wealth, and the rate of interest. If so, the transformation of housing wealth into cash
Housing, Credit Markets & the Business Cycle.092307 ​-8-
should not affect consumption but should be used only to reduce debt or invest in financial
assets. I’m not convinced for two reasons. First, as Mullbauer notes, individuals who are
liquidity constrained will consume more in response to an increased opportunity to borrow.
Second, consumers can regard the increased spending on home improvements and major
consumer durables as a form of investment that will provide services for years to come even
though the national income accounts classify these outlays as consumer spending.
The recently revised national income accounts show that personal saving fell sharply
from 2.1 percent of disposable income in 2003 and 2004 to less than 0.5 percent in 2005 and
2006, a decline equal to about a $160 billion annual rate. I believe that a substantial part of that
decline and the relative increase in consumer spending was due to the concurrent rise in MEW
that resulted from low mortgage interest rates and increasing home prices.
The potential implication of this for the future is clear. A decline in house prices and a
rise in mortgage interest rates should shrink MEW and cause the household saving rate to rise to
a more normal level. This is clearly good in the long term, permitting increased investment in
plant and equipment and reducing our dependence on capital from abroad. But in the short run a
rapid rise in the saving rate and a decline in consumer spending would mean less aggregate
demand. Whether this would be big enough to push the economy into recession depends on the
magnitude and speed of the adjustment in mortgage equity withdrawals, on the impact of the
MEWs on consumer spending, and on the state of aggregate demand as this occurs.
The volume of mortgage refinancing has recently begun to decline and the level of
revolving home equity loans has been declining since the beginning of the year. The household
saving rate has also started to rise. We will have to wait to see the impact of the sharp reduction
in available mortgage credit that occurred in recent weeks.
Possible Implications for Economic Policy
The three housing sector problems that I have discussed point to a potentially serious
decline in aggregate demand and economic activity. What are the possible implications for
current Federal Reserve policy?
It is widely agreed that neither the Federal Reserve nor the government should bail out
individual borrowers or lenders whose past mistakes have created losses. Doing so would
Housing, Credit Markets & the Business Cycle.092307 ​-9-
simply encourage more reckless behavior in the future. But it is also widely agreed that it would
be a mistake to permit a serious economic downturn just in order to punish those market
participants.
But what should be done about the frozen credit markets and the possible insolvencies
that could result from mortgage defaults? The Fed and other central banks have stressed their
roles as lenders of last resort, providing liquidity to member banks against good collateral
(although not collateral of the highest quality) at rates that exceed the federal funds rate. There
are of course many important financial institutions – including the investment banks and large
hedge funds – that do not have access to the Fed’s discount window. The Fed has encouraged
the commercial banks to lend to them against suitable collateral with the ability to rediscount
that collateral at the Federal Reserve.
It is not clear whether this will succeed, since much of the credit market problem reflects
more than a lack of liquidity: a lack of trust , an inability to value securities, and a concern about
counterparty risks. The inability of credit markets to function adequately will weaken the overall
economy over the coming months. And even when the credit market crisis has passed, the wider
credit spreads and increased risk aversion will be a damper on future economic activity.
Even with the best of policies to increase liquidity, future aggregate demand is likely to
be depressed by weak housing construction, depressed consumer spending, and the impaired
credit markets. Although lower interest rates cannot solve the specific problems facing credit
markets, lower interest rates now would help by stimulating the demand for housing, autos and
other consumer durables, by encouraging a more competitive dollar to stimulate increased net
exports, by raising share prices that increased both business investment and consumer spending,
and by freeing up spendable cash for homeowners with adjustable rate mortgages.
But the Fed also has a responsibility to focus on inflation. There now remains a
significant risk of rising inflation because of slowing productivity growth (unit labor costs are up
4.5 percent from the second quarter of 2006 to the second quarter of 2007), the falling dollar,
and higher food prices that have pushed market based consumer prices up at a 4.6 percent rate in
the most recent quarter.} How should the Fed now balance these two goals?
We know that there is no long-run trade-off between price stability and achieving full
Housing, Credit Markets & the Business Cycle.092307 ​-10-
employment and growth. But how should policy makers deal with the short run relation between
price stability and employment?
One view is that monetary policy should focus exclusively on achieving price stability
because that is the best way to achieve full employment and maximum sustainable growth as
rapidly as possible. If that view is correct, there is no reason to change current monetary policy.
The existing 5.25 percent nominal federal funds rate is relatively tight in comparison to the
historic average real fed funds rate of about two percent. The housing and credit market
problems that I have discussed will simply reinforce this tight monetary policy and speed the
decline in inflation.
But there is an alternative and more widely held view that the Federal Reserve should
give explicit weight to unemployment or unused capacity in the short run as well as to inflation.
That is the view that underlies all variants of the Taylor rule. If that view is accepted, there are
two reasons for a major reduction now in the federal funds rate – possibly by as much as 100
basis points.
First, experience suggests that the dramatic decline in residential construction provides
an early warning of a coming recession. The likelihood of a recession is increased by what is
happening in credit markets and in mortgage borrowing. Most of these forces are inadequately
captured by the formal macroeconomic models used by the Federal Reserve and other macro
forecasters.
Second, even if all of the evidence does not add up to a high probability of an
unacceptable decline in economic activity, the Fed could adopt the risk-based “decision theory”
approach in responding to the current economic environment. If the triple threat from the
housing sector materializes with full force, the economy could suffer a very serious downturn. A
sharp reduction in the interest rate – in addition to a vigorous lender of last resort policy – would
attenuate that very bad outcome.
But what if the outcome in the absence of a substantial rate cut would be more benign
and yet the Fed nevertheless cuts the federal funds rate? The result would be a stronger
economy with higher inflation than the Fed desires, an unwelcome outcome but one that might
be judged to be the lesser of two evils. If that happens, the Fed would have to engineer a longer
period of slower growth to bring the inflation rate back to its desired level. How well it would
Housing, Credit Markets & the Business Cycle.092307 ​-11-
succeed in doing this would depend on its ability to persuade the market that a risk-based
approach in the current context is not an abrogation of its fundamental pursuit of price stability.

IS THE 2007 U.S. SUB-PRIME FINANCIAL CRISIS SO DIFFERENT? AN INTERNATIONAL


HISTORICAL COMPARISON
Carmen M. Reinhart
Kenneth S. Rogoff

Is the 2007-2008 U.S. sub-prime mortgage financial crisis truly a new and different phenomena? Our
examination of the longer historical record finds stunning qualitative and quantitative parallels to 18
earlier post-war banking crises in industrialized countries. Specifically, the run-up in U.S. equity and
housing prices (which, for countries experiencing large capital inflows, stands out as the best leading
indicator in the financial crisis literature) closely tracks the average of the earlier crises. Another
important parallel is the inverted v-shape curve for output growth the U.S. experienced as its economy
slowed in the eve of the crisis. Among other indicators, the run-up in U.S. public debt and is actually
somewhat below the average of other episodes, and its pre-crisis inflation level is also lower. On the
other hand, the United States current account deficit trajectory is worse than average. A critical question
is whether the U.S. crisis will prove similar to the most severe industrialized-country crises, in which
case growth may fall significantly below trend for an extended period. Or will it prove like one of
the milder episodes, where the recovery is relatively fast? Much will depend on how large the shock
to the financial system proves to be and, to a lesser extent, on the efficacy of the subsequent policy
response.

I. Introduction
The first major financial crisis of the 21​st ​century involves esoteric instruments,
unaware regulators, and skittish investors. It also follows a well-trodden path laid down
by centuries of financial folly. Is the “special” problem of sub-prime mortgages this time
really different?
Our examination of the longer historical record, which is part of a larger effort on
currency and debt crises, finds stunning qualitative and quantitative parallels across a
number of standard financial crisis indicators. To name a few, the run-up in U.S. equity
and housing prices that Graciela L. Kaminsky and Carmen M. Reinhart (1999) find to be
the best leading indicators of crisis in countries experiencing large capital inflows closely
tracks the average of the previous eighteen post World War II banking crises in industrial
countries. So, too, does the inverted v-shape of real growth in the years prior to the
crisis. Despite widespread concern about the effects on national debt of the early 2000s
tax cuts, the run-up in U.S. public debt is actually somewhat below the average of other
crisis episodes. In contrast, the pattern of United States current account deficits is
markedly worse.
At this juncture, the book is still open on the how the current dislocations in the
United States will play out. The precedent found in the aftermath of other episodes
suggests that the strains can be quite severe, depending especially on the initial degree of
trauma to the financial system (and to some extent, the policy response). The average
drop in (real per capita) output growth is over 2 percent, and it typically takes two years
3
to return to trend. For the five most catastrophic cases (which include episodes in
Finland, Japan, Norway, Spain and Sweden), the drop in annual output growth from peak
to trough is over 5 percent, and growth remained well below pre-crisis trend even after
three years. These more catastrophic cases, of course, mark the boundary that
policymakers particularly want to avoid.
II. Post War Bank-Centered Financial Crises: The Data
Our comparisons employ a small piece of a much larger and longer historical data
set we have constructed (see Reinhart and Kenneth S. Rogoff, 2008.) The extended data
set catalogues banking and financial crises around the entire world dating back to 1800
(in some cases earlier). In order to focus here on data most relevant to present U.S.
situation, we do not consider the plethora of emerging market crises, nor industrialized
country financial crises from the Great Depression or the 1800s. Nevertheless, even in
the smaller sample considered in this paper, the refrain that “this time is different”
syndrome has been repeated many times.
First come rationalizations. This time, many analysts argued, the huge run-up in
U.S. housing prices was not at all a bubble, but rather justified by financial innovation
(including to sub-prime mortgages), as well as by the steady inflow of capital from Asia
and petroleum exporters. The huge run-up in equity prices was similarly argued to be
sustainable thanks to a surge in U.S. productivity growth a fall in risk that accompanied
the “Great Moderation” in macroeconomic volatility. As for the extraordinary string of
outsized U.S. current account deficits, which at their peak accounted for more than twothirds
of all the world’s current account surpluses, many analysts argued that these, too,
4
could be justified by new elements of the global economy. Thanks to a combination of a
flexible economy and the innovation of the tech boom, the United States could be
expected to enjoy superior productivity growth for decades, while superior American
know-how meant higher returns on physical and financial investment than foreigners
could expect in the United States.
Next comes reality. Starting in the summer of 2007, the United States
experienced a striking contraction in wealth, increase in risk spreads, and deterioration in
credit market functioning. The 2007 United States sub-prime crisis, of course, has it
roots in falling U.S. housing prices, which have in turn led to higher default levels
particularly among less credit-worthy borrowers. The impact of these defaults on the
financial sector has been greatly magnified due to the complex bundling of obligations
that was thought to spread risk efficiently. Unfortunately, that innovation also made the
resulting instruments extremely nontransparent and illiquid in the face of falling house
prices.
As a benchmark for the 2007 U.S. sub-prime crisis, we draw on data from the
eighteen bank-centered financial crises from the post-War period, as identified by
Kaminsky and Reinhart (1999), Gerard Caprio et. al. (2005), and Andrew Mullineux
(1990).
These crisis episodes include:
The Big Five Crises​: Spain (1977), Norway (1987), Finland (1991),
Sweden (1991) and Japan (1992), where the starting year is in parenthesis.
Other Banking and Financial Crises​: Australia (1989), Canada (1983),
Denmark (1987), France (1994), Germany (1977), Greece (1991), Iceland
5
(1985), and Italy (1990), and New Zealand (1987), United Kingdom
(1973, 1991, 1995), and United States (1984).
The “Big Five” crises are all protracted large scale financial crises that are
associated with major declines in economic performance for an extended period. Japan
(1992), of course, is the start of the “lost decade,” although the others all left deep marks
as well.
The remaining rich country financial crises represent a broad range of lesser
events. The 1984 U.S. crisis, for example, is the savings and loan crisis. In terms of
fiscal costs (3.2 percent of GDP), it is just a notch below the “Big Five” 1​ ​. Some of the
other 13 crisis are relatively minor affairs, such as the 1995 Barings (investment) bank
crisis in the United Kingdom or the 1994 Credit Lyonnaise bailout in France. Excluding
these smaller crises would certainly not weaken our results, as the imbalances in the runsup
were minor compared to the larger blowouts.
III. Comparisons
We now proceed to a variety of simple comparisons between the 2007 U.S. crisis
and previous episodes. Drawing on the standard literature on financial crises, we look at
asset prices, real economic growth, and public debt. We begin in Figure 1 by comparing
the run-up in housing prices. Period ​T ​represents the year of the onset of the financial
crisis. By that convention, period ​T-4 ​is four years prior to the crisis, and the graph in
1 ​Thefiscal costs of cleaning up after banking crises can be enormous. The fiscal cleanup from Sweden’s
1991 crisis was 6 percent of GDP and Norway’s 1987 crisis was 8 percent. Spain’s post-1977 cleanup cost
over 16 percent of GDP. Estimates for Japan’s bill vary widely, with many in excess of 20 percent of GDP.
6
each case continues to ​T+3​, except of course in the case of the U.S. 2007 crisis, which
remains in the hands of the fates.​2 ​The chart confirms the case study literature, showing
the significant run-up in housing prices prior to a financial crisis. Notably, the run-up in
housing prices in the United States exceeds that of the “Big Five” .
Figure 1: Real Housing Prices and Banking Crises
95
100
105
110
115
120
125
130
135
t-4 t-3 t-2 t-1 T t+1 t+2 t+3
Index
Average for banking crises in
advanced economies
US, 2003=100
Index t-4=100
Average for the "Big 5"
Crises
2 ​Forthe United States, house prices are measured by the Case-Shiller index, described and provided in
Robert Shiller (2005). The remaining house price data were made available by the Bank for International
Settlements and are described in Gregory D. Sutton (2002).
7
Figure 2 looks at real rates of growth in equity market price indices. (For the United
States, the index is the S&P 500; Reinhart and Rogoff, 2008, provide the complete listing
for foreign markets.)
Once again, the United States looks like the archetypical crisis country, only more
so. The Big Five crisis countries tended to experience equity price falls earlier on than
the U.S. has, perhaps because the U.S. Federal Reserve pumped in an extraordinary
amount of stimulus in the early part of the most recent episode.
Figure 2: Real Equity Prices and Banking Crises
80
85
90
95
100
105
110
115
120
125
130
135
t-4 t-3 t-2 t-1 T t+1 t+2 t+3
Index
Average for banking crises in
advanced economies
US, 2003=100
Index t-4=100
Average for the "Big 5"
Crises
8
Figure 3: Current Account Balance/GDP on the Eve of Banking Crises
-7
-6
-5
-4
-3
-2
-1
0
t-4 t-3 t-2 t-1 t
percent of GDP
Average for banking crises in
advanced economies
U.S.
Figure 3 looks at the current account as a share of GDP. Again, the United States
is on a typical trajectory, with capital inflows accelerating up to the eve of the crisis.
Indeed, the U.S. deficits are more severe, reaching over six percent of GDP. As already
mentioned, there is a large and growing literature that attempts to rationalize why the
United States might be able run a large sustained current account deficit without great
risk of trauma. Whether the U.S. case is quite as different as this literature suggests
remains to be seen.
Real per capita GDP growth in the run-up to debt crises is illustrated in Figure 4.
The United States 2007 crisis follows the same inverted V shape that characterizes the
earlier episodes. Growth momentum falls going into the typical crisis, and remains low
9
for two years after. In the more severe “Big Five” cases, however, the growth shock is
considerably larger and more prolonged than for the average. Of course this implies that
the growth effects are quite a bit less in the mildest cases, although the U.S. case has so
many markers of larger problems that one cannot take too much comfort in this caveat.
Figure 4: Real GDP Growth per Capita and Banking Crises
(PPP basis)
-2
-1
0
1
2
3
4
5
t-4 t-3 t-2 t-1 t t+1 t+2
Percent
Average for banking crises in
advanced economies
US
Average for the "Big 5"
Crises
Figure 5 looks at public debt as a share of GDP. Rising public debt is a near
universal precursor of other post-war crises, not least the 1984 U.S. crisis. It is notable
that U.S. public debt rises much more slowly than it did in run-up to the Big Five crisis.
However, if one were to incorporate the huge buildup in private U.S. debt into these
measures, the comparisons would be notably less favorable.
10
The correlations in these graphs are not necessarily causal, but in combination
nevertheless suggest that if the United States does not experience a significant and
Figure 5: Public Debt and Banking Crises
90
110
130
150
170
190
210
230
250
t-4 t-3 t-2 t-1 T t+1 t+2 t+3
Index
Average for banking crises in
advanced economies
US, 1997=100
Index t-10=100
Average for the "Big 5" Crises
protracted growth slowdown, it should either be considered very lucky or even more
“special” that most optimistic theories suggest. Indeed, given the severity of most crisis
indicators in the run-up to its 2007 financial crisis, the United States should consider
itself quite fortunate if its downturn ends up being a relatively short and mild one.
11
IV. Conclusions
Tolstoy famously begins his classic novel ​Anna Karenina ​with “Every happy
family is alike, but every unhappy family is unhappy in their own way.” While each
financial crisis no doubt is distinct, they also share striking similarities, in the run-up of
asset prices, in debt accumulation, in growth patterns, and in current account deficits.
The majority of historical crises are preceded by financial liberalization, as documented
in Kaminsky and Reinhart (1999). While in the case of the United States, there has been
no striking de jure liberalization, there certainly has been a de facto liberalization. New
unregulated, or lightly regulated, financial entities have come to play a much larger role
in the financial system, undoubtedly enhancing stability against some kinds of shocks,
but possibly increasing vulnerabilities against others. Technological progress has plowed
ahead, shaving the cost of transacting in financial markets and broadening the menu of
instruments.
Perhaps the United States will prove a different kind of happy family. Despite
many superficial similarities to a typical crisis country, it may yet suffer a growth lapse
comparable only to the mildest cases. Perhaps this time will be different as so many
argue. Nevertheless, the quantitative and qualitative parallels in run-ups to earlier postwar
industrialized-country financial crises are worthy of note. Of course, inflation is
lower and better anchored today worldwide, and this may prove an important mitigating
factor. The United States does not suffer the handicap of a fixed exchange rate system.
On the other hand, the apparent decline in U.S. productivity growth and in housing prices
does not provide a particularly favorable backdrop for withstanding a credit contraction.
12
Another parallel deserves mention. During the 1970s, the U.S. banking system
stood as an intermediary between oil-exporter surpluses and emerging market borrowers
in Latin America and elsewhere. While much praised at the time, 1970s petro-dollar
recycling ultimately led to the 1980s debt crisis, which in turn placed enormous strain on
money center banks.​3 ​It is true that this time, a large volume of petro-dollars are again
flowing into the United States, but many emerging markets have been running current
account surpluses, lending rather than borrowing. Instead, a large chunk of money has
effectively been recycled to a developing economy that exists within the United States’
own borders. Over a trillion dollars was channeled into the sub-prime mortgage market,
which is comprised of the poorest and least credit worth borrowers within the United
States. The final claimant is different, but in many ways, the mechanism is the same.
Finally, we note that although this paper has concentrated on the United States,
many of the same parallels hold for other countries that began experiencing housing price
duress during the 2007, including Spain, the United Kingdom and Ireland. Indeed, as
Appendix Table 1 reminds us for the panic of 1907 and the crash of 1929, the global
dimension of the current crisis is neither new nor unique to this episode. As history has
shown, there can be similarities across unhappy families, too.

Money for Nothing and Checks for Free:


Recent Developments in U.S. Subprime
Mortgage Markets
John Kiff and Paul Mills
After a number of warning signs, the U.S. “subprime mortgage crisis” became a headline
issue in February 2007. Notwithstanding the bankruptcy of numerous mortgage companies,
historically high delinquencies and foreclosures, and a significant tightening in subprime
lending standards, the impact thus far on core U.S. financial institutions has been limited.
This paper reviews the history and structure of the subprime market. The results suggest that
new origination and funding technology appear to have made the financial system more
stable at the expense of undermining the effectiveness of consumer protection regulation.
Potential solutions to the management of this trade-off are then explored.

I. I​NTRODUCTION
After a number of warning signs, the U.S. “subprime mortgage crisis” became a headline
issue in February 2007. Notwithstanding the bankruptcy of numerous mortgage companies,
historically high delinquencies and foreclosures, and a significant tightening in subprime
lending standards, the impact thus far on core U.S. financial institutions has been limited.
And while some structured credit hedge funds have suffered large losses, mortgage
securitization appears to have helped disperse the impact throughout the financial system, in
contrast to the Savings & Loan crisis of the early 1990s. The credit cycle is thus largely
playing out in the securities and derivatives markets, rather than on bank balance sheets.
This paper reviews the history and structure of the subprime market. The results suggest that
new origination and funding technology appear to have made the financial system more
stable at the expense of undermining the effectiveness of consumer protection regulation.
Potential solutions to the management of this trade-off are then explored.
II. O​RIGINS AND ​HI​ STORY OF THE ​SU​ BPRIME M ​ RTGAGE ​MA
​ O ​ RKET
Subprime mortgages are residential loans that do not conform to the criteria for “prime”
mortgages, and so have a lower expected probability of full repayment. This assessment is
usually made according to the borrower’s credit record and score, debt service-to-income
(DTI) ratio, and/or the mortgage loan-to-value (LTV) ratio. Borrowers with low credit
scores, DTIs above 55 percent, and/or LTVs over 85 percent are likely to be considered
subprime. So-called “Alt-A” loans fall into a gray area between prime and subprime
mortgages. These began as a more flexible alternative to prime loans, mainly for borrowers
who met all of the credit score, DTI, and LTV prime criteria, but did not provide full income
documentation.
Several legal milestones facilitated the development of the modern subprime mortgage
market. Interest rate caps imposed by states were preempted by federal legislation in 1980
while lenders were allowed to offer adjustable-rate mortgages from 1982. Also the Tax
Reform Act of 1986 left residential mortgages as the only consumer loans on which the
interest was tax deductible. This made home equity withdrawal (for instance, through “cashout”
refinancing of a mortgage) a preferred means of financing home improvements and
personal consumption, relative to other forms of consumer loans (Klyuev and Mills, 2006).
Automated underwriting and securitization were also key developments in reducing the cost
of subprime mortgage lending. Automated underwriting (using computer models rather than
loan officer judgment) has made loan origination more cost efficient, while advances in
statistical credit scoring have led to more accurate and consistent assessments of borrower
4
credit risk.​2 ​Securitization also facilitated market growth by dispersing risk, providing
investors with a supply of highly-rated securities with enhanced yield, and opening up the
origination business to non-depository specialty finance companies (Box 1).
Consequently, subprime lending
developed as a specialist loan class in the
mid-90s and facilitated a substantial
expansion of home ownership (Figure 1).​3
These developments allowed a relaxation
of credit rationing for borrowers—such
as the poor, or those in minority
communities—previously considered too
risky by traditional lenders.​4
Loans for subprime borrowers were once
predominantly guaranteed by the Federal
Housing Association (FHA). However,
subprime loans have displaced FHAguaranteed
lending (Figure 2) due to the
FHA’s less aggressive product mix, its
lack of flexibility to changing market
conditions, and its low lending limits.​5
Mortgage originators also complain that
the fees that they earn on FHAguaranteed
mortgages do not adequately
compensate for their higher processing
costs.

Box 1. Twisting by the Pool: The Mechanics of Mortgage Securitization


Subprime mortgages are predominantly securitized in the form of mortgage-backed securities (MBS).​1 ​These
securities are enhanced with mechanisms to protect higher-rated tranches from shortfalls in cash flows from
the underlying collateral (for instance due to defaults or lower than expected interest income). These
mechanisms include various kinds of explicit insurance, for instance as provided by mortgage insurers.
However, most of the credit enhancement comes from structural features such as subordination, overcollateralization,
and excess spread:
• ​Subordination: ​Losses from defaults of the underlying mortgages are applied to junior tranches before
they are applied to more senior tranches. Only once a junior tranche is completely exhausted will defaults
impair the next tranche. Consequently, the most senior tranches are extremely secure against credit risk,
are rated AAA, and trade at lower spreads.
• ​Overcollateralization: ​The excess of outstanding mortgage loans over the par value of the outstanding
securities is used to make up any shortfalls in cash flows for the other tranches, and thus serves as a form
of internal credit insurance.
• ​Excess spread: ​A preset amount of interest is explicitly set aside from the servicing of the collateral each
month, and is used to enhance the initial overcollateralization. A “residual tranche” also collects unused
excess spread and overcollateralization.​2
The AAA-rated “Class A” tranches, which comprise about 80 percent of a typical transaction, enjoy a broad
investor base among high-grade bond investors, including the GSEs. However, there are few natural end
investors for the “Class M” mezzanine tranches, which comprise most of the other 20 percent of a typical
mortgage securitization structure (10 percent AA, 5 percent A and 5 percent BBB+ and below), and these are
typically resecuritized into collateralized debt obligations (see below). The below-mezzanine tranches are
usually either retained by the originator or sold to hedge funds and investment bank proprietary desks.
Collateralized debt obligations (CDOs) are a key subprime MBS investor constituency, particularly for the
mezzanine tranches, due to the yield pick-up available. According to J.P. Morgan Securities, about
$244 million of ABS-backed CDOs were issued in the U.S. in 2006, about $98 billion of which were
“mezzanine” ABS CDOs (backed mainly by mezzanine MBS tranches, most of which are subprime or home
equity loans).
There has been some speculation that if the “CDO bid” for subprime MBS mezzanine tranches dries up, the
volume of available subprime mortgage financing could shrink dramatically (Mason and Rosner, 2007a). The
idea is that, because 80 percent or so of the Class A securities cannot be sold without also selling the 20
percent or so of mezzanine and lower tranches, falling CDO demand will have a leveraged effect on the
availability of mortgage loans. This leverage is said to be amplified by similar structural factors in the CDO
market itself – i.e., there is no natural market for their A- and BBB-rated mezzanine tranches, which typically
comprise about five to ten percent of a transaction. Hence, the mezzanine tranches are usually resecuritized in
other CDOs.
_________________________________
1 ​Asset-backed securities (ABS) backed by home equity loans are also referred to as subprime MBS.
2 ​Excess spread is also characterized as the difference between the net interest rate on the underlying mortgage
loans and the weighted-average coupon on the securities. After covering current period losses, the excess
spread is used to over-collateralize the senior tranches. Typically, excess spread is used to over-collateralize
the senior tranche only up to a certain point (e.g., three percent of notional) over a certain period of time (e.g.,
three years). If, after the predefined time period, the over-collateralization has attained the target level, some
of the excess spread can be released to the residual tranche.

Despite advances in credit scoring techniques, the subprime market experienced its first
“crisis” in 1998-99. Subprime loan delinquencies transpired to be higher than anticipated by
the new models while the East Asian and LTCM crises reduced investor appetite for higherrisk
mortgage securities. As a result, the majority of the largest subprime lenders went
bankrupt.​6
​ PID ​RE
III. T​HE ​RA ​ CENT ​EX
​ PANSION OF ​SU
​ BPRIME ​LE​ NDING
Until 2003, the majority of mortgage originations were “prime conforming” loans. These
were then purchased by two government-sponsored housing enterprises (GSEs - Fannie Mae
and Freddie Mac). However, by 2006, over half of all originations did not meet the GSEs’
“conforming” criteria.

Consequently, the share of mortgage


originations represented by subprime or
Alt-A loans rose rapidly (Figure 3). The
transformation of the market was such
that, of 2006 originations, only 36 percent
were conforming loans, 15 percent were
prime “jumbo” loans (which exceeded the
ceiling for conforming mortgages), three
percent comprised of loans guaranteed by
the FHA and the Department of Veterans
Affairs (VA) while the remainder comprised
“nonprime” loans—Alt-A (25 percent) and
subprime (21 percent).
There are several reasons for the rapid recent expansion in non-conforming mortgage
lending. Conforming single-family loans are currently capped at $417,000, and there are
strict requirements on DTI and LTV ratios, and required proof-of-income documentation. As
the rapid rise in U.S. house prices stretched affordability, more loans fell outside the
conforming criteria as individuals stretched to buy a house. Simultaneously, accounting and
governance issues forced the GSEs to contract their mortgage purchase operations while
innovative securitization techniques provided private label originators with lower costs of
funding.
6 ​Chomsisengphet and Pennington-Cross (2006).
7
Depository institutions still originate
half of all mortgages, but given
increased securitization, they hold only
30 percent of outstanding loans (Figure
4). About 38 percent of end-2006
outstanding mortgages were held by
GSE securitization pools (plus the three
percent held directly by the GSEs), 18
percent by non-GSE (“private label”)
securitization pools, five percent by
finance companies, and most of the
remainder by real estate investment
trusts (REITS) and households.
IV. W​HAT ​PR​ OMPTED THE ​SU ​ BPRIME ​“C​RISIS​?”
Recent subprime lending growth was boosted by more highly leveraged lending against a
background of rapidly rising house prices. Housing affordability dropped to the point where a
significant proportion of borrowers were financially overstretching via risky “affordability
products” (see Box 2), with many apparently lying about their financial resources to get
loans. Also, speculative borrowers obtained loans on the basis of expected collateral
appreciation, with little account taken of their ability to make the requisite mortgage
payments. Although average subprime borrower credit scores have been rising, so have their
LTVs and DTIs, especially as a result of increased use of second lien loans, which need not
necessarily be declared to the primary mortgage lender.​7
At the same time, strong investor appetite for higher-yielding securities in 2005–06 probably
contributed to looser underwriting standards. Safeguards ensuring prudent lending were
weakened by the combination of fee-driven remuneration at each stage of the securitization
process and the dispersion of credit risk which weakened monitoring incentives. Hence,
intermediaries were remunerated primarily by generating loan volume rather than quality,
even as the credit spreads on the resulting securities shrank.
The rapid deterioration of 2006 vintage loans has resulted largely from a slowing of house
price appreciation. While prices were rising, distressed borrowers had the equity to sell their
homes and prepay their mortgages. However, as interest rates rose and house prices flattened
and then turned negative in a number of regions, many stretched borrowers were left with no
choice but to default as prepayment and refinancing options were not feasible with little or no
housing equity.
7 ​Zimmerman (2007).
Source: Board of Governors of the Federal Reserve System.
Figure 4. Declining Mortgage Holdings of Depository
Institutions
0
20
40
60
80
100
120
1978 1982 1986 1990 1994 1998 2002 2006
0
20
40
60
80
100
120
Depository institutions GSEs (incl. securitizations)
Private label securitizations REITS and households
(percent of mortgages outstanding)
8
Box 2. Brothers in ARMs: Hybrids, Options, IOs, Neg-Ams, and Teasers
Most ARMs are actually hybrid products that combine floating and fixed rates. For example, about twothirds
of recent ARM originations were “2/28” hybrids, which are effectively two-year FRMs that
convert to 28-year ARMs at the end of the second year.​1 ​The initial fixed rate is often a below-market
(i.e., “teaser”) rate, so that “reset shock” can be substantial when the adjustable-rate period starts,
although various caps often protect the borrower from rapid and sharp increases in payments. In
addition, interest-only and negative amortization loans comprise the bulk of subprime and Alt-A ARM
origination. In an interest-only mortgage, payments cover just the interest accruals in the first years
(usually two or three in the case of ARMs and up to ten for FRMs), and in a negative amortization
mortgage, the payments do not even cover the interest accruals. Typically, the accumulated negative
amortization is subject to a 15 to 25 percent cap, relative to the original loan amount. When the cap is
hit, the loan converts to a full-interest loan. At the end of every five years, the loan is recast and
payments are computed on the new higher loan balance.
Also popular are option ARMs, which give borrowers a variety of payment options each month,
including interest-only and negative amortization options. Typically, the options remain open until five
years into the mortgage (the “recast date”) or the outstanding balance reaches 110 percent of the original
principal. In addition, interest accrues at a deeply discounted interest rate until the recast date, after
which full principal and interest payments start. Although option ARMs have been available for decades,
originations have surged since 2003, from around 10 percent of Alt-A origination to about 40 percent
more recently (Barclays Capital, 2006). Option ARM delinquency rates remain very low, compared to
those of other ARMs, but that may change when the post-2003 issuance starts to hit recast dates after
2007.
_____________________________
1 ​Most ARMs adjust every month and are indexed to a publicly-available interest rate index such as one
of the Constant Maturity Treasury indices, a Cost of Savings Index, or the 11​th ​District Cost of Funds
Index. For more on mortgage mechanics see mortgage-x.com or mtgprofessor.com.
As a result, delinquencies and defaults on subprime mortgages originated in 2006 have
soared, despite a benign economic backdrop (Figures 5 and 6). Adjustable-rate mortgages
(ARMs) have been particularly distress-prone, while fixed-rate mortgages (FRM) have
generally fared better (see Figure 7). Even more striking has been the speed of the
deterioration, as measured by the volume of “early payment defaults,” in which the borrower
Source: Citigroup.
Figure 5. ARM Delinquencies and Foreclosures
0
2
4
6
8
10
12
14
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
0
2
4
6
8
10
12
14
Prime
Alt-A
Subprime
(percent of outstanding loans in foreclosure or
sixty days or more past due)
Sources: Merrill Lynch; and Intex.
Figure 6. Subprime ARMs: Delinquencies by Mortgage
Vintage Year
0
2
4
6
8
10
12
14
1 13 25 37 49 61 73
Months after origination
0
2
4
6
8
10
12
14
(percent of oustanding loans sixty days or more past due)
2005
2001
2004
2002
2003
2006
2000
9
misses one or two of the first three monthly payments (Figure 8).​8 ​Fraud appears to have
played a key role in accelerating the deterioration, which resulted in the failure of a number
of originators in 2006–07 as securitizers exercised “put-back” options—forcing lenders to
take back delinquent mortgages.
The highest delinquency rates are associated with “affordability products” such as “hybrid”
and “option” ARMs. These require interest-only payment at fixed “teaser” rates that can
result in negative amortization during the first few years. According to Freddie Mac, ARMs
comprise about 90 percent of recent subprime home-purchase loan originations, most of
which incorporate affordability features (Box 2). In addition, the worst performing loans
involved risk “layering”—high LTV loans to high DTI borrowers who offered little income
verification.
​ PACT ON ​FI​ NANCIAL ​IN
V. T​HE ​IM ​ STITUTIONS
The subprime crisis has so far affected mostly banks with subprime-specialist subsidiaries
(e.g. HSBC) and a number of specialty finance companies. Since mid-2006 such nondepository,
poorly capitalized firms, representing about 40 percent of 2006 subprime
originations, have either closed down operations, declared bankruptcy, or been bailed or
bought out. Some investment banks may be holding residual interests in the subprime
securitization transactions that they have arranged, but losses announced thus far have been
limited and may have been offset by gains on hedge transactions (e.g., ABS-backed credit
8 ​Early
payment default definitions vary, but the one used here defines it as any loan that became 60 or more
days delinquent in the first four months of the loan’s life (Credit Suisse, 2006).
Source: Mortgage Bankers Association.
Figure 7. Delinquency Rates for Adjustable-Rate and
Fixed-Rate Mortgages
0
5
10
15
20
1998 1999 2000 2001 2003 2004 2005 2006
0
5
10
15
20
Prime fixed
Prime adjustable
Subprime fixed
Subprime adustable
(percent of outstanding loans past due)
Sources: Credit Suisse; and LoanPerformance.
Figure 8. Early Payment Defaults
0
1
2
3
4
5
6
2000 2001 2002 2003 2005 2006
0
1
2
3
4
5
6
(percent of outstanding loans sixty days or more past due
within four months of origination)
10
default swaps and short positions in the ABX, a tradable basket of 20 liquid ABS-backed
credit default swaps).
Losses are likely to appear at the end of the securitization chain among the holders of unrated
and lower-rated MBS and CDO equity and mezzanine tranches. The size of these realized
losses will depend on the dollar volume of defaults among the underlying mortgage loans and
on the timing of loss realizations, over which there is some uncertainty. Not all delinquent
loans eventually default and there can be a long lag from when a default is registered to when
MBS and CDO principal payments are impacted, because the foreclosure process can take up
to 18 months to complete. During this period, the loan servicer continues to make the
principal and interest payments to the MBS pool, although it then has a claim on the
foreclosure proceeds.​9 ​Finally, it can take weeks for constituent MBS rating downgrades to
be reflected in CDO ratings, so triggering mark-to-market revaluations (Mason and Rosner,
2007b).
Nevertheless, losses are beginning to crystallize in hedge funds specializing in lower-rated
subprime ABS and CDOs. The lag between rising subprime delinquencies and resulting
ratings downgrades means that exposed ABS and CDO investors need not necessarily
revalue their portfolios to make losses apparent. However, recent investor withdrawals and
margin calls have forced some hedge funds to liquidate holdings and crystallize losses. The
speed with which other investors are forced to do so will be heavily dependent on rating
agency downgrades of ABS and CDO securities.
Assuming flat house prices, $18-$25 billion of mark-to-market losses may accrue on about
$350 billion of outstanding MBS-backed CDOs. Assuming house prices fall 5 percent, markto-
market losses are estimated to rise to approximately $60 billion.​10
​ PACT ON ​HO
VI. T​HE ​IM ​ USEHOLDS
Looking ahead, the combination of interest rate resets will create significant payment shocks
for borrowers in 2007–09. Cagan (2007) estimated that 59 percent of all 2004–06 ARM
originations will see payment increases of 25 percent or more in 2007 and beyond, and on
19 percent of loans, payments will increase by 50 percent or more. In addition, about
13 percent, or 1.1 million, of these ARMs could foreclose as a result of payment reset during
9 ​Apayment is considered delinquent by servicers when it is 15 days late, but not until 90 days have passed is
the loan considered “non-recoverable”, at which point workout or liquidation proceedings begin. Until the loan
becomes non-recoverable, the servicer must cover the missed payments. Workouts may include forbearance
(temporarily reduced payments) or loan modifications (interest rate reductions and term extensions).
Liquidation takes the form of either a voluntary title transfer (“deed-in-lieu” or pre-foreclosure “short sale”),
which takes an average of about 12 months to resolve; or a foreclosure, which takes about 18 months.
10 ​Lehman Brothers (2007). Citigroup (2007) has estimated that undiscounted losses on all mortgages will
amount to about $275 billion, $175 billion of which will be on securitized mortgages.
11
the next seven years, assuming flat house price appreciation. By comparison, the Mortgage
Bankers Association estimated that about 800,000 mortgages foreclosed in 2006.
In the recent past, subprime borrowers were able to limit payment shocks by refinancing,
which will now be significantly harder. If subprime borrowers maintain a complete payment
history for the first two or three years of the loan, they may qualify as prime borrowers when
refinancing. However, the more marginal borrowers (low credit scores and high LTV/DTIs)
with blemished payment histories will find refinancing difficult in 2007–08, as lenders
tighten standards and house prices fall.
Their ability to do so will also be hampered by heavy prepayment penalties more prevalent
among subprime borrowers with low credit scores.​11 ​Even though prime loans are at least as
likely to prepay as subprime loans, less than two percent of them contain prepayment penalty
provisions (Goldstein and Son, 2003, and Engel and McCoy, 2007).​12
VII. R​ISK ​MA ​ NAGEMENT AND ​CO ​ NSUMER ​PR ​ OTECTION IN THE ​SE​ CURITIZATION ​MO ​ DEL
The originate-to-distribute model is driven by fee generation, facilitated by risk dispersion
and compartmentalization. The pursuit of fee income along the entire origination-to-funding
chain brings with it potential incentive conflicts. For example, because few lenders retain the
mortgages they originate, incentives for diligent underwriting and monitoring are diminished.
Recourse and collateral substitution clauses, such as early payment default “put-backs,” go
some way towards aligning originator and investor incentives, but their value is diminished
by the limited period to assess early payment defaults and, in some cases, thin originator
capitalization. The latter results in originator insolvencies when delinquencies rise,
reinforcing moral hazard. In turn, due diligence incentives at the securitization end of the
chain are diminished by risk dispersion, compartmentalization, and remoteness from legal
liability for predatory lending. Finally, the perceived need for investor due diligence is
diminished, particularly for those investors in the less risky AAA- and AA-rated MBS and
CDO tranches that are immune to all but the most catastrophic loss scenarios. Such investors
delegate the evaluation and monitoring of their MBS and CDO holdings to credit rating
11 ​A typical prepayment penalty is effective for up to three years after the origination date, and amounts to up to
six months of interest on 80 percent of the remaining balance. The proportion of subprime mortgages with
prepayment penalties peaked at about 80 percent of originations in 2000-02, but has since declined to about 60
percent, after the Office of Thrift and Supervision effectively reduced the ability of specialty finance companies
to impose them in 2002.
12 ​Prime borrowers are usually motivated by opportunities to refinance when interest rates fall, whereas
subprime borrowers are more often incentivised to refinance by improving credit scores (i.e., “curing”)
(Pennington-Cross, 2003). Going forward, delaying payment shocks on hybrid and option ARMs may become
an important motivation for prepayment. Also, Chari and Jagannathan (1989) show that “points” serve
effectively as prepayment penalties, when explicit penalties are forbidden. Lenders frequently let borrowers pay
points to lower the interest rate on their mortgage. Each point costs one percent of the mortgage amount, and is
paid up front (or rolled into the loan and pay over time). In return, the loan's interest rate drops permanently,
often from one-eighth to one-quarter of a percentage point for every point paid.
12
agencies, who also in turn have a vested interest in the continuation of the securitization
process to generate fees.
The dispersion of credit risk to a broader and more diverse group of investors has
nevertheless helped to make the U.S. financial system more resilient. The magnitude and
scale of losses being currently experienced in subprime mortgage markets would have
materially impacted some systemically-important U.S. financial institutions in the traditional
originate-and-retain business model. But, thus far, most subprime losses have been borne by,
and contained in, the origination network’s periphery of thinly-capitalized specialty finance
companies, lower-rated ABS and CDO tranches, and some hedge funds. A proportion of the
loss is no doubt accruing to foreign investors.
In the move to a securitized loan market, U.S. borrower protections have been weakened. If
borrowers become over-extended, they now have limited legal recourse if they have been
wronged. Hence, if borrowers now try to sue for redress for fraud or some other consumer
protection violation, the originator could very well be bankrupt, and, in any case, the legal
complexity and expense would be daunting. “Whereas forty years ago, a borrower might
need to serve one party [the “creditor”], to bring the full range of legal claims and defenses to
bear on a securitization conduit can require serving ten or more different businesses”
(Peterson, 2007). MBS investors are not responsible for fraudulent or illegal practices that
may have been employed in loan origination as they are “holders in due course,” so avoiding
liability for the actions of the mortgage lenders (Eggert, 2007).
In addition, current Federal laws designed to protect borrowers from predatory lending are
limited in their scope regarding current subprime lending practices. The Truth in Lending Act
(1968) and subsequent Home Ownership and Equity Protection Act (HOEPA) (1994)
regulate “creditor” behavior with regard to exploitative lending practices and customer
disclosure. However, most subprime loans are handled by a chain of intermediaries that do
not constitute a single “creditor.” Also, Federal Reserve regulations enacted under HOEPA
currently only apply to loans with an annual percentage rate in excess of 8 percent over the
comparable maturity Treasury yield. Consequently, they failed to apply to the vast majority
of subprime originations of recent vintages, made at a lower rate.
Federal banking regulators have recently tightened guidance on extending nontraditional
mortgages and for hybrid ARM lending. However, the fragmented nature of U.S. financial
regulation means that observance and enforcement of such standards is not uniform. The five
regulators can enforce compliance by their regulated institutions but, since non-bank lenders
and loan brokers are state-regulated, such initiatives also rely on consistent state-level
enactment and enforcement.
VIII. R​ESOLVING THE ​PO ​ LICY ​TR
​ ADE​-O
​ FF​: P​ALLIATIVES VERSUS ​FU​ TURE ​RE​ FORMS
Policy responses to the rise in subprime foreclosures have been either palliatives for
distressed borrowers or proposed reforms to the subprime market. Responses of the first type,
13
which aim to ameliorate the servicing problems faced by existing subprime borrowers, are
worthwhile for the households concerned but are, as yet, unlikely to be of macroeconomic
significance given the potential numbers of households affected nationwide. The second type
seeks to ensure that similarly lax or predatory lending standards do not recur. These are wellintentioned,
but caution is warranted to avoid unintended consequences for both future
mortgage availability and the attractiveness of U.S. capital markets to foreign investors.
A. Palliatives
The proposed interventions range from borrower subsidies to lender forbearance. Some state
bodies (e.g., the Ohio Housing Finance Agency), GSEs, national community groups, and
commercial banks are offering distressed subprime borrowers debt counseling and
refinancing assistance through subsidized fixed rate loans. While valuable in keeping some
overstretched borrowers from foreclosure, such programs are thus far of insufficient scale to
have a significant impact on the million or so anticipated additional foreclosures. Also,
unless carefully targeted, such subsidies risk keeping some borrowers in houses that they
ultimately cannot afford.
Regulators are also encouraging lenders and servicers to exercise restraint in foreclosing on
mortgages. Such actions may reduce, or at least postpone and smooth, the rise in subprime
foreclosures, so softening the immediate negative impact on house prices from distress sales.
The best servicers already make contact with borrowers approaching payment resets and, if
meeting the higher rate is problematic, can offer a range of modifications to the loan rate,
term, or principal if the borrower wishes to remain in the home. If they do not, or such
options are impractical, servicers may consider a “short” sale to crystallize a loss of principal
if this is likely to be less costly than a full foreclosure process.​13 ​Incentives to minimize
losses are most closely aligned when the loan’s origination, servicing, and securitization is
conducted by the same institution, which then retains a share of the riskier ABS tranches.
However, a number of factors may constrain the degree of flexibility servicers can show to
avoid foreclosure. First, if remunerated purely on a fee-basis, servicers are likely to be
reluctant to incur the costs of applying more flexible workout arrangements. (They may be
similarly reluctant in the case of smaller loans, against which workout costs could be
relatively ​bigger.) Second, servicers’ discretion to modify the terms of loans in a securitized
pool may be constrained by the terms of the document governing the securitization. This
often specifies that the loans modified must be limited to 5-10% of the original value of the
loans outstanding. Third, the governing document usually states that modifications can only
be made if they are in the “best interest of investors,” without specifying which class(es) of
investors’ interests are paramount.
13 ​However, a subprime borrower may be liable to pay tax if they benefit from a short sale, or other element of
principal forgiveness in a loan modification.
14
If widespread loan modification changes the expected cashflow differentially to different
ABS tranches, modifications could give rise to conflicts between investors (Scholtes, 2007).
In addition, accounting rules can require that substantially modified pools are taken back on
the originator’s balance sheet. Given the stated belief of the rating agencies that loan
modifications are likely to be in the general interests of ABS investors, it is unlikely that such
actions in themselves would prompt widespread rating downgrades. Nevertheless, there
remain a number of potential hurdles to servicers adopting widespread restraint within the
securitization model.
B. Future Reforms
Some politicians and states’ attorneys-general have advocated passing the liability for
predatory lending to the investment banks and rating agencies involved in securitizing such
loans. These calls reflect frustration that, given the widespread bankruptcy of subprime
originators, there are few solvent parties liable to pay restitution for such misdemeanors
within the securitization chain. If, as may have been the case, investment banks have
inadequately monitored the pools of securitized mortgages for predatory loan features, a
possible solution would be to adopt a capped liability of the mortgage assignee for predatory
features of mortgage loans—as currently happens for loans originated in five U.S. states
(Engel and McCoy, 2007). As long as liability were capped at a reasonable level, such a
retention would incentivize securitizers to monitor the quality of loans they buy from
originators more rigorously and screen out those with characteristics that put borrowers
clearly at risk. Although this transfer would raise the cost and reduce the supply of subprime
lending, it would align incentives to monitor loan quality with ability and expertise to do so.
However, if potential liability were uncapped, there is a danger that few if any subprime
loans would be originated or securitized (as happened in Georgia in 2002).
An even greater threat to the securitization model would be to make investors liable for
damages from predatory or fraudulent loans within the pools backing their securities, as some
have suggested. Not only have such investors already suffered market losses, but such a
move would also place the obligation for monitoring the loan origination process on
investors who have insufficient information to perform this function. Such a move would
substantially raise the risk premium on such securities, and hence subprime borrowing costs.
In addition, extension of liability to ABS investors could also significantly reduce the
attractiveness of such markets to foreign investors, so making the financing of the U.S.
current account deficit less easy.
Moves to reassign liability appear unnecessary to tighten current lending standards. Already,
subprime standards have been tightened sharply given greater scrutiny from investors, rating
agencies, and regulators, and risk layering features of securitized mortgages have declined as
a result.​14 ​In addition, Fannie Mae and Freddie Mac will soon only buy subprime securities
14 ​Federal Reserve Board, ​Senior Loan Officer Survey​, April, 2007, question 9.
15
whose loans adhere to the new guidance from Federal regulators on non-traditional and
hybrid mortgage lending, and have also reduced their purchases of low- and nodocumentation
loans. Given that the two GSEs buy about 25 to 30 percent of MBS AAArated
tranches, their influence could effectively raise lending standards to conform to
regulatory guidance across the market. In addition, rating agencies are moving to increase the
degree of overcollateralization required in subprime ABS structures to achieve a particular
rating and are refining their models so as to penalize mortgage pools with the risk-layering
features that have correlated with high delinquencies. If anything, with a high level of loan
resets and refinancing demand in 2007–08, the danger to subprime borrowers and dependent
housing markets is that lending standards are being tightened too much, not too little.
The Federal Reserve is reviewing the appropriateness of the regulations it has established
concerning loan disclosure and outlawed lending practices. While rules under HOEPA have
the advantage that they apply to all mortgage lenders, not just regulated depository
institutions, enforcement still relies on one of the five federal regulators of depository
institutions, the Federal Trade Commission, or state mortgage lending regulators. Hence,
consistent application of any new restrictions will be difficult to achieve. Also infringements
not only leave lenders open to regulatory enforcement action but also to private lawsuits for
redress, and so striking the balance between sufficient consumer protection and the
continuing availability of subprime mortgage credit will be a delicate operation (Bernanke,
2007).
Reform of the FHA loan guarantee program is currently receiving bipartisan support as a
response to subprime mortgage problems. Current proposals are designed to allow a larger
number of borrowers to qualify for an FHA loan guarantee by: increasing the maximum
mortgage size that can be FHA-guaranteed to each local markets’ median home price;
simplifying FHA down-payment rules, and allowing for minimal or zero down-payments for
qualified applicants; allowing the FHA to charge for guarantees according to the credit risks
the underlying mortgages represent; and allowing the FHA to offer more innovative loan
products to keep pace with private market developments, such as a 40-year term.
If a market failure exists in lower quality mortgage insurance, then these reforms are
necessary to ensure availability of such assistance to all borrowers. However, the provision
of federal guarantees to zero down-payment mortgages and extending FHA guarantees to
refinance subprime loans that would otherwise be in distress risks guaranteeing speculative
loans and bailing out irresponsible or fraudulent borrowers at the general taxpayers’ expense.
Ideally, distressed subprime borrowers should not be artificially kept in houses that they
cannot ultimately afford.
IX. C​ONCLUSION
The recent experience in the subprime market is a case study in the costs and benefits of
financial innovation in an environment of shifting asset price dynamics. On the one side, the
16
cost of risky mortgages has fallen, allowing for the expansion of homeownership—especially
among minority groups—and default risks have been dispersed away from core depository
institutions to the capital markets. On the other, the viability of the riskiest mortgages and
mortgage-related securities became reliant on continuing house price appreciation, and
lending standards were relaxed to generate high-yielding loans to meet securitization
demand. Moreover, lending standards may also have suffered because fee-remunerated
intermediaries within the securitization process had insufficient incentive to monitor and
maintain long-term loan quality. Less sophisticated investors were content to outsource the
risk management of their positions to the credit rating agencies, who initially appeared slow
to respond to deteriorating mortgage performance. It is questionable whether the extreme
version of this business model, which satisfied demand for high risk loans from nonviable
borrowers at the top of the housing market, should have a future.
With lending standards already tightened, the policy response should balance greater
consumer protection with maintaining the viability of the securitization model. Most of the
actual and anticipated losses from subprime delinquencies have been suffered by bankrupt
originators, on-balance sheet lenders, or investors in the riskier ABS and CDO tranches.
Appropriately, lending standards been have tightened and ratings models are being
strengthened but subprime credit is still readily available—at a price—while no depository
institution has failed as a result. When considering future policy changes, regulators and
lawmakers need to balance carefully the need to limit future predatory lending excesses,
while preserving a model that has successfully dispersed losses from higher-risk mortgages
away from the banking system and maintaining the ability of stretched but viable subprime
borrowers to refinance when confronted with reset payment shock. This is a challenging task
within a regulatory and legal framework ill-suited to provide consumer protection in an
originate-to-securitize financial system.

International Direct Real Estate Investment:


A Review of the Literature
C. F. Sirmans and Elaine Worzala
[Paper received in final form, December 2002]
Summary. This paper provides a critical review of research on international direct real estate
investment issues. To date, no review article has explored the various findings of studies
completed on the benefits of international real estate diversification. In the past 10 years, the
quantity and variety of work have increased dramatically. The paper is organised by how
investing in a real estate asset is analysed: in a mixed-asset portfolio context or a real-estate-only
portfolio context. A fourth section focuses on research that has explored currency risk, one of the
prevailing risks associated with international investing. The last section provides conclusions
about the research and offers ideas for future research in this growing area of real estate
investment.
Introduction
Since the inception of modern portfolio
theory (MPT; see Markowitz, 1959), many
researchers have studied and attempted to
model the benefits of establishing diversification
strategies for portfolio investments.
Initial work only focused on potential
gains from combining different stocks into a
single portfolio, but research has been extended
into bonds, currencies, real estate,
international stocks and bonds and, recently,
researchers have explored the potential
benefits of including international real estate
in investment strategies.
Institutional investors—such as insurance
companies, banks, corporations and pension
funds—are the primary capital players in
most investment environments today. As detailed
in Table 1, the estimated value of the
global investment market in 2000 (insurance
companies and pension funds around the
world) was $23 trillion (Henderson Investors,
2000). The estimated total invested
institutional direct property market is around
$1.3 trillion which includes direct property
holdings of insurance companies, pension
funds and property companies in the major
economies. They also estimate the global
investible institutional property market and
conclude that it is likely to be around $4.3
trillion, although they recognise that this
number is difficult to determine and suggest
it could be as high as $6 trillion or as low as
$3.5 trillion. Whatever the true amount, it is
large and has certainly not been fully tapped
by the institutional investment community.
As illustrated in Table 2, the authors estimate
that only about one-third of the market is in
the US. This suggests that, if an investor

wants to hold a global portfolio, international


investments should be made. Given that
stock and bond markets were about $50 trillion
in 2000, the global property market represents
probably about 10 per cent of the
world portfolio. This percentage could actually
be higher given the bullish stock markets
in the past several years.
Conner ​et al​. (1999) also suggest that the
US market makes up one-third of investment-
grade real estate on a global basis.
They suggest that 80 per cent of the investment-
grade global property portfolio is in
‘core’ investments, 12 per cent is ‘non-core’,
while 8 per cent of the available portfolio is
in emerging real estate markets. Finally,
Webb and O’Keefe (2002) suggest that real
estate comprises 10–20 per cent of total capitalised
stocks, bonds and real estate in developed
countries.
Recently, industry studies produced by
major investment advisors, including Henderson
Investors (2000), Prudential (1988
and 1990), Jones Lang LaSalle, Lendlease,
and AIG, have all advocated that international
real estate should be the next frontier
for the institutional investor. Webb and
O’Keefe (2002) suggest that there are only
14 countries that can actually support real
estate as a unique asset class while the rest of
the world must invest internationally to have
access to the investment-grade real estate

asset class. Thus, in their opinion, international


funds are essential for investors.
Over the past decade, there has been a
proliferation of private investment vehicles.
These investment opportunities have grown
from slightly less than 1 billion euros in 1991
to 80 billion euros in 2002 (Baum, 2002).
Investors have over 100 funds from which to
choose. Baum (2002) examines the funds
that are investing in Europe. As illustrated in
Figure 1, the majority of the funds are ‘opportunity-
based’ funds, commonly defined as
funds investing in high risk/high return (new
development or vacant buildings) with expected
returns of more than 16 per cent. A
significant amount of these funds is not fully
invested, with 30 billion euros available for
investment opportunities in 2002, primarily
in continental Europe. The majority of funds
are run by US managers and are evenly split
between global portfolios (slightly under 35
billion euros) and European portfolios (30
billion euros). Some funds have a single
country or region focus but the value of these
funds is about 18 billion euros. To illustrate
the dramatic growth of the international real
estate funds, in 1991 there were only a handful
of funds that had been established to
invest in international real estate (Worzala
1992). For most of the funds, money had
been accumulated, indicating a growing interest
in international real estate, but no
investments had been made. Whitaker (2001)
found that during 1992–99 there had been
$1.7 trillion in private capital flows to emerging
markets. As interest grows and financial
capital markets become more integrated, it
is important to review the proliferation of
studies that examine the potential benefits
and additional risks of a global direct real
estate investment strategy.
Given the volume of funds interested in
international real estate investments, it is not
surprising that there has also been a
significant amount of research focused on the
potential benefits of an international real
estate investment strategy. The real estate
academic community first began to examine
this issue in the mid 1980s, but in the past
five years research has proliferated due to
increased availability of data as well as the
increased interest of institutional investors.
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1084 ​C​. ​F​. ​SIRMANS AND ELAINE WORZALA


Investment management and advisory firms
clearly support and promote the diversification
benefits of international real estate
and have been instrumental to the debate
as they amass large quantities of data and
work to improve the quality of research in
this area.
This paper provides a critical review of the
growing body of literature focused on international
direct real estate investment. It is
organised by how the direct real estate investment
is analysed: in a mixed-asset portfolio
context or a real-estate-only portfolio
context. Additionally, where appropriate, the
treatment of exchange rates is noted as this
can distort the analysis from the modern
portfolio context, particularly in the mixedasset
analysis. If all assets in one country are
adjusted by the same currency fluctuations,
they will become highly correlated and only
the best-performing assets will enter the international
efficient portfolios. The fourth
section of the paper explores studies focusing
explicitly on how to mitigate the currency
risk that makes implementation of an international
strategy difficult. The fifth section of
the paper provides conclusions and highlights
ideas for future research.
Studies Examining a Mixed-asset Portfolio
Strategy
Table A1 (see Appendix) summarises the
studies examining the addition of international
direct real estate investments into a
mixed-asset portfolio. For each of the various
studies is reported the type of real estate data
used in the analysis, the international markets
studied, the time-interval of the analysis, the
type of analysis that was completed, a brief
summary of the results and the treatment of
exchange rate risk.
Ross and Webb (1985) were among the
first researchers to look at the diversification
benefits from adding direct international real
estate to a mixed-asset investment portfolio.
Their analysis focused simply on comparing
the international real estate with a stock portfolio.
These authors examined 14 countries
over the 1958–79 period and compared the
real estate performance, as measured by the
rental indices reported to the UN, with stocks
in general and then stocks of US multinational
firms. They apply the CAPM model
to examine the riskiness of the international
investments. They use a weighted average of
the percentage change in the rent values of
eight countries to create a world market index.
The weights are based on the GNP
values of each of the countries. The authors
then compare the systematic risk coefficients
(betas) and find that they are significant for
11 of the 14 countries. They conclude that
real estate has less systematic risk than the
more traditional financial assets and could be
an appropriate tool for diversification.
Marks (1986) provided a fairly extensive
empirical study of how investors of different
nationalities might benefit from investing in
the Prudential Property Investment Separate
Account (PRISA)—a US Commingled Real
Estate Fund. He derives returns from the
perspective of six international investors
to ascertain how currency translation and
home-country inflation affect the returns to
each investor. He uses quarterly data from
1978 to 1984 and finds that US real estate
outperforms every country’s equity index
except Japan’s. The time-period investigated,
however, is a time when the US
dollar strengthened against all major currencies.
The authors do not differentiate between
the returns generated by the real estate
and the returns generated by the currency
translation.
Webb and Rubens (1989), in an unpublished
working paper, were the first to examine
the potential diversification benefits from
including direct international real estate investments
in a portfolio context. The real
estate data are from a proprietary database of
investment returns named Finnegan’s Financial
Green Sheets, developed by R. F.
Loarie.​1 ​Two time-periods of annual data,
1926–59 and 1960–86, are examined. Optimal
mixed-asset portfolios are constructed
with US Treasury bills, government bonds,
corporate bonds, common stocks, small
stocks, US residential real estate, US
business real estate, US farmland and UK
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INTERNATIONAL DIRECT REAL ESTATE INVESTMENT ​1085


business real estate. The Loarie database is
used to develop the real estate returns that
are based on sales transaction data according
to the authors. The British business real
estate data are adjusted for exchange rate
fluctuations and returns are analysed from a
US investor perspective.
Initial analysis of the data reveals low and
negative correlation coefficients when UK
returns are compared with traditional US investment
alternatives. The correlations suggest
that UK real estate should provide
additional diversification benefits if added to
a domestic-only portfolio. However, when
efficient frontiers are developed, the UK
commercial real estate asset fails to enter the
portfolio at any risk level. The authors attribute
the findings to the high volatility of UK
returns, but they provide limited information
on the UK data and how they were derived.
This high volatility could be due to the real
estate itself but, more realistically, it is attributable
to the annual exchange rate
fluctuations. The US real estate data are also
ill-defined, including both residential and
farm real estate. These return series may not
be appropriate proxies for a typical institutional
investor’s real estate investments.
Giliberto (1989) compares historical real
estate investment performance with other traditional
financial assets within two countries—
the UK and US. Rather than looking
at investments in an international perspective,
his primary focus is on the domestic
portfolio for each investor examining
benefits derived from adding the real estate
asset class to their investment portfolio.
Potential benefits from cross-border investments
are only briefly addressed in the
closing remarks where he notes that
the lack of correlation in real returns
would have suggested diversification …an
investor would have recognised benefits
from holding a portfolio containing both
US and UK real estate (Giliberto, 1989,
p. 6).
Giliberto uses the quarterly Russell–NCREIF
Property Index as a proxy for US real estate
and a quarterly index from Weatherall, Green
and Smith (WGS) for a UK real estate
investment. Giliberto finds that real estate
investments should be considered as an
alternative investment class by both American
and British investors. He also finds real
estate has historically acted as a good
inflation hedge in both countries particularly
during periods of high inflation (1980–82).
This result changes in times of low inflation
where supply and demand factors within the
individual markets influence returns and provide
for diversification benefits from real
estate investing. Giliberto is one of the first
to conclude that US and UK markets are on
different real estate and economic cycles and
suggests that benefits may be gained from
holding investments in both countries.
Ziobrowski and Curcio (1991) was the
first of a series of papers where the authors
explore potential benefits from adding international
real estate investments to a mixedasset
portfolio. They measure diversification
gains from the British and Japanese investor’s
perspective. In most of their studies,
Ziobrowski ​et al. ​conclude that investors
should not include international real estate
investments as the international real estate
asset class does not enter the portfolios along
the efficient frontier. These early studies all
suffer from a lack of good quality data spanning
a long time series. In the US, the real
estate returns are estimated from a composite
index provided by Ibbotson. It is a combination
of residential, agricultural and commercial
real estate measured on an annual
basis. Each real estate sector in the series is
given equal weight. This could be a problematic
assumption given that agricultural and
residential real estate are not typically held
by the institutional investor. The UK real
estate index is a combination of two data
series. From 1973 to 1980, UK data were
from Jones Lang Wootton and are a combination
of a rental value index and a capital
value index. The rental growth index is segregated
by property type (office, shop and
industrial) on a quarterly basis for the entire
period. The capital growth index, however,
was available only on an aggregate level for
the various property types from 1973 to
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1086 ​C​. ​F​. ​SIRMANS AND ELAINE WORZALA


1977. To get total returns from these two
indices, several simplifying assumptions
about the rate of capital appreciation and
growth of net operating income for each
property type must be made. While the assumptions
made by the authors may be
reasonable and accurate, they provide no
supporting justification.
The second set of data, from 1981 to 1987,
is a different data series based on pooled data
from four independent real estate investment
firms: JLW, Healey and Baker, Hillier
Parker, and Richard Ellis. Although the new
data series provides broader representation of
the market, no discussion is provided on how
the two data series compare in terms of
property type, location or performance.
Changing components of the data and
methodology used to calculate returns in
midstream creates problems in accurately assessing
the consistency of results. Japan is
the third market examined and the data series
provided by the Japanese Real Estate Institute
also required numerous assumptions.
Given the early nature of this research, the
authors use a single index model (Elton ​et
al​., 1976) to compute the efficient frontiers.
This model requires a market index that the
researchers create by taking equal weightings
of each asset class considered in the opportunity
set under examination. That is, if UK
financial assets and real estate are the alternative
investments available to the investor, the
index is equally weighted by returns from the
UK financial assets and real estate. The market
index changes with the opportunity set
that is considered in each scenario. This assumption
seems intuitively unreasonable
since the market value of each asset class is
not equivalent and an investor who is trying
to hold the market portfolio would not be
equally invested in each asset class.
Ziobrowski and Curcio try to determine
whether additional diversification benefits
can be generated by adding international real
estate investments to portfolio. Starting with
traditional asset class investments, they systematically
add alternative investment
classes—first domestic real estate, then international
financial assets and finally international
real estate. The authors adjust the
annual returns and standard deviations to
reflect changes in each currency from the
viewpoint of each investor (American,
British and Japanese). The adjusted ​ex post
returns are then used to estimate mean annual
returns and standard deviations together with
intra-investment correlation coefficients. Optimal
portfolios at numerous risk-free rates
are constructed and the composition of these
portfolios determines the role alternative investments
play in the portfolios. In almost all
portfolios (from every investor’s perspective),
international real estate does not enter
the portfolio to any considerable degree. This
phenomenon leads to the conclusion that international
investment in real estate provides
no additional diversification benefits.
They note that, when returns of each investment
are converted to the investor’s
domestic currency, the international investments
become highly correlated with each
other. In fact, they write that
The evidence suggests that volatile exchange
rate fluctuations induce a level of
risk in these assets that offset any potential
diversification benefits (Ziobrowski and
Curcio, 1991, p. 119).
This conclusion is not surprising since all of
the assets are being adjusted with the same
currency fluctuations.
In an unpublished dissertation (Worzala,
1992) and a working paper (Worzala and
Vandell, 1995), a systematic analysis of
adding international real estate to the more
traditional stock and bond portfolios is completed
from both a US and UK investor’s
perspective. These authors use the NCREIF
property index for a US real estate proxy and
the Weatherhall, Green and Smith property
index for a UK real estate proxy. British
stocks are proxied by the Financial Times
Index (FT-A 500) and US stocks by the S&P
500. The UK bonds are proxied by the 5–15
Year Gilt Index and the US bond investments
are proxied by the Shearson Lehman Hutton
Government/Corporate Bond Index. After
adjusting the real estate data for volatility
(due to appraisal-based data), trans​Downloaded
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INTERNATIONAL DIRECT REAL ESTATE INVESTMENT ​1087


action costs and liquidity, efficient portfolios
were created first with domestic-only assets,
then with the addition of international stocks
and bonds and finally with the addition of
international real estate. The portfolios with
international real estate investments dominate
domestic portfolios from both the US
and UK investor’s perspective. The authors
analyse both annual and quarterly data and
find in both cases that international real estate
enhances the portfolio. The benefits are
significantly reduced, however, when currency
fluctuations are incorporated into the
data. To adjust for currency fluctuations, the
authors use the Mantell (1986) model incorporating
both the return from the movement
in currency as well as the impact of the
currency fluctuation on the return of the investment.
In addition, the portfolio variance
equation is revised to incorporate the variance
of the currency fluctuation and the correlation
of not only real estate assets but also
the real estate assets and the currency
fluctuations. These researchers examine both
the risk and return factors generated from the
local real estate markets and the risk and
return characteristics more appropriately attributable
to currency fluctuations. To explore
separately the risk and return
characteristics of the real estate markets and
exchange rate fluctuations, efficient portfolios
are built twice—first in local currency
terms and then converted to each investor’s
domestic currency to examine the real estate
investments performance adjusted for currency
(that is, including the risk and return
generated from exchange rate fluctuations).
These studies are some of the first explicitly
to explore the impact of currency risk on the
construction of portfolios including international
real estate.
Newell and Webb (1996) analyse the
mean returns, standard deviations and correlation
coefficients for five countries: US, UK,
Canada, Australia and New Zealand. They
examine biannual data from 1985 to 1993
and test for autocorrelation in the time series
due to the appraisal smoothing. As with previous
studies, the authors find low correlations
between the asset classes ranging from
_​0.42 (Australian bonds and USRE) to 0.81
(Canadian bonds/US bonds). They find that
the autocorrelation analysis suggests risk estimates
for real estate should be increased by
34–47 per cent depending on the country to
account for the appraisal smoothing and intertemporal
correlations for the real estate
assets. The authors also adjust the returns for
currency fluctuations and examine the results
from each investor’s perspective. In this
analysis, they find that accounting for currency
fluctuations increases the risk associated
with the international investments,
particularly the real estate investments. However,
the correlation coefficients are reduced
providing evidence that international diversification
benefits could be improved. It is
not clear how the currency adjustments are
made or if transaction costs are included in
their analysis.​2
Quan and Titman (1997) compare the performance
characteristics of 17 real estate
markets with their respective stock markets.
These authors complete their analysis using
the JLW all-cities index for most of the real
estate markets (for Australia, Canada, New
Zealand and the US, they use the Frank
Russell Company indices) and the Morgan
Stanley Capital International Indices for the
stock markets except for Malaysia (KL Composite
Index) and Indonesia (all stocks index
on the Jakarta exchange). They analyse the
time-period of 1977–94 and examine the
capital and income returns as well as total
returns for the real estate. They look at both
the correlations between the property in each
country and the correlations with stock
prices. In the real estate area, the authors find
a wide range of correlation coefficients from
_​0.79 to 0.886 for capital returns and
_​0.821 to 0.999 for the income portion of
the returns. In the aggregate, they find the
relationship between real estate and stock
markets to be strong and positive although it
varies from country to country. It is most
significant in the Asia–Pacific region with a
few European countries also having a positive
relationship. Diversification into international
real estate for investors from these
countries may not be beneficial. However,
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1088 ​C​. ​F​. ​SIRMANS AND ELAINE WORZALA


the US, Australia, Canada and Hong Kong
markets did not have significant correlation
coefficients between real estate and the stock
prices indicating that investing in international
real estate into these markets could
provide diversification benefits. No currency
analysis was completed in this study. All
returns were left in domestic terms implying
that investors could be fully hedged at no
cost.
Stevenson (1998) also examines a mixedasset
portfolio including multiple countries.
He examines an opportunity set of 18 stock
markets, 5 bond markets, US direct real estate
proxied by NCREIF, US indirect real
estate proxied by the NAREIT equity index,
UK direct real estate proxied by the JLW
Property Index and UK indirect real estate
proxied by UK property companies. He
analyses quarterly data from 1980 to 1996
and focuses primarily on whether or not
domestic real estate maintains its place in a
mixed-asset portfolio when international
financial assets are added to a portfolio.
When the international financial assets are
added to the portfolios for both a UK and US
investor, direct real estate investments remain
in the efficient portfolios, dominating
the low risk/return level. The author notes
that the allocations are probably below the
benchmark performances for most pension
funds so he constrains the domestic equities
and bond investments to a minimum of 15
per cent each. Not only is the performance of
the efficient portfolios enhanced, but real
estate takes on a larger allocation in the
portfolio. His analysis is done with and without
currency adjustment but no conclusions
are drawn from the results. The author does
note that hedging may be an important consideration
but it is not incorporated into his
analysis.
In a second paper, Quan and Titman
(1999) use the same data from their earlier
research and attempt to try to isolate a common
factor influencing the returns in the
various countries. They analyse the annual
data from 1984 to 1996. To examine the
stability of returns, they split the data in to
sub-periods: 1983–89 and 1990–96. They
find that there were significant positive relationships
between the real estate capital values,
estimated rental rates and stock market
returns. They also find that a large degree of
the positive correlation can be attributed to
changes in economic fundamentals, particularly
changes in the GDP of the countries.
This result provides evidence that a common
factor does exist. The authors also test for the
impact of inflation and find real estate to be
a good long-term hedge but not on a shortterm
basis. The authors complete the analysis
both with and without currency adjustment to
a US investor’s perspective but provide no
analysis of the results. The common factor
analysis is completed with US dollar denominated
returns that incorporate the full impact
of currency fluctuations on the investor.
Chua (1999) does an extensive analysis of
a mixed-asset portfolio including international
real estate by examining assets from
five different countries. He includes direct
real estate, stocks, bonds, cash and gold and
analyses quarterly data over the period 1977–
97. Adjustments are made for many of the
often-cited problems with real estate data
including appraisal smoothing, taxes, transaction
costs and asset management fees. He
also uses a constrained portfolio that includes
no short sales, a maximum level of any one
asset in one country set at 20 per cent, a
maximum of any asset in any country set to
the GDP weight of the asset in its country
and, finally, maximum allocation to cash is
set at three times the world-wide average of
pension fund allocations to cash. The
efficient frontier that includes international
real estate in the opportunity set clearly outperforms
portfolios that do not. The inclusion
of real estate reduced portfolio risk by as
much as 16 per cent. Optimal portfolio allocations
to real estate ranged from 3.7 to 20.7
per cent, depending on the level of risk/
return for the portfolio. As for currency risk,
returns were all adjusted to an individual
investor’s perspective but no specific analysis
on currency implications is completed.
Cheng ​et al. ​(1999) use a bootstrapping
technique to create a more extensive data-set
for analysing the benefits of international
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INTERNATIONAL DIRECT REAL ESTATE INVESTMENT ​1089


diversification. Similar to earlier work by
Ziobrowski, they examine mean returns,
standard deviations, coefficient of variations,
correlation coefficients and efficient portfolios.
All returns are adjusted annually to
the perspective of the three different investors:
British, Japanese and American.
From the correlation analysis, they find that
the coefficients are generally quite low between
domestic markets and foreign markets.
However, same-country investment correlations
are relatively high and the currencyadjusted
international investments from the
same country are also highly correlated due
to the common currency adjustment. They
conclude that currency risk is very large and
dominates the asset volatility of foreign investments.
Therefore, they suggest that an
investor should view all three foreign assets
as one asset when contemplating diversification.
They compute efficient frontiers
with three different opportunity sets:
domestic only, domestic plus foreign
financial assets and domestic plus international
financial assets and international real
estate. This analysis provides some evidence
that under some circumstances international
real estate investments do fall into the optimal
portfolios (up to 20 per cent). However,
they recommend that only the high risk tolerant
investors consider foreign real estate in
the 5–10 per cent allocation range.
A report from AIG (2001) analyses the
mean returns, standard deviations and correlation
coefficients for an opportunity set that
includes US stocks and bonds, direct and
indirect US real estate (NCREIF and
NAREIT) and direct real estate in the UK
and Ireland from 1979 to 2000. Efficient
frontiers were constructed when adding international
real estate to the portfolio. The
efficient frontiers from including international
real estate in the opportunity set
outperformed domestic portfolios providing
evidence that international real estate diversification
benefits are possible. No adjustment
was made for currency fluctuations of
the international real estate investment.
Hoesli ​et al​. (2002) do a thorough exploration
of including direct and indirect international
real estate in a mixed-asset portfolio.
They examine the benefits from an international
diversification strategy from the perspective
of seven different countries: the US,
the UK, France, the Netherlands, Sweden,
Switzerland and Australia. They use annual
data from 1987 to 2001 for the various asset
classes. For the direct real estate, they use a
corrected series for the often-noted appraisal
smoothing problem associated with appraisal-
based returns. They examine the
mean returns, standard deviations, correlation
coefficients and efficient frontiers for
three scenarios of financial assets including
indirect real estate only, adding domestic
direct real estate, and adding international
direct real estate proxied by a ‘world’ real
estate index. This index is created by weighting
the constituent indices by their respective
GDPs. The researchers find that the correlation
coefficients of direct and indirect real
estate are relatively low, suggesting the potential
for diversification benefits from an
international investment strategy. The results
vary depending on the country analysed.
Hoesli ​et al​. (2002) further examine the
performance characteristics assuming that investors
hedge the currency risk of the international
investments with forward contracts.
When these hedged returns are used, the real
estate correlations stay relatively constant but
the bond correlations increase. In both
scenarios, asset allocations to real estate
within the efficient portfolios fall in the 15–
25 per cent range, including both domestic
and international direct real estate investments.
It is interesting to note that indirect
real estate does not enter many of the
efficient portfolios. The researchers incorporate
the costs of the hedging strategy into their
analysis and find that the impact of hedging
varies depending on the country under analysis.
The authors suggest that hedging does
not improve performance for a UK or US
investor but it is a beneficial strategy for
investors from other countries under analysis.
All of the studies reviewed in this section
have one thing in common: the analysis combines
real estate with other financial assets in
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1090 ​C​. ​F​. ​SIRMANS AND ELAINE WORZALA


a mixed-asset portfolio context. In addition,
even though the studies use a number of
different return series and countries, the conclusions
in almost all of the research indicate
that an international direct real estate diversification
strategy provides benefits.
Efficient portfolios that include international
direct real estate in a mean–variance framework
outperform those that do not. The only
studies to argue consistently that international
direct real estate should not be included
in a mixed-asset portfolio were done
early when access to real estate data was
extremely difficult. In addition, their treatment
of currency fluctuations requires an
implicit assumption of annual repatriation for
the international investments. This forces the
assets in one country to become highly correlated
with each other so only the highest
returning assets were allocated in the
efficient portfolios of a given country.
Although the results are interesting and
relatively consistent, it is important to provide
some caution and caveats with the studies
that are summarised in this section. The
use of the mean–variance framework (MPT)
for real estate has been seriously questioned
by many researchers. Lizieri and Finley
(1995) provide one of the earliest critiques of
its use in an international context. The majority
of problems that they uncover continue
to plague the international real estate research
community. They analysed the performance
of the suggested portfolios of
Sweeney (1989) and found that a fund using
the proposed strategy would have had a disastrous
performance. The authors suggest
several reasons for this including technical
problems with the data (rental rates as a
proxy for performance assumes that yields
are stable over time) and the corner solutions
often resulting from the mathematics of
modern portfolio theory.
Many of the summarised studies in this
section note the instability of returns and
how results are dependent on the time-period
analysed. With unstable returns, the historical
mean returns, standard deviations and
correlation coefficients between countries
may not be the best way to analyse the real
estate asset class. This is important particularly
since the majority of the real estate
return series used in the summarised studies
are under a 15-year time-span. In addition,
direct real estate investments are not singleperiod
investments and they lack the liquidity
of the more traditional asset classes.
Direct real estate is characterised by its long
holding-period so the international studies
that convert returns to a given investor’s
perspective are ignoring these very important
characteristics of a direct real estate investment.
Finally, as discussed by Lizieri and Finley,
there are additional risks associated with an
international diversification strategy that
include asset-specific, domestic sector, domestic
market, international sector, international
market and currency markets. It is
difficult to incorporate these risks into the
traditional mean–variance framework for a
mixed-asset portfolio and for the most part
they are ignored in the studies summarised in
this section.
Studies Using a Within-real-estate Asset
Class Portfolio
This section reviews the research that focuses
on including international direct real
estate investments in a real-estate-only portfolio.
The studies are summarised in Table
A2 (see Appendix). As in the previous section,
the majority of work finds that international
real estate does provide
diversification benefits. However, the treatment
of currency risk in most of the studies
is ignored: either researchers complete the
analysis in local currency, implicitly assuming
a costless hedge; or, returns are converted
to an individual investor’s perspective
with no analysis of the currency risk provided.
These issues are discussed in the next
section of this paper.
Some of the early studies advocating international
diversification from a ‘within-assetclass’
perspective are Sweeney (1988 and
1989), Reid (1989), Wurtzebach (1991) and
Baum and Schofield (1991). It is interesting
to note that most of the pioneers in this area
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INTERNATIONAL DIRECT REAL ESTATE INVESTMENT ​1091


were researchers working in industry rather
than academic researchers. Wurtzebach was
working with Prudential Real Estate Investors,
Sweeney and Reid were working for
Richard Ellis; and Baum and Schofield, although
published by the University of Reading,
were working with Henderson Real
Estate Strategy when the work was completed.
Given a paucity of data, research done
during this early time-period was relatively
crude. Sweeney (1988) examines rental value
growth rates for 16 countries from 1970 to
1986.​3 ​Overall findings indicate that an investor
would have earned superior returns if
a global investment strategy had been
adopted. The amount of diversification
benefits was dependent on the nationality of
each investor. She provides only a cursory
example of how international real estate diversification
could help overall portfolio returns
by examining a scenario in which
Glasgow real estate is added to a US-only
portfolio. This situation would increase annual
returns from 7.45 per cent to 8.25 per
cent and reduce overall portfolio risk (measured
by the standard deviation) by 48 per
cent, from 12.78 to 6.58, indicating substantial
benefits from adding an international investment
to the portfolio. Sweeney adjusts
the international returns for currency from
each investor’s perspective but makes no
distinction between the risk and return generated
from local real estate markets and currency
fluctuations.
In a supplementary article, Sweeney
(1989) completes a similar analysis, but adds
an efficient frontier dimension. In this study,
local rental growth rates in 11 real estate
office markets from 1978 to 1988 are
analysed. Sweeney uses an optimisation
model to derive efficient portfolios and asset
allocations. For the maximum return and
risk, the entire portfolio would be invested in
Sydney. Yet, for a minimum risk and return
level, international investments are held in
the efficient portfolio and assets are split
between 7 out of the 11 countries. Reid
(1989) uses the same rental value growth
data as Sweeney (1989) and focuses his
analysis on the correlation matrix of the various
return series. He arrives at a similar
conclusion to that of Sweeney—that diversification
benefits can be gained from
adopting an international real estate portfolio
strategy.
Arnold and Kavanaugh (1988) examine
data from the Jones Lang Wootton proprietary
database over a 10-year timehorizon.
They compare the JLW property
index in London, Paris and Sydney with the
US NCREIF Index from 1978 to 1987. They
find that Paris and Sydney substantially outperform
the US market during this timeperiod
and that the standard deviations of
returns for London and Paris indicate that
high returns with relatively low risk are possible.
Also using correlation analysis, the authors
find US real estate to be positively
correlated with returns in Sydney and Paris,
but negatively correlated with investments in
the City of London. It is unclear if the returns
are adjusted for currency risk. No further
analysis on diversification benefits is completed
but in their concluding comments the
authors acknowledge the many differences
between the individual real estate markets,
including vacancy rates, lease structures and
capital markets. The authors suggest that the
differences may play a significant role in the
different levels of real estate performance in
each market and therefore provide substantial
diversification benefits in a portfolio context.
An industry report was completed and distributed
in 1988 by a major US institutional
investor and a large real estate advisory firm
(Prudential/JLW, 1988). With in-house databases
on six international markets from 1978
to 1987, the authors build hypothetical investments
in Class A office space in the
prime international business districts of each
country.​4 ​That is, the authors create an institutional
office building investment that is
hypothetically purchased in 1978 and held
until 1987. Investments are assumed to have
multiple tenants and the authors try to incorporate
different lease terms, market rent reviews
and rent indexation that are common
in the different countries under analysis. Annual
returns are calculated by taking each
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1092 ​C​. ​F​. ​SIRMANS AND ELAINE WORZALA


year’s net income and applying the respective
market capitalisation rate to derive an
estimated capital value for the hypothetical
investments. Total returns, income returns
and capital returns are all based in local
currency.
Two portfolios are analysed, one equally
weighted between all six markets and the
other more heavily invested in the larger
investment markets—London, Tokyo and the
US. Results favour a diversified portfolio
over single-country investments and the authors
conclude that investors with an international
investment strategy experience the
best of both worlds—increased levels of
return and lower levels of risk.
Wurtzebach (1991) examines vacancy
rates, rental value changes, capitalisation
rates and projected rates of return for office
investments in five major metropolitan areas.
He compares the individual markets with a
global portfolio.​5 ​He finds that in all categories
the global portfolio has reduced
volatility from the US-only portfolio. In
many cases, the global portfolio also has
lower volatility than the single-country portfolios.
The data span from 1978 to 1989
(estimates are used for 1989) and are based
on annual holding-periods. All of the return
data are in local currency, so the analysis
assumes that investors can costlessly fully
hedge the international investments. The author
is one of the first to consider explicitly
some of the additional risks of non-US real
estate investments including: lack of local
knowledge (he suggests joint ventures could
be the solution), currency risk (he advocates
hedging annual cash flow), political risk (he
suggests is greater in less mature markets)
and the smaller scale of other markets compared
with the US (he suggests this could
actually enhance performance of the investment
as population densities are higher and
with highly regulated markets, the competition
may be less).
Gordon (1991) compares real estate with
the alternative financial assets and computes
mean returns, standard deviations and correlation
coefficients for all of the asset classes.
He uses a return series from 1970 to 1990
and finds that UK property returns have no or
negative correlation with all of the US assets
except inflation. He then builds propertyonly
portfolios and systematically alters the
allocations to one country or the other. He
finds that an investor would gain from holding
both US and UK property in one portfolio.
To get the longer time-series he is
forced to combine two data-sets for both
countries. In the US, he uses the EAI survey
and the NCREIF Index; while in the UK, he
combines the JLW Property Index with the
IPD index in the later years. For his portfolio
analysis, he did not adjust for currency
fluctuations but he did examine the performance
characteristics with and without currency
adjustments. He finds that the currency
adjustments significantly alter the return patterns
for the various asset classes and he
suggests that an investor should simply take
the long view of real estate and ignore shortterm
currency fluctuations.
In her unplublished dissertation, Worzala
(1992) also examined the real-estate-only
portfolios on an international scale. Using the
same data (NCREIF for the US and Weatherall,
Green and Smith for the UK), she examines
the means, standard deviations and
correlation coefficients for office, retail and
industrial property. She finds that correlation
coefficients are relatively low for all of the
different property types. She constructs
efficient frontiers with and without the international
investments and with and without
currency fluctuations. As with her analysis in
the mixed-asset portfolio context, Worzala
finds gains from international diversification
for the real-estate-only portfolios but enhanced
performance is more likely if local
returns are used for the international investments
Eichholz ​et al​. (1995) also examine the
prospects of property type diversification but
they compare the results on a country basis
and do not formally test the potential benefits
of international diversification. In addition,
they focus on regional diversification within
the different countries. For the US, the
NCREIF Index by Property and Geographical
Location from 1983 to 1992 is employed.
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INTERNATIONAL DIRECT REAL ESTATE INVESTMENT ​1093


The UK real estate investment was proxied
by the ​Investor’s Chronicle ​Hillier-Parker index
from 1973 to 1993. Although a comparison
is made, the analysis is primarily done
within country rather than across country.
The time-series interval for the US is quarterly
while the UK is biannually. The authors
used the Jennrich test of correlation matrices
and found that diversification benefits are
greater for a geographical strategy rather
than an investment strategy based on property
type. They also examined efficient frontiers
and found that diversification benefits
varied extensively depending on the country,
property type or region under analysis.
Goetzmann and Wachter (1995) examine
the office market only and use the ICPA
database of asking rents and yields from 21
countries. For the majority of countries, the
data series is on an annual basis and extends
from 1986 to 1993. They analyse returns
over time and use principal components
analysis to find a common factor from the
various return series. They create efficient
portfolios and use ​K​-means cluster analysis
and bootstrapping techniques to examine the
potential benefits of diversification. They
find significant evidence that the property
crash of the 1980s was indeed a global crash
and that the performance of office market
investment moves with a global business
cycle. Using principal component analysis,
the authors found that 44 per cent of the
variation in returns was due to a common
factor. Therefore, these authors question
gains to diversification by holding international
investment in office property. In addition,
they also use an efficient frontier
(after noting the problems with it) to show
that naı¨vely using the MPT model sends an
investor chasing after the past winners. These
results show clearly that inputs for these
models are extremely important and very
sensitive.
With their ​K​-means clustering analysis,
the authors find that the selected countries
can be divided into three groups, although an
investor could have as many as seven different
groups to invest in. North America clusters
with the UK and Australia. The more
conservative portfolios are tilted towards the
US and continental Europe investments
while more aggressive portfolios contain investments
in the Asian and Iberian countries.
All of the data were converted to a US
investor’s perspective.
Hudson-Wilson and Stimpson (1996)
complete an analysis of benefits from international
diversification from a Canadian investor’s
perspective. They examine the
impact of adding US real estate on a national
level, by different property types and 50
different US markets. They use the NCREIF
combined index for the US total return. For
the property type and geographical analysis,
they use a proprietary database created by
Property and Portfolio Research. The database
is based on an econometric model forecasting
the total returns for the various
markets on an unleveraged basis. For
Canada, the authors combine the Mourgand
Property Index (1980–85) with the Russell
Canadian Property Index (1986–94). The authors
compute the traditional mean returns,
standard deviations and correlation
coefficients as well as the construction of
mean–variance-efficient portfolios from the
Canadian investor’s perspective. They begin
their analysis with the national-level US data
and then expand into the more specialised
markets. At the national level, the researchers
find that including US real estate in
the portfolio enhances an exclusively Canadian
opportunity set.
The authors then systematically analyse
the impact of property type and find that
apartments have the greatest impact on the
portfolio performance. When analysing the
US databased on geographical location, they
find that the results shift depending on which
property type and metropolitan area are included.
These authors attempt to recognise
the impact of currency fluctuations on returns
as the full analysis was completed with and
without conversion to the Canadian dollar.
Like Worzala (1992), these authors find that
the results are very different and acknowledge
that the risk from currency changes
could be substantial. They suggest that hedging
might be a good idea but caution that in
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1094 ​C​. ​F​. ​SIRMANS AND ELAINE WORZALA


a portfolio context the currency exposure for
the whole portfolio rather than just the international
real estate needs to be considered.
They suggest that a currency overlay management
strategy could be considered to minimise
the risk for the entire portfolio.
D’Arcy and Lee (1998) focus their analysis
on the European markets and analyse
which is the better diversification strategy:
country, property type or city type. For the
city-type analysis, they separate the cities
into two classifications: a major financial
centre in a country or a secondary city in the
same country. They use the ICPA/ONCOR
return series and create a multiple regression
model with dummy variables to represent the
three different types of diversification. In
their analysis, they find there is more to be
gained from analysing across countries, but
city type also provides diversification
benefits. The authors caution, however, that
an understanding of the institutional environments
is essential for making international
investment decisions and one should not
blindly depend on asset allocation models.
Addae-Dapaah and Yong (1998) examine
the potential diversification benefits from
holding international real estate investments
in an office portfolio from the viewpoint of a
Singaporean investor. The research employs
market rental and capital value data on nine
different office property markets from the
Jones Lang Wootten Asia Pacific Property
Digest. The return series spans from 1984 to
1997. The authors focus on the impact of
currency risk on the performance characteristics
and the efficient frontiers of an internationally
diversified office portfolio in the
Asia–Pacific region. Quarterly returns are adjusted
for currency from the Singaporean
investor’s perspective. Without currency adjustments,
the correlations coefficients are
relatively low positive and negative correlations
suggesting gains from diversification.
Incorporating exchange rate fluctuations has
both a positive and negative impact on the
mean returns and correlation coefficients depending
on the market combinations under
consideration. However, the authors find that
the differences between the currency adjusted
and unadjusted mean returns and correlation
coefficients are not statistically
significant. When comparing the efficient
frontiers, with and without currency adjustments,
the authors find that the increased risk
from the currency fluctuations is marginal
and also not statistically significant. The authors
conclude that there are significant gains
from international diversification but that the
risk of currency fluctuations did not
significantly impact returns on the fully diversified
international office portfolio. These
authors suggest that the movements between
the exchange rate returns and the fully diversified
office portfolio returns provide a
natural hedge against the exchange rate
volatility.
Case ​et al​. (1999) examine the GDP
influence on income and capital returns for
real estate investments. They use the ICPA
data and examine 22 real estate markets in 21
countries from 1987 to 1997. They examine
the mean returns, standard deviations and
correlation coefficients and find they were
relatively low, ranging from 0.33 to 0.44 for
all property types across countries. They then
test to see if real estate returns are correlated
with GDP changes in the individual countries.
To do this analysis, the authors create
an equally weighted index of international
GDP changes. They find evidence that crossborder
correlations are partially due to a
common exposure to fluctuations in the global
economy. They also find that countryspecific
GDP changes help to explain some
of the variation. For their analysis, the researchers
adjust all returns to a US investor’s
perspective so currency risk is not explicitly
examined. The authors then examine the diversification
benefits from adding international
property to a real estate portfolio
and conclude that industrial property investments
achieve the greatest reduction in risk
while office investments achieve the least
reduction in risk.
Several recent industry-sponsored reports
have also been released that are strong proponents
of including international real estate
in an investment portfolio. Henderson Investors
(2000) examines mean returns, stan​Downloaded
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INTERNATIONAL DIRECT REAL ESTATE INVESTMENT ​1095


dard deviations, coefficient of variation and
correlation coefficients for the US, the UK,
Australia, continental Europe, Asia and the
world using an annual return series from
1984 to 1999. They find that over the past 15
years, a global real estate portfolio would
have offered a higher return per unit of risk
than a single property market. They find that
global markets are not perfectly correlated
providing diversification benefits—particularly
from Asian markets (​_​0.13 US/Asia).
They do not do any analysis on the currency
risk associated with an international investment
strategy.​6
Whitaker (2001) also argues for international
direct real estate diversification. The
proxy for international real estate is the IPD
index in both the UK and Ireland from 1979
to 2000 (annual returns). For the US investor,
the NCREIF index is used. He finds that
adding private, direct international real estate
to a US investor’s portfolio improves performance.
He also notes that international
real estate investment is where growth is
likely to occur as developing countries are
presently experiencing higher economic
growth than the developed countries. These
emerging markets will need an increase in
investment-grade real estate to meet the
needs of their expanding economy. As with
Baum (1995), the author cites the advantage
of access to capital money as essential for
growth; developing market investors may not
have the same access to capital markets, thus
increasing diversification benefits.
The studies in this section all focus on
analysing the potential diversification
benefits in a real-estate-only portfolio context.
Even though the authors use a number
of different return series and countries, the
conclusion from most of the studies advocates
the inclusion of international real estate
in a mean–variance framework. International
efficient portfolios outperform domestic-only
real estate portfolios. It appears as though the
consensus is that both the property type and
region make a difference and regional diversification
appears to be more important.
The majority of the studies in this section
employ the mean–variance framework
(MPT) and so they require the same caution
and caveats given to the studies in the previous
section. In addition, the real-estateonly
studies have a further problem in that
they are not a true reflection of a typical
institutional investor who holds a mixed-asset
portfolio that is primarily allocated to
other asset class investments. As noted earlier,
real estate is only about 5–8 per cent of
the typical institutional investment portfolio.
Therefore, the decision to invest in international
real estate should not be made in
isolation—an implicit assumption of the
work summarised in this section. In theory,
the alternative assets an investor is considering
should all be considered at the same time
because asset allocations shift as additional
assets with alternative performance characteristics
are added to the opportunity set.
Worzala (1992) finds that the percentage
asset allocations within the real-estate-only
portfolio and the mixed-asset portfolio are
similar when the minimum variance portfolios
are considered. However, as the investor
moves out on the efficient frontier, the
proportional allocations to the various real
estate investments change significantly between
the real-estate-only portfolio and the
mixed-asset portfolio. The main reason for
the difference is that, as additional assets are
added to the portfolios, the relationship between
the assets will change, particularly the
covariances of the assets involved. Additional
research is necessary into the validity
of using real-estate-only diversification
strategies for an institutional investor that has
a mixed-asset portfolio to invest. This research
is extremely important as the practical
limitations of making investments typically
result in investors making the real estate
allocations in isolation from the other asset
classes. Further studies are needed to determine
under what conditions the allocation
from a real-estate-only portfolio can or
should be used for the mixed-asset portfolio.
Analysis of Currency Risk in International
Real Estate Investing
In most of the research analysing the di-
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1096 ​C​. ​F​. ​SIRMANS AND ELAINE WORZALA


versification benefits of international real estate
investments, researchers have assumed
either that returns were unhedged or fully
hedged at no costs. In a few studies, both
techniques are used and it is clear that currency
fluctuations change the diversification
benefits associated with international real estate
investments.​7 ​In some cases, it may be
appropriate to consider ​hedging ​the currency
exposure of an investment—that is, use a
financial instrument to ensure that adverse
currency movements do not affect investment
returns. Unfortunately, most of the
available hedging instruments have been designed
for use with short time-horizon assets—
stocks, bonds and cash. As a result,
while they may be well suited to hedging
indirect property investments, such as shares
in real estate investment trusts or property
companies, they may be less appropriate for
direct equity ownership of foreign property.
Given its high transaction costs and relative
illiquidity, directly held real estate tends to
have longer holding-periods than more liquid
assets. The long holding-period adds uncertainty
to the investment, since the final sale
price (exit value) is unknown, making it
difficult to hedge the capital appreciation.
Furthermore, few of the available hedging
instruments have long settlement-periods,
making the task of hedging more complex. In
developing a currency strategy, an investor
must consider transaction risk (the risks associated
with the actual purchase of the asset in
the foreign currency) and translation risk (the
impact of currency movements on the repatriation
of funds, both of income and of the
uncertain terminal value).​8
A few studies have focused on using some
of the alternative hedging techniques. In Ziobrowski
and Boyd (1991), the researchers
attempt to hedge the currency risk by incorporating
US leverage to protect the British
and Japanese investor from currency
fluctuations. In their analysis, the international
investor takes on varying levels of
US debt to reduce currency risk. The researchers
find that this strategy does indeed
reduce the currency risk, but the investor
trades currency risk for financial risk. They
assume that the loan will be continually
taken out on an annual basis and will be
subject to annual interest rate adjustments.
The increased level of volatility means that
the international investor does not gain from
holding international real estate investments.
Their chosen scenario, however, is not
necessarily how back-to-back loans work. In
most cases, the international investor works
with a local investor that typically has a
comparative advantage in borrowing funds
locally. In addition, they will have access to
fixed-rate financing for a specified period of
time. In this type of arrangement, the foreign
investor would make interest payments (presumably
from the foreign asset income) and
repay the loan on maturity (from the sale of
the asset). The financial risk could be locked
in for the holding-period and currency risk
mitigated. However, any surplus capital after
repayment of the loan is still subject to currency
risk. In addition, a loan could also have
accounting implications and there is the potential
for default risk that also needs to be
analysed. This is an area where further research
would be beneficial to shed light on
the potential of using domestic leverage as a
hedging strategy for an international real
estate investment.
Two other studies explore the use of options
(Ziobrowski and Ziobrowski, 1993) and
forward contracts (Ziobrowski and Ziobrowski,
1995). Both studies are also framed
within a portfolio context, utilising appraisalbased
real estate index returns adjusted on a
periodic (generally annual) basis. While this
is consistent with reporting standards, the use
of a hedge with this type of data effectively
implies annual repatriation of funds. In practice,
while rental income might be repatriated,
the capital gain component can only be
realised on sale of the property and is, thus,
dependent upon aggregate currency movement
over the holding-period rather than on
the sub-period movements. In the absence of
long-term contracts, both strategies should
require an investor to stack up a number of
short-term options or contracts at the start of
the holding-period and incur settlement costs
over time. In both studies, the authors avoid
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INTERNATIONAL DIRECT REAL ESTATE INVESTMENT ​1097


roll-over costs and assume that the contracts
close out at the end of each year without
incurring settlement or transaction costs.
Making more realistic assumptions,
Worzala (1995) examines the use of forward
contracts for a US investor purchasing UK
real estate. She shows that forward contracts
appear to improve the risk-adjusted return
(measured by the coefficient of variation) for
the US investor. However, when the transaction
and roll-over costs of the three-month
forward contracts are included, the volatility
increases sharply. Over this particular timeperiod,
the investor would have obtained superior
results by ‘going naked’—that is, not
attempting to hedge at all.
In Ziobrowski ​et al​. (1997), the researchers
examine the use of currency swaps.
In this study, they find that hedging the US
real estate investment with swaps suppresses
most of the currency risk but the improvements
are insufficient to produce diversification
gains in the context of a
mean–variance portfolio context.​9
Worzala and co-workers (Worzala ​et al.​,
1997; Lizieri ​et al​., 1998) argue that results
based on portfolio-based indices may be misleading
for all but the largest institutional
investors. Most investors would be exposed
to tracking error and specific risk, given the
heterogeneity of private real estate performance
and the typically small number of foreign
properties held. Moreover, they argue
that ​ex post ​data are historically contingent
and hence ignore uncertainty. (This problem
is also addressed in Cheng ​et al.​, 1999.) As a
result, they suggest that the appropriate test
of the efficacy of hedging techniques for
individual investors is to use a forwardlooking
simulation approach with realistic
expectation and volatility inputs for key variables.
10
Worzala ​et al. ​(1997) examine the use of
simulation to model the impact of hedging an
international investment (a UK office building)
with currency swaps for a US investor.
The investment is 100 per cent leased on an
upward-only rent review contract and is
analysed over a five-year holding-period so
rental income is stable. Uncertainty is factored
in for the sale price at the end of the
holding-period, which depends on rental
growth, depreciation and shifts in the capitalisation
rate (initial yield).
The authors use a straightforward (‘plain
vanilla’) currency swap to hedge the income
element of the investment. The return generated
by the property is then analysed using a
Monte Carlo simulation approach. A series
of trials are run with the currency allowed to
vary randomly but subject to a set of rules.
Three scenarios were tested: an appreciating
dollar (which has negative impact for the US
investor), an appreciating pound (positive for
the investor) and a neutral, randomly
fluctuating exchange rate (which is broadly
neutral but increases investment volatility).
The costs of the swap (a 1 per cent initiation
fee and a 25-basis-point charge on swap
payments) are incorporated into the analysis
but the capital appreciation is left unhedged.
As might be expected, when the pound
appreciates, the investor loses out both from
the cost of the hedge and the failure to
benefit from the favourable currency shift.
This effect overwhelms any reduction in
volatility. Similarly, when the currency shifts
against the investor, hedging is highly advantageous
(an IRR of 9 per cent hedged compared
with 4.8 per cent unhedged). The
interesting case is the random currency
fluctuation. Here, the cost of hedging reduces
the overall return (IRR 9.64 per cent to 9.97
per cent, NPV £0.699 million to £1.077 million)
but the currency swap greatly reduces
the volatility of the investment (the standard
deviation being reduced six-fold) resulting in
a superior risk-adjusted return. The authors
suggest that this provides evidence that it
may be feasible to hedge partially against
adverse currency movements in making
international real estate investments.
From this original study, three additional
studies have been done to examine the usefulness
of alternative hedging techniques. In
Lizieri ​et al​. (1998), the authors continue to
explore just the use of a currency swap but
they also examine the impact of currency
fluctuations on the reversionary value by
allowing the capitalisation rate and the
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1098 ​C​. ​F​. ​SIRMANS AND ELAINE WORZALA


market rents to vary. In all scenarios, the use
of the currency swap reduced the volatility of
returns but the swap’s ability to reduce risk
becomes more limited as the cash flows become
less certain. In Johnson ​et al. ​(2002),
the authors continue to use an office building
simulation. In this study, they employ a combination
of both a currency swap to hedge
the initial investment and periodic cash flows
and a forward contract taken out on the
expected appreciation in the property value.
The ability of the swap alone to reduce risk
turns out to be somewhat limiting but the
combination of swap with the forward contract
enhances the overall performance,
greatly reducing the uncertainty associated
with the investment and in turn the downside
risk. Finally, Johnson ​et al. ​(2001) examine
the ability of the combination currency swap
and forward contract strategy to hedge an
international hotel investment. This product
type carries a significantly greater level of
cash flow uncertainty and again the combination
of a currency swap and forward contract
is the most successful in allowing the
investor to mitigate the impact of adverse
currency fluctuations and to capitalise on
currency markets if they move in the investor’s
favour. The results were relatively sensitive
to the underlying assumptions
regarding costs of the swap and the discount
rate used for the analysis. If these variables
are increased, many of the advantages of
purchasing the hedging instruments are eliminated.
However, incorporating the hedging
strategy significantly reduces the level of
downside risk associated with the investment
as the range of simulated net present values
is reduced, particularly in terms of losses.
The above studies assume that investors
would hedge at the individual-property level
or on a country-by-country basis for their
real estate investments. While this might be a
valid assumption for an individual investor
or a property company with exposure to just
one or two foreign real estate markets, it may
not be an optimal strategy for a large corporate
or institutional investor with a diversified
international portfolio. Kateley
(2002) states that currency risk is real but
that large institutional investors will have
other international investment allocations
and should invest in a currency overlay management
system to manage the entire exchange
rate exposure for the portfolio.
Currency assets and liabilities could be
netted out to reveal the net exposure to particular
exchange rate movements and that
risk could then be managed centrally, maximising
economies of scale in carrying out
the currency hedges. This is definitely an
area where future research will be important
as investors implement their diversification
strategies of including international real
estate in the investment portfolio.
Whitaker (2001) also suggests some strategies
for mitigating currency risk that include
hedging but correctly acknowledges this is
only an appropriate strategy for real estate
investments in developed markets, given the
lack of hedges available for capital invested
in emerging markets. He also advocates the
use of domestic leverage. Finally, he suggests
an additional strategy that investors
could focus on investments in markets where
they can negotiate lease terms denominated
in their own currency. A US investor would
look for dollar-denominated rents while
Europeans might negotiate euro-denominated
rents. In this scenario, currency risk is passed
on to the tenants.
Another recent contribution to the hedging
debate includes a study by Hoesli ​et al​.
(2002) where they analyse efficient portfolios
that are constructed with local returns and
also with returns that are hedged for currency
risk using a forward contract denominated in
US dollars. Results are interesting in that
they find not all nationalities need to hedge
their currency risk. The US and UK investors
have better performance from the unhedged
mixed-asset portfolios while investors in
some of the smaller countries gain additional
benefits by taking on a forward contract
hedging strategy. It is not entirely clear how
the researchers incorporated settlement costs
but they have included transaction costs for
the forward contract in their hedged returns.
In summary, currency risk is an important
factor that should be included in the analysis
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INTERNATIONAL DIRECT REAL ESTATE INVESTMENT ​1099


when considering an international real estate
investment strategy. The investment characteristics
of commercial real estate make
many of the financial hedging instruments
developed for more liquid assets like stocks
and bonds inappropriate for directly held
property. However, some of the risk of adverse
currency moves can be hedged, particularly
where rental cash flows are
comparatively stable. For firms with diversified
mixed-asset portfolios of international
assets, it may be more efficient to
manage currency risk at the overall portfolio
level. However, performance measurement
of individual assets and asset classes should
strictly reflect their contribution to the costs
of currency management. There is little evidence
that this takes place in practice and
this is another area that is open for further
research.
Conclusions and Implications for Further
Research
Over the past 20 years, a significant amount
of research focusing on direct international
real estate as an alternative asset has been
completed. As the availability and quality of
data have increased over time, studies have
expanded to include more sophisticated
analysis but there are still many questions
that have been left for future research. In the
early studies, researchers studied the individual
real estate markets using relatively crude
proxies for real estate including rental rate
growth. Later studies combined real estate
assets into a mixed-asset portfolio with international
stocks and bonds also included in
the opportunity set. For the most part, results
concluded that international real estate did
provide diversification benefits and investors
should not ignore this asset class when making
asset allocation decisions. The one major
exception to these results are the findings by
Ziobrowski ​et al. ​published in several papers
throughout the 1990s. However, as detailed
earlier in this paper, questionable data
sources as well as the annual repatriation of
funds adjusted for the same exchange rate
fluctuations as the alternative asset classes,
worked to keep international real estate out
of the efficient portfolios.
Over the years, additional analysis has
been completed and studies show that there
is a common continental factor and regional
factors that should be considered in the overall
investment strategy. These studies conclude
that investment decisions should not be
made solely on a geographical basis. Other
studies focused on comparing the direct real
estate asset class with other investments, primarily
the stock markets in the various countries.
Again, the majority of the studies
conclude that diversification benefits are
likely as the markets are not perfectly correlated,
but the degree of similarity varies depending
on the countries analysed. For most
of these studies, the data series are short. As
time passes and data become more available,
future researchers will be able to provide
better insights into the true performance
characteristics of the real estate asset class.
In addition, many researchers question the
use of ​ex post ​data to ascertain the inputs for
the mean–variance portfolio analysis. The
majority of research summarised in this paper
uses historical data and mean–variance
portfolios to analyse the benefits of international
real estate. Modern portfolio theory,
however, suggests the ​expected ​performance,
so the reliability of the results from the studies
summarised in this paper is questionable.
Currency risk has been shown to be an
important consideration for the international
investor. This area of research is still in its
infancy. A limited number of studies highlight
this risk and examine ways to try to
mitigate it but the area remains relatively
unchartered, particularly for an investor
holding a mixed-asset portfolio with both
short-term (stock) and long-term (real estate)
assets that are subject to exchange rate
fluctuations. Several authors suggest a currency
overlay management strategy for the
portfolio, but at this point no research explores
what the strategy might actually entail.
There are a significant number of other
issues that have not been included in the
portfolio diversification studies but are areas
for future research so that we can better
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1100 ​C​. ​F​. ​SIRMANS AND ELAINE WORZALA


understand the international real estate investment.
The treatment of accounting, tax
and legal implications from owning real estate
on an international basis has not yet been
explored by any of the researchers. Institutional
differences between countries are obvious,
but no one has explored how one
might measure and account for their impact
on returns. Finally, there is some early research
that markets are converging but it is
difficult to test, as the time-series of data for
most real estate markets is too short. All of
these areas are fertile ground for further
research.

Credit Booms and Lending Standards:


Evidence from the Subprime Mortgage
Market
Giovanni Dell’Ariccia, Deniz Igan,
and Luc Laeven

This paper links the current sub-prime mortgage crisis to a decline in lending standards
associated with the rapid expansion of this market. We show that lending standards declined
more in areas that experienced larger credit booms and house price increases. We also find
that the underlying market structure mattered, with entry of new, large lenders triggering
declines in lending standards by incumbent banks. Finally, lending standards declined more
in areas with higher mortgage securitization rates. The results are consistent with theoretical
predictions from recent financial accelerator models based on asymmetric information, and
shed light on the relationship between credit booms and financial instability.

Recent events in the market for mortgage-backed securities have placed the U.S. subprime
mortgage industry in the spotlight. Over the last decade, this market has expanded rapidly,
evolving from a small niche segment to a major portion of the U.S. mortgage market.
Anecdotal evidence suggests that this trend was accompanied by a decline in credit standards
and excessive risk taking by lenders, and possibly by outright fraud. Indeed, the rapid
expansion of subprime lending, fueled by financial innovation, loose monetary conditions,
and increased competition, is seen by many as a credit boom gone bad. Yet, few attempts
have been made to link empirically lending standards and delinquency rates in the subprime
mortgage market to its rapid expansion. To our knowledge, our paper is the first to do so.
How does the recent increase in delinquency rates relate to the boom? How did lending
standards change over the expansion? How did changes in local market structure and
financial innovation affect lender behavior during the boom? What was the role of monetary
policy? To answer these questions, we use data from over 50 million individual loan
applications combined with information on local and national economic variables.
Reminiscent of the pattern linking credit booms with banking crises, current mortgage
delinquencies appear related to past credit growth. In particular, delinquency rates rose more
sharply in areas that experienced larger increases in the number and volume of originated
loans (Figure 1). We find evidence that this relationship is linked to a decrease in lending
standards, as measured by a decline in loan denial rates and a significant increase in loan-toincome
ratios, not explained by an improvement in the underlying economic fundamentals.
Consistent with recent theories suggesting that banks behave more aggressively during
booms than in tranquil times, the size of the boom mattered. Denial rates declined more and
loan-to-income ratios rose more where the number of loan applications rose faster.
The subprime boom also shared other characteristics often associated with aggregate boombust
credit cycles, such as financial innovation (in the form of securitization), changes in
market structure, fast rising house prices, and ample aggregate liquidity. We find evidence
that all these factors were associated with the decline in lending standards. Denial rates
declined more in areas with a larger number of competitors and were further affected by the
entry into local markets of large financial institutions. The increasing recourse to loan sales
and asset securitization appears to have affected lender behavior, with lending standards
deteriorating more in areas where lenders sold a larger proportion of originated loans.
Lending standards also declined more in areas with more pronounced housing booms.
Finally, easy monetary conditions also played an amplifying role. These effects were more
pronounced in the subprime mortgage market than in the prime mortgage market, where loan
denial decisions were more closely related to economic fundamentals.
We obtain this evidence in an empirical model where, in addition to taking into account
changes in macroeconomic fundamentals, we control for changes in the distribution of
4
applicant borrowers and for the potential endogeneity of some of the explanatory variables.
Specifically, we develop a two-stage regression framework, explained in detail later on, that
exploits individual loan application data to control for changes in the quality of the pool of
loan applicants. We focus on loan applications rather than originations to reduce further the
concern for simultaneity biases. For further robustness, we run an instrumental variable
specification of our model, where we instrument the subprime applications variable with the
number of applications in the prime market.
The contribution of this paper is twofold. First, the paper sheds some light on the origins of
the current crisis by establishing a link between credit expansion and lending standards in the
subprime mortgage market, and by identifying increased loan sales and changes in the
structure of local credit markets as factors amplifying the decline in denial rates and the
increase in loan-to-income ratios.
Second, the boom-bust cycle of the subprime mortgage industry, beyond being of interest in
itself, provides an excellent “lab case” to gain insights into the black box of credit booms in
less developed credit markets. Subprime borrowers are generally riskier, more
heterogeneous, can post less collateral, and have shorter or worse credit histories (if any) than
their prime counterparts. These are all features often prevalent in developing countries. At
the same time, the wealth of information available and the geographical variation (Figure 2)
in this market allow us to control for several factors, such as changes in the pool of loan
applicants, that are difficult to take into account when studying episodes of aggregate credit
growth. Thus, the subprime mortgage market provides an almost ideal testing ground for
theories of intermediation based on asymmetric information (and adverse selection in
particular).
From a policy point of view, the evidence in this paper alerts against the dangers arising from
lax standards during credit booms, and it is relevant for the debate on cyclical management of
prudential regulation and on the potential effects of monetary policy on banks’ risk-taking
(Jimenez et al., 2007). To the extent that during booms standards decline more than justified
by economic fundamentals, our findings are consistent with the view that bankers have “an
unfortunate tendency” to lend too aggressively at the peak of a cycle and that most bad loans
results from this aggressive type of lending. That said, credit booms may still be beneficial.
While, in light of the recent financial turmoil, it is easy to argue that standards were
excessively lax, it is much harder to compute the benefits associated with greater access to
credit and, hence, the net welfare effect of the subprime expansion.
The rest of the paper is organized as follows. Section II reviews the related literature. Section
III provides a description of the data and introduces some stylized facts. Section IV describes
our empirical methodology. Section V presents the results. Section VI concludes.
5
II. R​ELATED ​LI​ TERATURE
Several studies examine the interaction between economic fluctuations and changes in bank
credit (Bernanke and Lown, 1991, Peek and Rosengren, 2000, Black and Strahan, 2002, and
Calomiris and Mason, 2003). However, little evidence has been collected on how lending
standards are related to credit booms. Asea and Blomberg (1998) find that loan
collateralization increases during contractions and decreases during expansions, while Lown
and Morgan (2003) show that lending standards are associated with innovations in credit.
Jimenez, Salas, and Saurina (2006) find that during booms riskier borrowers obtain credit
and collateral requirements decrease.
A few papers have examined the recent boom from a house-price perspective, while not
strictly focusing on the subprime market (Himmelberg et al., 2005, and Case and Shiller,
2003). The literature on subprime mortgages has instead largely focused on issues of credit
access and discrimination and on what determines access to subprime versus prime lenders.
Our loan level analysis builds on a model from Munnell et al. (1996) who show that race has
played an important, although diminishing, role in the decision to grant a mortgage. A few
papers examine how local risk factors affect the fraction of the market that uses subprime
lending (Pennington-Cross, 2002). Other studies focus on how borrowers choose a mortgage
and on their decision to prepay or default on a loan (Deng et al., 2000, Campbell and Cocco,
2003, and Cutts and Van Order, 2005).
A few recent papers focus on how securitization affects the supply of loans (Loutskina and
Strahan, 2007) and mortgage delinquencies. Demyanyk and Van Hemert (2007) find that
delinquency and foreclosure rates of subprime borrowers are to a large extent determined by
high loan-to-value ratios. Mian and Sufi (2007) link the increase in delinquency rates to a
disintermediation-driven increase in loan originations, while Keys et al. (2007) find that
loans that are easier to securitize default more frequently.
Most theoretical explanations for variations in credit standards rely on financial accelerators
based on the interaction of asymmetric information and business cycle factors (Bernanke and
Gertler,1989, Kiyotaki and Moore, 1997, and Matsuyama, 2007; see Ruckes, 2004, for a
review of this literature). Others focus on the potential for herding behavior by bank
managers (Rajan, 1994), on banks’ limited capacity in screening applications (Berger and
Udell, 2004), or on how strategic interaction among asymmetrically informed banks may
lead to changes in lending standards during booms (Gorton and He, 2003, and Dell’Ariccia
and Marquez, 2006).
III. D​ATA AND ​DE ​ SCRIPTIVE ​ST​ ATISTICS
We combine data from several sources. Our main set of data consists of economic and
demographic information on applications for mortgage loans. We use additional information
on local and national economic environment and on home equity loan market conditions to
construct our final data set.
6
The individual loan application data come from the Home Mortgage Disclosure Act
(HMDA) Loan Application Registry. Relative to other sources, including LoanPerformance
and the Federal Reserve Bank’s Senior Loan Officer Opinion Survey, this dataset has the
important advantage of covering extensive time-series data on both the prime and subprime
mortgage markets. The availability of data on the prime mortgage market provides us with a
control group generally unavailable to studies focusing on aggregate credit. By comparing
prime and subprime mortgage lenders we are also able to identify differences between the
two lending markets. Given the different risk profiles of the prime and subprime markets, we
include variables that proxy for the risk characteristics of a loan application to enhance
comparability of the results across the two markets.
Enacted by Congress in 1975, HMDA requires most mortgage lenders located in
metropolitan areas to collect data about their housing-related lending activity and make the
data publicly available. Whether a lender is covered depends on its size, the extent of its
activity in a metropolitan statistical area (MSA), and the weight of residential mortgage
lending in its portfolio. Comparisons of the total amount of loan originations in the HMDA
and industry sources indicate that around 90 percent of the mortgage lending activity is
covered by the loan application registry (Table 1).
Our coverage of HMDA data starts from 2000 and ends in 2006. This roughly corresponds to
the picking up of both the housing boom and the rapid subprime mortgage market expansion
(Figure 3). HMDA data does not include a field that identifies whether an individual loan
application is a subprime loan application. In order to distinguish between the subprime and
prime loans, we use the subprime lenders list as compiled by the U.S. Department of Housing
and Urban Development (HUD) each year. HUD has annually identified a list of lenders who
specialize in either subprime or manufactured home lending since 1993. HUD uses a number
of HMDA indicators, such as origination rates, share of refinance loans, and proportion of
loans sold to government-sponsored housing enterprises, to identify potential subprime
lenders.
Since 2004, lenders are required to identify loans for manufactured housing and loans in
which the annual percentage rate (APR) on the loan exceeds the rate on the Treasury security
of comparable maturity by at least three (five, for second-lien loans) percentage points and
report this information to the HMDA. The rate spread can be used as an alternative indicator
(to the HUD list) to classify subprime loans. For the years with available data, the ranking of
subprime lenders using the rate spread variable alone coincides closely with the ranking in
the HUD list. The HUD list of subprime lenders is also preferable to the rate spread
information for a number of reasons. First, rate spreads are not available prior to 2004.
Second, subprime loans do not necessarily have APRs that are three (or five) percentage
points above a comparable Treasury rate but may reflect fees and yield spread premiums or
other borrower characteristics determined by the lender. Third, and most importantly, the rate
spread in HMDA is available only for originated loans, making it impossible to calculate
denial rates for prime and subprime applications separately.
7
We remove some observations with missing HMDA data from the sample and also focus on
the subset of loans that are either approved or denied. First, we drop applications with loan
amounts smaller than $1,000 because loan values are expressed in units of thousands of
dollars and rounded up to the nearest number. Second, applicant income is left-censored at a
value of $10,000. We therefore eliminate applicants with missing applicant income or
applicant income of exactly $10,000. Third, we drop loans for multi-family purpose from the
sample, as this is a distinct market from the overall mortgage market for single family homes.
Fourth, we drop federally insured loans and refinancing loans as their risk profile is likely to
differ from that of other loans. Finally, and importantly, we eliminate all application records
that did not end in one of the following three actions: (i) loan originated, (ii) application
approved but loan not originated, or (iii) application denied. Other actions represent dubious
statuses (e.g. application withdrawn by applicant) or loans purchased by other financial
institutions. Including purchased loans would amount to double-counting as these loans are
reported both by the originating institution and the purchasing institution.
We supplement the HMDA information with MSA-level data on economic and social
indicators published by federal agencies, including annual data on macroeconomic variables,
such as personal income, labor and capital remuneration, self-employment, and population
from the Bureau of Economic Analysis (BEA), data on unemployment and inflation
(consumer price index) from the Bureau of Labor Statistics (BLS), data on total population
from the Census Bureau, and data on house price appreciation in a given MSA (based on a
quarterly housing price index) from the Office of Federal Housing Enterprise Oversight
(OFHEO). We also obtain data on “seriously delinquent” subprime loans, defined as
subprime loans with 60 or more days delay in payment, from LoanPerformance, a private
data company. Data on these delinquency rates are available only for 2004 onwards.
Over the last decade, subprime mortgage lending has expanded rapidly both in terms of the
number of loans originated and the average loan amount. Subprime mortgage originations
almost tripled since 2000, reaching $600 billion in 2006. Against an also fast growing market
for prime mortgages, this boom brought the share of subprime lending from 9 percent in
2000 to 20 percent of all mortgage originations in 2006. Average loan amount also grew
reaching $132,784 in 2006 or 90 percent of the prime mortgage average amount. In absolute
terms, the subprime market reached a size of about $1.3 trillion in 2006.
A first look at our data suggests that rapid growth in subprime loan volume was associated
with a decrease in denial rates on subprime loan applications and an increase in the loan-toincome
ratio on the loans originated by subprime lenders (Figure 4). These casual
observations lend some support to the view that lending decisions are influenced by market
conditions and rapid credit growth episodes tend to beget trouble later on. In the next
sections, we explore these relations in a more formal setting.
Table 2 presents the name and definitions of the variables we use and the data sources. Table
3 presents the sample period summary statistics of these variables at the loan application and
8
MSA levels. The data cover a total of 387 MSAs for a period of 7 years (2000 to 2006),
amounting to a total of 2,709 observations. For the entrant and incumbent variables,
summary statistics are based on data for the period 2001 onwards only, as entry data is
missing for the first year of the sample period. The summary statistics show that about one in
five loan applications is denied, while about one-fourth of all loans are extended by subprime
lenders. As expected, the denial rate of subprime lenders is much higher (about 2.5 times)
than the denial rate of prime lenders.
IV. E​MPIRICAL ​ME ​ THODOLOGY
We rely on two main indicators of lending standards: the application denial rate and the loan
to income ratio. We focus primarily on regressions at the MSA level. We control for changes
in the economic environment in the MSA by including variables that have been shown to be
good predictors of loan denial decisions at the individual level (see Munnell et al., 1996),
such as average income, income growth, the unemployment rate, and the self-employment
rate. We include a measure of house price appreciation to take into account the role of
collateral. The number of competing lenders is a proxy for the competitive conditions in the
MSA. Finally, we include the number of loan applications as a measure of credit expansion.
We find this variable preferable to the number of loans originated or the growth in credit
volume as it is arguably less endogenous to the dependent variable (i.e., denial rates).
Endogeneity may remain a concern to the extent that potential borrowers might be deterred
from applying for a loan if denial rates are generally high in their area. For this reason, we
also estimate an instrumental variable specification of the model (details later in the paper).
In addition, we control for time-invariant MSA specific factors and for time-variant
nationwide-uniform factors by including MSA and time fixed effects.
We estimate the following linear regression model:
DRi​ t ​= αt​ ​+ ​γ
i​+ β1​ ​AVGINCi​ t ​+ β2​ ​INCGROWi​ t ​+ β3​ ​UNEMPi​ t ​+ β4​ ​SELFEMPi​ t ​+ β5​ ​POPi​ t​+
β6​ ​COMPi​ t ​+ β7​ ​HPAPPi​ t-1 ​+ β8​ ​APPLi​ t ​+ εi​ t​,
(Eq. 1)
where ​DRi​ t ​is the average denial rate of mortgage loan applications for home purchase and
refinance purposes in MSA ​i ​in year ​t​. It is computed as the number of loan applications
denied divided by the total number of all loan applications in a given MSA using loan-level
data at individual banks, and hence, takes on values between 0 and 1.​2 ​All explanatory
variables are also measured at the MSA level. ​AVGINC ​denotes average income, ​INCGROW
is income growth, ​UNEMP ​is unemployment rate, ​SELFEMP ​is self-employment rate, ​POP
is the log of total population, ​COMP ​is the number of competing lending institutions, ​HPAPP
2 ​Weestimate regression equation 1 using ordinary least squares as well as using truncated regression methods.
The results remain the same.
9
is the annual change in house price appreciation, and ​APPL ​is the log of the number of loan
applications. The error term ​εi​ t ​has the standard properties. MSA and time fixed effects
control for time-constant regional idiosyncrasies and nationwide changes in economic
conditions. The first five variables are meant to control for the general economic and
demographic conditions in the MSA. We expect areas with higher per capita income and
income growth to have lower denial rates; areas with higher unemployment rates and larger
proportions of self-employed people (whose income may be considered less stable) to have
higher denial rates; and areas with larger populations, proxying for market size, to have lower
denial rates.
The number of competing lenders in the MSA is meant to capture the effects of competition
on lending standards. Since theory does not deliver unambiguous predictions, we do not have
a strong prior on the sign of this coefficient.​3 ​The house price appreciation variable is
computed over the same period as the denial rates, although the results are not sensitive to
using one-period lagged changes in house price appreciation. We expect this variable to have
a negative coefficient. Price increases raise the net worth of borrowers, reducing their default
risk. At the same time, lenders may gamble on a continued housing boom to evergreen
potentially defaulting borrowers. Finally, our working assumption is that if banks did not
change their lending standards during the boom, the variable measuring credit expansion
should not be statistically significant after controlling for the other factors affecting the
banks’ decision. If instead banks lent more leniently in regions and times of fast credit
expansion, we should find a negative and significant coefficient for this variable. In that case,
we would have established a link between credit expansion and loan quality that, in turn,
would explain why we now observe higher delinquency rates in regions that experienced
greater booms.
Theoretical models focusing on adverse selection (such as Broecker, 1990, and Riordan,
1993) predict that an increase in the number of competing lenders in a market may have the
perverse effect of increasing lending interest rates and make banks more choosy (tighten
standards). However, it has also been argued that, when local borrowers have an
informational advantage, the threat of new entry may induce incumbents to cut standards and
trade loan quality for market shares. We test for these effects by focusing on the behavior of
incumbent lenders when large nationwide institutions entered local markets. To that purpose
we augment the model in equation (1) with a variable measuring the market share of new
entrants that belong to the top 20 lending institutions in the country. We compute the market
share in terms of number of loan applications, not originations, to limit concerns about
endogeneity. We expect the coefficient on the entrants variable to be negative since we
already control for the adverse selection effect considered by Broecker (1990), among others,
with the number of competing lenders in the region.
3 ​See Dell’Ariccia and Marquez (2006) for a discussion of this issue.
10
For robustness purposes, we construct an alternative denial rate-based measure of lending
standards. We borrow and augment the empirical model presented in Munnell et al. (1996) to
estimate bank’s loan approval decision with individual application data, though we do not
have all variables they consider. Specifically, we do not have data on borrower credit scores.
We augment their specification by including several new variables, including whether or not
the loan is being used for refinancing purposes and whether or not the household income of
the loan applicant is below the poverty line (as applicable in the year of loan application). We
expect the latter to be particularly important in the case of subprime loans because applicants
for subprime loans tend to have low income. We estimate the following logit specification at
the loan application level for the year 2000:
D​jk ​= ​α​k ​+ γ​1​INC​j ​+ γ​2​LIR​j ​+ γ​3​POV​j ​+ γ​4​REFIN​j ​+ γ​5​OCC​j ​+ γ​6​F​j ​+ γ ​7​B​j ​+ γβ​8​W​j ​+ ε​jk​,
(Eq. 2)
where ​j ​denotes loan application ​j​, ​k ​denotes lender ​k​, ​α
k ​denotes lender-specific fixed
effects, and ​Dj​ k ​is a dummy variable that takes a value of one if lender ​k ​denied loan
application ​j ​in year 2000, and zero otherwise. All explanatory variables are measured at the
loan application level. ​INC ​is applicant income, ​LIR ​is the loan-to-income ratio, ​POV ​is a
dummy variable denoting whether or not the applicant income is below the poverty line for a
family of four, ​REFIN ​is a dummy variable denoting whether or not the purpose of the loan is
to refinance an existing loan, ​OCC ​is a dummy variable denoting whether or not the property
financed by the loan is intended for owner occupancy, ​F ​is a dummy variable indicating
whether or not the applicant is female, ​B ​is a dummy variable indicating whether or not the
applicant is black, and ​W ​is a dummy variable indicating whether or not the applicant is
white (the default option being of Hispanic origin).
Next, we use the estimate coefficients of Regression (2) to forecast the denial rate for
mortgage applications in subsequent years, and aggregate the residuals of this regression at
the MSA level. Finally, we use this constructed measure of prediction errors as the dependent
variable for our main model. The advantage of this two-stage regression approach over using
simple, unadjusted denial rates is that it takes into account changes in the pool of applicant
borrowers that are difficult to control for at the MSA level.
As an alternative measure of lending standards, we consider the average loan-to-income ratio
in the MSA. Other things equal, an increase in this ratio would signal a looser attitude in
banks’ decisions to grant loans. We estimate the following regression model:
LIRi​ t ​= αt​ ​+ ​γi​ ​+ β1​ ​AVGINCi​ t ​+ β2​ ​INCGROWi​ t ​+ β3​ ​UNEMPi​ t ​+ β4​ ​SELFEMPi​ t ​+ β5​ ​POPi​ t​+
β6​ ​COMPi​ t ​+ β7​ ​HPAPPi​ t-1 ​+ β8​ ​APPLi​ t ​+εi​ t​,
(Eq. 3)
where the set of explanatory variables is the same as in regression model 1.
11
Our final set of regressions are aimed at measuring the effect of securitization on bank
lending decisions. The specifications presented above are augmented with a variable
measuring the percentage of loans in an MSA that are sold within a year from origination.
According to the view that securitization causes moral hazard in loan originators, we should
find that lending standards are looser (lower denial rates and higher loan-to-income ratios) in
MSAs with higher securitization rates.
V. E​MPIRICAL ​FI​ NDINGS
We find robust evidence that lending standards eased in the subprime mortgage industry
during the fast expansion of the past few years. After controlling for economic fundamentals,
lenders appear to have denied fewer loan applications and to have approved larger loans.
Results for the denial rate regression, controlling for MSA fixed effects, are in Table 4.
Column (1) reports results for all lenders, while columns (2) and (3) report results separately
for either only prime lenders or subprime lenders (where subprime lenders are defined
according to the annual list compiled by the HUD). This sample breakdown between prime
and subprime lenders allows us to identify different characteristics of the two lending
markets, including differences in the evolution of lending standards. Most coefficients have
the expected sign. Starting from our main variables of interest, a faster rate of house price
appreciation was associated with lower denial rates. This, as discussed before, is consistent
with the notion that lenders were to some extent gambling on speculative borrowers, but may
also reflect the positive effect of higher borrower net worth on creditworthiness. Notably, this
effect was much more pronounced in the subprime relative to the prime mortgage market
where both these factors are likely to be more relevant. Denial rates in both markets are also
lower in MSAs where applicants tend to have higher income. In the subprime mortgage
market, denial rates were lower in more competitive markets as measured by the number of
competitors in the MSA. This coefficient was, instead, not statistically significant for the
prime market. In the subprime mortgage market, the denial rate was also negatively and
significantly associated with the number of loan applications in the MSA. Given that we are
including MSA fixed effects and thus effectively estimating regressions in first differences,
this result suggests that the lending boom (as captured by changes in the number of
applications) was associated with a reduction in lending standards (as captured by changes in
denial rates). In the prime market, however, denial rates are positively and significantly
associated with the number of applications, consistent with the notion that the lending
standards in the prime market were tightened as applications grew. This suggests different
credit boom dynamics in these two markets. In the subprime market, the decline in standards
associated with the rise in the number of applications is consistent with theories of
intermediation where asymmetric information among lenders plays an important role. In the
prime market, the publicly available credit history of borrowers makes these frictions less
likely to be relevant, and the tightening of standards in reaction to a growing number of
applications may reflect an expected deterioration in the quality of the pool of applicants.
Indeed, the coefficient for the prime market loses significance when we control for changes
12
in the characteristics of the applicant pool (see below). The rest of the control variables have
the expected sign, but are generally not significant.
The finding that denial rates are negatively associated with the number of competitors only in
the subprime, and not in the prime mortgage market, also suggests that the decrease in
lending standards was associated with different forces in the prime and subprime mortgage
markets. In the subprime market, the evidence is consistent with a decline in standards linked
to lenders’ strategic interaction under asymmetric information and speculative behavior. In
contrast, for the prime market, it is more difficult to reject the hypothesis of a fundamentaldriven
decline in lending standards. This is consistent with our prior that, relative to
fundamentals, the deterioration in lending standards was more pronounced in the subprime
mortgage market where the class of borrowers tends to be riskier than in the prime market.
A comparison of year effects across the different specifications shows that denial rates
decreased until the end of 2003 and then increased from 2004 onwards, though only in the
prime mortgage market. In the subprime mortgage market, after controlling for other factors,
denial rates did not vary much over the period 2002 to 2006. Following several years of low
interest rates, the U.S. started tightening monetary policy in mid-2004 by increasing interest
rates. While denial rates in the prime mortgage market closely mimic the evolution of interest
rates in the U.S., with denial rates increasing sharply in 2005 compared to 2004, this is not
the case for the subprime market, where denial rates do not increase in 2005 compared to
2004 (although they do increase somewhat in 2006). This suggests that, while in the prime
market monetary policy changes reflected quickly in the denial rate likely through their effect
on loan affordability,​4 ​this did not happen for subprime mortgages. Indeed, a regression
specification replacing the year fixed effects with the Federal Fund rate returned a positive
coefficient for the prime market, but not for the subprime (not reported).​5
The economic effect of our main findings is substantial. From regression (3) in Table 4, it
follows that changes in the number of loan applications (a proxy for credit expansion) have a
particularly strong effect on denial rates in the subprime market. For example, a one standard
deviation increase in the log of the number of applications reduces MSA-level denial rates of
subprime lenders by 4 percentage points, which is substantial compared to a standard
deviation of subprime denial rates of 8 percentage points. The effect of applications on denial
4 ​This is also consistent with the idea of a negative relationship between bank risk-taking and the monetary
policy rate. This hypothesis is explored at length, though in a different context, in Jimenez et al. (2007).
5 ​One explanation for this result relies on the fact that prime mortgages are mostly fixed-rate and are by
definition underwritten for the fully-indexed cost while subprime mortgages are mostly adjustable-rate loans
with low teaser rates. It is possible that lending standards in the subprime market were already flawed in the
sense that the denial decision was based on initial debt-to-income ratios calculated using the teaser rate instead
of considering payment shocks that would occur with the reset of the loan rate. In that case, denial rates would
not respond to higher short-term interest rates, concealing the potential impact of monetary policy on lending
standards.
13
rates is significantly more negative in the subprime market than in the prime market. In fact,
the effect is positive and significant in the prime market. A one standard deviation increase in
the number of competitors reduces MSA-level subprime denial rates by 3 percentage points,
slightly smaller than the effect of applications though still substantial. For the prime market,
we obtain no significant relationship between denial rates and the number of competitors.
Finally, a comparison of coefficients across regressions (2) and (3) shows that a one standard
deviation increase in house price appreciation reduces MSA-level denial rates by 2
percentage points in the subprime market compared to only 1 percentage point in the prime
market (compared to a standard deviation of denial rates of about 7 percent in both markets).
A. Effects of Changes in the Pool of Applicant Borrowers
Changes in the pool of applicant borrowers not captured by aggregate controls could partly
explain our findings on the association between the number of applications and denial rates.
The results, however, are broadly the same when, following the two-step approach described
above, we control for changes in the underlying borrower population using data on individual
borrower characteristics.
To this end, we first identify in Table 5 which characteristics are likely to explain the
decision on a loan application. We follow earlier studies on mortgage lending to form a list
of variables that would account for the economic factors that might shape the financial
institution’s decision.​6 ​These regressions are based on a sample of close to 5 million loan
applications in 2000, and include lender-specific fixed effects. The regression coefficients
presented in Table 5 are odds ratios. We find that loan applications are more likely denied if
borrowers have low income, though this effect is only significant in the prime mortgage
market. Applications with higher loan-to-income ratios, denoting riskier loans, are more
likely denied in the subprime mortgage market, as expected, though we find the opposite
effect in the prime mortgage market. Taken together, these results indicate that applicant
income affects lending decisions in a nonlinear fashion, and differently in prime and
subprime markets. This is in part because applicants with higher incomes, who primarily
apply for prime loans, also tend to apply for larger loans. Loan applications are also more
likely denied for male applicants in the subprime market and for female applicants in the
prime market, while applications of African-American descent are more likely denied in both
markets (as compared to white applicants or applicants of Hispanic descent). White
applicants also appear to be less likely denied a mortgage in the prime market. Finally, loan
applications for refinancing purposes are more likely denied, while owner occupation does
not significantly affect the loan denial decision.
Next, we estimate the regression model with the MSA-level aggregated prediction errors
from the model estimated in Table 5 as dependent variable. The results of these regressions
6 ​See Munnell et al. (1996) and references therein.
14
(all of which include MSA fixed effects) are reported in Table 6. These results, where we
abstract from certain borrower characteristics that determine a lender’s decision on a loan
application, are broadly consistent with the findings in Table 4. Again, we find that denial
rates in both prime and subprime markets tend to deteriorate more in areas with a stronger
acceleration in house price appreciation. Subprime denial rates also respond negatively to an
increase in competition, as measured by an increase in the log of the number of competitors,
and to an increase in the number of loan applications, capturing the expansion of the credit
market.
B. Identification and Robustness Issues
One should be careful in interpreting the estimated coefficients as causal relationships. As
proxy for credit market expansion, the loan application series has arguably a smaller
endogenous component than the loan originations series. That said, at least in theory, there
remains some potential for reverse causality to the extent that potential borrowers may be
deterred from applying for a loan if denial rates are generally high in their locale. While our
focus on total applications (rather than applications in the subprime market only) partly
assuages the potential for an endogeneity bias, for further robustness we estimate an
instrumental variable (IV) specification of our model. In this particular specification, we use
the log of applications in the subprime market as our main regressor, but we instrument it
with the log of the number of prime applications. These two series are highly correlated (the
correlation coefficient is over 0.8), while, at least in theory, there should not be a direct
negative link between the denial rate in the subprime market and the number of applications
in the prime market. If anything, this relationship should be positive, as higher denial rates in
the subprime market would make the prime market more attractive. Indeed, the correlation
between the denial rates in the subprime and prime markets in our sample is only about 0.1,
suggesting that denial rates in both markets are largely independent from one another. For
comparison purposes, we also include the OLS regression of the specification that includes
the number of applications in the subprime market. These OLS and IV results are presented
in columns (1) and (2) of Table 7. The IV estimates broadly confirm our earlier results,
suggesting that our findings are not the product of an endogeneity bias. The F-test of
excluded instruments supports the choice of our instrument. The evidence supports the notion
of a negative causal link between an increase in the number of applications and denial rates
in the subprime market. For robustness, we also estimate our model using the number of
originated loans and the total loan volume as alternative measures of market expansion,
obtaining similar results (Table 7, columns 3 and 4).
Similarly, house price changes may be affected by lending standards to the extent that a
decline in standards and an increase in the local supply of mortgages leads to an increase in
demand for housing. To address this concern, we consider a specification where we lag the
house price variable one period. The results, presented in column (5) of Table 7, confirm our
earlier findings that denial rates are negatively affected by (lagged) house price appreciation.
Admittedly, some concern about endogeneity between denial rates and house price
15
appreciation remains since, while lagged house price changes are not directly affected by
lending standards, it is conceivable that the expectation of a decline in standards, and hence,
of an increase in the supply of mortgage liquidity may trigger speculative pressures on the
housing market. Crowe (2008) finds that in MSAs with a larger portion of the population
belonging to Evangelical churches house prices tend to rise disproportionately when the
“Rapture Index” rises.​7 ​This index maps current events into a subjective probability of an
imminent coming of a time of “extreme and terrible” events and as such is independent from
denial rates at the MSA level. We can then use the interaction term of the share of
Evangelicals in the MSA population and change in the Rapture index as an instrument for
house price appreciation. The results of this exercise are reported in column (6) of Table 7
and confirm our original estimates.
C. Sensitivity Analysis: Time and Size Effects
So far we have imposed the coefficient linking lending standards to market expansion to be
invariant across time and markets of different sizes. Yet, anecdotal evidence suggests that the
relaxation of standards associated with housing boom frenzy was more prevalent in large
metropolitan areas and that abundant liquidity due to loose monetary condition was at least in
part to be blamed. In this section, we attempt to formally test those assumptions by explicitly
allowing the “credit boom” coefficient to vary over time, with changes in monetary policy,
and across markets of different sizes.
First, we consider how this relationship has evolved over our sample period by
interacting the log number of applications with a simple linear trend (Table 8, column 1). The
negative and significant sign of the coefficient of this interacted term suggests that the link
between boom and standards become increasingly stronger over the sample period.
We test for the role of monetary policy by interacting the log number of applications with the
Federal Fund rate. The positive and significant coefficient of this interacted term suggests
that the effect of credit expansion on lending standards is indeed stronger when monetary
policy is loose (Table 8, column 2). Notably, this effect survives when we control for a time
trend (column 3).
Next, we confirm that the relationship between booms and standards was stronger in
relatively larger markets in a specification interacting our boom variable with the log of the
MSA population (Table 8, column 4). While the linear coefficient for the boom variable is
positive and significant, the overall relationship is negative for essentially all markets and
becomes significant for markets above the 25th percentile of the population distribution.
7 ​The Rapture Index is available at ​http://www.raptureready.com/rap2.html
16
The relationship between lending standards and credit expansion also appears to depend on
the size of the boom itself. Table 9 shows that the coefficient of log number of applications is
larger and more significant when our baseline specification is estimated on subsamples of
MSAs with the number of application above the median and the growth rate of applications
above the median.
D. Effects of Entry and Changes in Market Structure
We further refine our analysis by assessing the impact on denial rates of credit expansion by
new entrants (rather than incumbent institutions). In Table 10 we report the results of our
analysis of the effects of entry by new players on incumbent lending standards. Consistent
with asymmetric information theories of competition in credit markets implying that an
increase in the number of competing institutions increases adverse selection (Broeker, 1990,
and Riordan, 1993), we find that an increase in the number of entrants (i.e., competing
institutions) increases the denial rates of incumbent institutions in the overall mortgage
market (column 1). In this regression, we use the market share of entrants, computed as the
sum of each entrant’s share in total loan applications, rather than the simple number of
entrants, to control for the size of each entrant and capture overall market power of entrants.
The evolution of denial rates in the subprime mortgage market, however, supports the notion
of incumbents cutting their lending standards in reaction to the entry of new (and large)
competitors (column 3). As the industry expanded and more subprime lenders entered
specific metropolitan areas, denial rates by incumbent lenders went down. We take this as
direct evidence of a reduction in lending standards in this market. We find a similar, though
much less pronounced, effect in the prime market (column 2).
Denial rates of incumbent institutions are unlikely to affect the entry of new lenders to the
extent that they reflect underlying applicant fundamentals. Then, by focusing on the effect of
new entrants on the denial rates of incumbent lenders we are able to assess the independent
effect of market entry (and expansion) on incumbent lending standards. That said, high
denial rates could conceivably attract entry if they reflect collusion among incumbent lenders
rather than the underlying fundamentals in the MSA. However, a close-to-zero correlation
between the incumbent denial rate level (lagged) and our entry variable suggests that this is
unlikely to be the case. The evidence in this section suggests that, as for small business
lending (see Petersen and Rajan, 2002), information technology may have reduced but has
not eliminated the importance of geography in the mortgage market
E. Alternative Proxies for Lending Standards
We now turn to the loan-to-income (LTI) ratio regressions (Table 11). As mentioned earlier,
LTI ratios can be regarded as an alternative proxy for lending standards. We find that higher
average LTI ratios are associated with lower unemployment rates and are more common in
high income areas and where there is a larger percentage of the population that is self
employed. Turning to our variables of interest, the results indicate that LTI ratios grow with
the number of loan applications, particularly in the subprime market, confirming the notion
17
of a boom effect on lending standards. The effect of competition is also confirmed with
higher LTI ratios in MSAs with larger number of competing lenders. The house price
appreciation variable enters only significantly in the subprime market regression, suggesting
that LTI ratios in the prime market are not much affected by house price appreciation. In the
subprime market, LTI ratios are strongly positively associated with house price appreciation.
F. Effects of Loan Sales
The increased ability of financial institutions to securitize mortgages over the past decade
may have contributed to both the expansion of the mortgage market and the documented
decline in lending standards. In Table 12, columns 1 to 3, we explore how the increasing
recourse to securitization of mortgages has affected denial rates in the prime and subprime
mortgage industry. For each originated loan in the HMDA database, the variable “Purchaser
type” denotes whether the loan was securitized kept on the books of the originating
institution or sold through a private sale to another financial institution. We use this
information to compute the share of loans sold within a year of origination and use this as a
proxy for the ability to securitize loans in a given MSA. Given the share of sold loans
changes dramatically over the period,​8 ​we allow this coefficient to be different for the 2000-
2003 and the 2004-2006 periods.
The results indicate that denial rates were lower in MSAs where a greater proportion of
originated loans were sold within one year from origination, consistent with findings by Mian
and Sufi (2007) and Keys et al. (2007). During the first part of the sample period, this effect
was more pronounced for the prime than the subprime market. However, during the second
part of the sample period, when securitization of subprime loans increased dramatically, the
effect turns more pronounced for the subprime mortgage market.
In the remainder of Table 12, we document the relationship between the number of
applications and overall credit market expansion, as measured by changes in the ratio of
credit to income at the MSA level. We scale credit by income to control for changes in the
level of income in the MSA. Notice that the contribution to credit market deepening of higher
denial rates is much stronger in the subprime market compared to the prime market,
indicating that the link between deteriorations in lending standards and credit expansion is
stronger in the subprime market. This is not surprising given that the subprime mortgage
market tends to concentrate on high-risk mortgages.
Securitization also appears to have favored the expansion of overall credit with a positive and
significant effect on credit-to-income ratios, particularly during the second part of the sample
period. This evidence partially supports the view that disintermediation through
securitization provides lenders with incentives to extend riskier loans.
8 ​See Ashcraft and Schuermann (2007).
18
VI. D​ISCUSSION AND ​C​ONCLUSIONS
This paper provides robust evidence that the recent rapid credit expansion in the subprime
mortgage market was associated with easing credit standards and that the current troubles in
this market are more severe in the areas where the expansion was faster. We link the change
in lending standards to four main factors. First, we find evidence that standards declined
more where the credit boom was larger. This lends support to the assertions that rapid credit
growth episodes tend to breed lax lending behavior. Second, lower standards were associated
with a fast rate of house price appreciation, consistent with the notion that lenders were to
some extent gambling on a continuing housing boom, relying on the fact that borrowers in
default could always liquidate the collateral and repay the loan. Third, change in market
structure mattered: lending standards declined more in regions where (large and aggressive)
previously absent institutions entered the market. Finally, we find that disintermediation
played a role, with standards declining more in regions where larger portions of the lenders’
loan portfolios where sold to third players.
Our results are robust to a number of alternative specifications, including controlling for
economic fundamentals using out-of-sample data, using alternative measures of lending
standards, and introducing variables that capture the effect of new entrants on the denial rates
of incumbent lenders. The latter approach allows us to assess the independent effect of
changes in local market structure on lending standards. The results are also robust to using
instrumental variables to identify the independent effect of the number of applications and
changes in house prices on loan denial rates. This mitigates concerns that our results are
confounded by endogeneity between loan denial rates and the volume of loan applications.
Finally, the effects we identify for the subprime market are either much weaker or absent in
the prime mortgage market, lending additional support that the deterioration in lending
standards was more pronounced in the subprime mortgage market. Our evidence suggests
that while in the prime market lending standards were largely determined by underlying
fundamentals, for subprime loans lending market conditions and strategic interactions played
an important role in lending decisions.
Our results also shed some light on the effects of monetary policy on banks’ lending
standards. The evolution of U.S. interest rates mimics the evolution of denial rates in the
prime market remarkably well, with denial rates increasing in 2005 following monetary
tightening in 2004. Although we do not find such a relationship for the subprime market,
where denial rates remain relatively low, we find evidence suggesting that the negative
impact of rapid credit growth on lending standards was more pronounced when interest rates
were lower, suggesting that lax monetary policy may exacerbate the effects of booms on
lending standards.

Investing in International Real Estate Stocks:


A Review of the Literature
Elaine Worzala and C. F. Sirmans
[Paper received in final form, December 2002]
Summary. This paper summarises the various findings of studies completed on the benefits of
international diversification using real estate stocks. With the increased availability of data and
analytical tools, the quantity and variety of work over the past decade have increased dramatically
in this area. The first two sections of the paper chronologically review the studies, focusing
on how the diversification benefits are analysed: in a mixed-asset portfolio context or a realestate-
only portfolio context. The third section highlights work that uses alternative analyses to
the traditional mean–variance framework to examine the international real estate stock as an
investment alternative. Almost all of the studies reach the same conclusion: diversification gains
are possible but are often reduced if currency risk is included in the analysis.
Introduction
International ownership of real estate is not a
new concept. Colonial expansions in the 16th
and 17th centuries set in place a pattern of
international ownership that has had profound
implications for international trade and
development. More recently, multinational
corporations have made strategic decisions,
where local regulations have permitted, to
own their real estate in overseas locations.
However, the 1980s and 1990s experienced
an expansion in the ownership of overseas
property as an ​investment ​asset and the research
to support this investment strategy has
been extensive.
To gain exposure to international real estate,
investors can hold a direct equity investment
in the land, bricks and mortar alone or
with a local partner in a joint-venture relationship.
Sirmans and Worzala (this issue)
provide a detailed analysis of the research on
direct international real estate investing.
Given the difficulties of buying direct real
estate, many researchers have advocated an
investment strategy that uses ‘indirect’ real
estate investments, sometimes called property
securities (in the US typically proxied by
REITs), as the real estate asset class in an
investment portfolio. This current paper focuses
on this second option and summarises
the various findings of studies completed on
the benefits of international diversification
using real estate stocks. With the increased
availability of data and analytical tools, the
quantity and variety of work on this topic
have increased dramatically over the past
decade.

Over the past decade, the global real estate


securities market has grown extensively to an
estimated $265 billion in 2001 (Pierzak,
2001). As illustrated in Figure 1, about 50
per cent of the market is based on US companies,
Asia (25 per cent), the UK (10 per cent)
and continental Europe (10 per cent). The
number of companies that have a market
capitalisation greater than the $500 million
minimum for inclusion in the Salomon Smith
Barney index has nearly doubled since 1993.
The index is now based on 132 companies,
as illustrated in Table 1. One often-cited
advantage of property investments in stock is
that co-investors are often local, thus reducing
the information costs associated with
making an international investment. In addition,
investors can save on monitoring
costs and avoid barriers, such as the potential
legal difficulties, involved with direct international
real estate investments (Eichholtz
and Koedjik, 1996a).
Table 2 describes the various real estate
stock indices used in the majority of international
real estate research (Bigman, 2002).
Eichholtz and Keodjik (1996b) also compare
four of the international property share indices:
DataStream Global Indices, LIFE Global
Real Estate Securities Index provided by
Global Property Research (GPR), the MSCI
(MSCI) property shares index and the Salomon
Brothers World Equity Index for
property. They advocate the use of indirect
real estate investments but stress that a major
concern with choosing an index is the treatment
of investment companies versus development
companies, since risk and return
characteristics differ depending on the objectives
of the company. Additionally, the composition
of the indices (market-weighted or
equally weighted) can be important and investors
need to know if returns are reported
on a local or currency-adjusted basis. Not
surprising, the authors are proponents of their
index, the LIFE index, and argue that it is the
best index because it distinguishes between
property development and investment companies.
It also identifies international versus
domestic companies so a researcher can use
the index appropriate for their investment
strategy. Finally, it has relatively broad representations
across countries.
With the growth of international investment
opportunities and data, there has been a

role of international property stock in an


investment portfolio. The international real
estate diversification studies are chronologically
summarised in the next two sections
and are delineated by how the diversification
benefits are analysed: in a mixed-asset portfolio
context or a real-estate-only portfolio
context. In the past decade, many researchers
have noted the problems with the mean–
variance framework for the real estate asset
class. The liquidity of the real estate stock
investment alleviates some of the problems
with the mean–variance framework, but
others still exist. The third section highlights
research that uses alternative analyses to the
traditional mean–variance framework to
examine the potential role of international
real estate for an investor. The final section
provides conclusions and offers some ideas
for future research in this growing area of
real estate investment.
Mixed-asset Portfolio Studies Using Real
Estate Stocks
This section summarises the studies examining
the addition of international real estate
stocks into a mixed-asset portfolio. For each
of the various studies, Table A1 (see Appendix)
details the type of real estate data used
in the analysis, the international markets

studied, the time-interval of the analysis, the


type of analysis that is completed, a brief
summary of the results and the treatment of
exchange rate risk.
Asabere ​et al. ​(1991) are among the first
researchers to use stock market returns of
international property companies to represent
international real estate investments.​1 ​They
use a sub-index developed by Capital International
Perspective, a monthly index based
on the price movements of securities issued
by property companies located throughout
the world. The index is dollar-denominated,
so exchange rate fluctuations are implicit in
the derived returns; no attempt is made to
separate real estate risk from currency risk;
and no transaction costs are included in the
analysis. The authors analyse a mixed-asset
investment portfolio comparing the Capital
International Real Estate Index (a proxy for
international real estate companies) with US
REITs (a proxy for US real estate investments),
the Capital International Perspectives
World Index (a proxy for international securities
in general), the S&P 500 index (a
proxy for US securities) and the Ibbotson and
Sinquefield Corporate and Government bond
index. Using monthly data from 1980 to
1988, the researchers find that the international
property companies are negatively
correlated with T-Bills and only slightly positively
correlated with the REITs, World Index
and the Salomon Corporate Bond Index.
Results provide initial evidence on the diversification
gains from adding international
real estate to a mixed-asset portfolio.
The authors also create optimal portfolios
using the Elton, Gruber and Padberg singleindex
model and find the optimal portfolio
would have 5.6 per cent in international real
estate companies and 40 per cent in US
REITs. Their analysis is based on the assumption
that the S&P 500 accurately represents
the market portfolio, although the S&P
500 index excludes performance of equity
investments in US real estate, many foreign
stocks or international real estate.
Kleiman and Farragher (1992) use the
Capital Investment Perspectives indices that
in 1990 tracked over 1375 companies in 19
countries. They produce both a world index
and industry group indices including a property
sub-index. These authors use monthly
data from 1980 to 1990 and analyse several
financial ratios, concluding that propertybased
investments have superior performance
but are more risky than investing in the
world index. The authors also compare the
international real estate index with the performance
of US REITs over a similar period
(1982–90) and find that the world real estate
index showed higher price earnings multiples,
although the REITS perform better if
dividend yields are taken into account.
Barry ​et al. ​(1996) also focus on international
property companies in emerging
markets. They use the Emerging Markets
Database published by the International Finance
Corporation and compiled by Salomon
Brothers. The return series is based on SIC
codes for real-estate-related companies
which include companies that are investment-
related but also companies that derive
their income from real estate services such as
advising/consulting and construction companies.
The authors examine performance characteristics
of the various investments (real
estate companies and stocks) from 1989 to
1995. In addition, they analyse the correlation
coefficients of the real estate and equity
market, calculating a cut-off value of
correlation that makes investment in the
emerging market real estate companies unproductive.
In every case, emerging market
real estate is included in the efficient portfolios
The authors also build a series of real
estate portfolios that initially consists of a
100 per cent allocation to real estate companies
in developed markets and includes investments
in real estate companies from the
emerging markets in 5 per cent increments.
The minimum variance portfolio for holding
both developed and emerging market real
estate is achieved with an 11 per cent allocation
to real estate in emerging markets.
Eichholtz (1996) compares international
property, stocks and bonds performance from
1985 to 1994. He examines nine countries,
compares the mean returns, standard devia​Downloaded
from ​usj.sagepub.com ​at London School of Economics & Political Sciences on April 30, 2016
INVESTING IN INTERNATIONAL REAL ESTATE STOCKS ​1121
tions and correlation coefficients, and constructs
several different efficient frontiers. He
finds that correlation coefficients between
countries for property investments are
significantly lower than for stock and bond
investments. He also finds that the correlation
coefficients between international indirect
property markets increase over time,
theoretically reducing the benefits of international
diversification. Eichholtz compares
efficient portfolios and finds that an internationally
diversified property portfolio outperforms
a domestic portfolio in the UK, Japan,
US and France. He then examines the internationally
diversified property efficient frontier
and finds that it outperforms both an
international stock and bond portfolio.
Eichholtz and Koedjik (1996b) examine
the real estate securities from 25 different
countries and are some of the first researchers
to analyse regional diversification
on an international basis. They disaggregate
the data into regions and compare returns
with a global index. They find that the correlation
coefficients are relatively low when
US REITs are compared with the different
international markets. In addition, when the
regional property company data are analysed,
regions do offer relatively low correlation
coefficients. The authors conclude that diversification
into international real estate
stocks should provide positive portfolio implications.
Correlation coefficients are higher
and volatility is reduced when returns are
adjusted for an investor’s currency. The authors
suggest that hedging the exchange rate
risk could reduce the diversification benefits.
Eichholtz (1997a) further explores the relationship
between international real estate
stocks and general international stock indices.
Using correlation coefficients between
the real estate indices and stock indices in 19
countries and across 3 regions, he finds the
Asia markets to be highly correlated while
European markets are not. The author suggests
that the immature state of the markets
could be causing the high correlation
coefficients for Asia. Additionally, Asian
property companies make up a large part of
the Asian stock market. The author also suggests
that a development company is more
like a stock investment than a pure real
estate investment. Therefore, diversification
benefits on a mixed-asset basis might be
greater if data are limited to investment-only
companies. The analysis by Eichholtz is limited
to a study within each country or with
the entire global index so an international
investment strategy is not the focus of this
research.
Mull and Soenen (1997) add property securities
to the stock and bond portfolios of
the G-7 countries from 1985 to 1994. They
examine mean returns, standard deviations,
coefficient of variations, Sharpe ratios and
correlation coefficients for all three investment
alternatives. The international real estate
investment is proxied by US REITs and
adjusted for monthly currency fluctuations
from each investor’s country. The authors
find that the correlation coefficients are relatively
high, particularly between the stock
investments in each country and the US
REITs. The authors also test the inflation
hedging capability of the alternative investments
and find real estate to be an inflation
hedge, but so are the other assets. Finally, the
authors compute efficient frontiers and compare
a domestic-only, two-asset portfolio
with a portfolio containing international real
estate. For the whole period, adding US
REITs only marginally enhanced portfolios
for any of the investors. Even for a US
investor, REITs are not a major asset in the
portfolios.
The authors contend that results could be
driven by the period of data, so they also
examine two sub-periods. They find that,
depending on the period, US REITs play a
significantly different role. In the early period,
1990–94, they enhance the portfolio,
while in the latter period, REITs do not
provide diversification benefits.
Gordon ​et al. ​(1998) examine the addition
of international property securities and international
equities to a mixed-asset portfolio of
stocks, bonds and domestic real estate. They
use the GPR quarterly return series for 14
countries from 1984 to 1997. The authors
examine quarterly mean returns and risk-
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1122 ​ELAINE WORZALA AND C​. ​F​. ​SIRMANS


adjusted returns for US stocks, US bonds, US
real estate and international stocks and international
real estate stock. Risk-adjusted returns
are significantly different depending on
the country and the investment alternative.
The authors present a scatter plot of the
risk–return relationship and separate the
countries into four risk–return quadrants for
both the real estate and the stock markets.
Country correlation coefficients ranged from
0.24 to 0.96 providing evidence that for some
countries diversification benefits might be
gained from an international investment
strategy. All of the return data are adjusted
for currency risk on a quarterly basis from a
US investor’s perspective. Therefore, both
the general stock and real estate stock returns
are adjusted with the same currency
fluctuations which could be driving the high
correlation coefficients between the withincountry
assets.
The authors compute cross-country correlation
coefficients between the real estate and
stock market securities. They find that, for
every country, the cross-country real estate
stocks are not as highly correlated as the
cross-country stock markets. Finally, the authors
compute efficient frontiers for three
different portfolios: US-only investments;
US investments plus international equity investments;
and US investments plus international
stock and international real estate
stocks. They find that the minimum variance
portfolio standard deviation decreases by 46
basis points when international real estate
stocks are included in the investment opportunity
set. At higher return levels, the standard
deviation falls by 245 basis points.
Liu and Mei (1998) also find that investing
in international real estate securities provides
diversification benefits, although they find
that the majority of benefits come from the
currency fluctuations and conclude that the
results could be period-specific. These authors
use monthly returns on property trust
and/or property-related securities and the
capital market indices from six countries.
Examining the correlation coefficients, the
authors find that the within-asset-class correlation
coefficients are much lower than the
between-asset-class correlations and conclude
that, although adding international real
estate stocks provides some diversification
benefits, the gains are modest. These benefits
are relatively more pronounced at the lower
risk levels of the optimal portfolios and are
present regardless of whether currency risks
are hedged. All returns are adjusted to a US
investor’s perspective and analysed with and
without currency adjustments. They find that
the exchange rate risk accounts for a sizeable
return of the volatility and conclude that
investors should consider hedging strategies
if they take on an international investment
strategy.
Gordon and Canter (1999) examine the
correlation coefficients between the international
real estate stocks and the general
stock markets in 14 countries from 1984 to
1997. They use the Global Property Research
indices for 13 countries and the NAREIT
index for US real estate investment. For large
cap stocks, they use the MSCI indices for
each of the countries. They examine quarterly
data at a country, continent and world
level. They also create efficient frontiers and
find that the portfolio including international
property stocks outperforms both a US-only
portfolio and a portfolio with US investments
and international stocks.
Stevenson (1999) analyses 17 stock market
indices, 13 bond market indices, 5 commodities,
UK property proxied by the JLW
index and Irish property proxied by the Irish
Institutional Property funds. He analyses the
mean returns, standard deviations and correlation
coefficients of the returns and examines
several efficient frontiers, systematically
adding international stocks and bonds to the
opportunity set. Stevenson is one of the first
real estate researchers to constrain the portfolios.
He puts a minimum constraint investment
for domestic investments, including the
Irish property funds, and a maximum investment
constraint on international investments.
As one would expect, the international bonds
enter the portfolio at lower risk–return levels
and international stocks enter at higher risk–
return levels. Irish real estate remains in the
portfolio at the lower risk–return levels while
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British real estate, the proxy for international
real estate, only enters the portfolio with a
slight allocation at the mid-range of risk–
return level. The author compares the results
with and without currency adjustments. He
finds evidence that incorporating currency
into the analysis increases risk but not to
significant levels although international real
estate falls out of the efficient portfolios. This
is one of the few indirect real estate investment
studies to find no gains from diversification.
However, it is questionable how
international ​UK investments are for an Irish
investor, given the close proximity and economic
connections between the two countries.
Stevenson (2000) uses a hedged REIT
technique originally developed by Giliberto
(1993) to create a direct real estate return
series by removing the impact of the general
stock market on the indirect property returns.
His hedged index is computed on a 49-month
rolling basis for 10 different countries (the
US is proxied by the NAREIT index, while
the other 9 indices are from Data Stream).
The monthly data span from 1978 to 1997,
although the hedged series uses data from
1980 to 1997. The author examines the mean
returns of property companies, the standard
deviations, correlation coefficients and finally
efficient portfolios. He finds that the correlation
coefficients are very low (0.008–0.461)
but even lower if the hedged indices are used
(​_​0.124 to 0.189). In addition, the hedged
series is significantly less volatile than the
indirect series but more volatile than a typical
direct real estate proxy. When the efficient
frontiers are analysed, Stevenson finds that
more diversification benefits are derived from
using international stocks but both international
real estate stocks and the more general
stock investments are dominant in the
efficient portfolios.
Before currency adjustment, adding international
real estate to the domestic portfolio
did provide statistically significant diversification
benefits for most investors.
However, once currency risk is incorporated,
this is not the case. Only three of the countries
benefit from holding international indirect
property investments—Japan, the
Netherlands and Singapore. Stevenson decomposes
the currency and real estate risk
and, in all countries, the greatest degree of
risk is from the asset, then the currency and
finally the covariance of the two.
Maurer and Reiner (2002) also analyse
mixed-asset portfolios including stocks,
bonds and international real estate companies
from five countries. The real estate data are
primarily an indirect real estate index although
the types of investment vary somewhat
from country to country as detailed in
Table A1. These authors complete the typical
analysis of comparing mean returns, standard
deviations and efficient frontiers, but employ
a shortfall-risk framework. They analyse the
portfolios from both the US and the German
investors’ perspective and find that adding
international real estate improves the risk–
return characteristics of the portfolios particularly
for the low- to medium-risk tolerance
for investors of both nationalities. The returns
are analysed with and without currency adjustment.
To try and hedge the currency exposure,
the authors also applied an optimal
hedging strategy using currency forwards
based on the optimal portfolio weights of the
efficient portfolios. In both the US and German
investor scenarios, the optimal hedge
strategy improved the performance of the
portfolios providing additional evidence that
developing hedging strategies to mitigate
some of the currency risk may be worthwhile
for the international investor.
Additionally, these authors compare an
equally weighed portfolio (naı¨ve investor
with minimum technical expertise) to the
minimum risk portfolio to the tangency portfolio
(highest risk adjusted return). They
examine the Sortino ratio (similar to the
Sharpe ratio) to measure the performance of
the alternative investment scenarios. Comparison
of the three different portfolios indicates
that adding international real estate
companies to the portfolios enhances its performance,
as does the optimal hedging strategy.
Finally, the authors complete an ​ex ante
analysis using 48 months of data with a
1-month holding-period. Results again indi-
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1124 ​ELAINE WORZALA AND C​. ​F​. ​SIRMANS


cate that integrating international property
companies in a mixed-asset portfolio using
the ​ex ante ​analysis also results in superior
performance in most cases. The authors provide
significant evidence that both the German
and US investors benefit from holding
international real estate in their portfolio and
that currency hedging enhances the performance
characteristics of the mixed-asset investment
portfolio.
Conover ​et al. ​(2002) examine the risk–
return data from publicly traded foreign real
estate companies and compare their performance
with investments in US stocks, US real
estate (as measured by NAREIT) and foreign
stock investments from 1986 to 1995.​2 ​They
specifically focus their analysis on the 1987
stock market crash in order to measure the
value of foreign diversification during times
of increased volatility and greater uncertainty.
For five of the six countries, the correlation
coefficients are lower for US stock and foreign
real estate investments than for US stock
and foreign stock investments. The authors
also create efficient frontiers comparing the
performance of US mixed-asset portfolios
with US investments and international stocks
and then finally adding international real estate
to a mixed-asset portfolio. Results indicate
that the foreign property companies play
a significant role in the portfolio, taking on a
majority weight in some of the efficient portfolios.
The maximum return for a US investor
without foreign real estate is 1.88 per cent
with a standard deviation of 8.57 per cent. If
international stock and real estate are added to
the portfolio, the risk in the portfolio falls to
5.73 per cent for the same return level. Portfolios
with international property dominate
the other portfolios. Comparing the minimum
variance portfolios, the return increases
slightly from 0.67 per cent to 0.71 per cent on
a monthly basis and the risk level falls from
3.07 per cent to 2.92 per cent by including the
foreign real estate investments.
Real-estate-only Portfolio Studies Using
Real Estate Stocks
This section reviews the research that focuses
on including international real estate stock
investments in a real-estate-only portfolio.
The studies are summarised in Table A2 (see
Appendix). As in the previous section, the
majority of work finds that international real
estate provides diversification benefits within
the real-estate-only portfolio context as well.
Giliberto (1990) is one of the first researchers
to test the international real estate diversification
issue for a real-estate-only portfolio.
He uses the real estate firm sub-sector
of the Salomon-Russell Global-Equity Index
to proxy real estate investments. The monthly
index consists of property company data from
81 companies located in 11 countries from
1985 to 1989. These real estate companies are
primarily engaged in the development and
management of commercial real estate.
Therefore, the returns may not be representative
of an equity real estate investment, but
instead may reflect the many additional decisions
involved with running a company: firm
management capabilities, debt and equity decisions,
and development and disposition
strategies.
Giliberto first examines currency
fluctuations and compares property stock returns
with and without conversion to the US
dollar. He notes that, over this particular
time-period, currency markets provide an increase
in return for an American investor, but
also increase the volatility level of investments.
A correlation matrix (using the unadjusted
data) and an efficient frontier are then
analysed. The correlation coefficients for 22
of the 55 international combinations are relatively
low (below 0.20), with 7 being negative.
The 3 efficient portfolios indicate that
western European investments dominate the
lower risk–return portfolios, while Japan
(with a 57 per cent allocation) dominates the
higher risk–return portfolios.
Addae-Dapaah and Kion (1996) examine
international diversification from the perspective
of a Singaporean investor. They focus
their analysis on investments in 7 countries
using monthly property company indices as
the proxy for real estate investments from
1977 to 1992. They examine the mean
returns, standard deviations, coefficient of
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INVESTING IN INTERNATIONAL REAL ESTATE STOCKS ​1125


variations, correlation coefficients and finally
efficient frontiers from the viewpoint of a
Singaporean investor. In addition, they analyse
3-year sub-periods to test the stability of
the returns. The authors find relatively low
correlation coefficients for most of the countries
ranging from 0.03 (Japan/Hong Kong)
to 0.79 (Singapore/Kuala Lumpur) for the
whole period. In addition, the authors find
significant instability in the correlation
coefficients across time. When analysing
efficient frontiers, the authors find that diversification
benefits do exist and benefits are
enhanced when returns are adjusted for currency
fluctuations from the Singaporean investor’s
perspective.
Wilson and Okunev (1996) analyse the
role of real estate stocks in a diversified
portfolio. These researchers analyse quarterly
data from 1980 to 1987 from the US, UK and
Australia. They first examine the general
stock and real estate stock markets to see if
they are co-integrated. Co-integration tests
show an absence of any long-run equilibrium
relationship so the authors conclude that
there should be gains from diversification.
The tests favour international property stock
segmentation, but they comment that the potential
gains were dependent on the exchange
rate risk. This is a common finding of most
research that includes currency fluctuations
(see Sirmans and Worzala (this issue) for a
more detailed discussion on this). They also
examine the data on both sides of the 1987
market crash. In all cases, the researchers
find that the two markets are segmented.
Finally, the authors construct efficient portfolios
with three assets: real estate stocks from
the US, the UK and Australia with returns
adjusted to a US investor’s perspective. They
find low and negative correlation coefficients
between property markets in the various
countries with the US/Australia being negative.
For the efficient frontiers, portfolios
include investments in at least two of the
countries but in most cases there are allocations
to all three. The only exception is for
the highest risk–return levels that are 100 per
cent invested in the US marketplace. These
results hold for all three periods.
Eichholtz (1997b) examines real estate
stocks by property type and regions. He uses
the GPR date series from 1984 to 1997 and
examines the mean returns, standard deviations
and correlation coefficients between the
regions and property types. He finds low
correlation coefficients when the data are
examined by region (0.30–0.40) and higher
correlation coefficients by property type
(0.50–0.70). Residential property shows the
highest returns, the lowest volatility and relatively
low correlation coefficients with the
other property types, indicating that it might
be best for gaining diversification benefits by
property type. However, Eichholtz concludes
that regional diversification is more
beneficial than property type. Returns are all
dollar denominated, potentially driving the
higher correlation coefficients.
Pierzak (2001) explores the potential
benefits of holding international real estate
stocks from a US investor’s perspective.
They examine the regional risk–return tradeoff,
the currency outlook and efficient frontiers.
They compare a 100 per cent US
portfolio with portfolios that are 90 per cent
and 80 per cent US invested, with the rest of
the portfolio invested in international property
companies. Pierzak finds that portfolio
performance improves as international real
estate is added to the portfolio.
Bigman (2002) also analyses the role of
international listed property companies in a
real-estate-only portfolio. He examines the
returns, standard deviations and correlation
coefficients by region from 1983 to 2001. To
avoid the problems associated with using ​ex
post ​returns, the author used various ‘investor
frameworks’ to come up with ​ex ante
mean returns, standard deviations and covariance
inputs for a mean–variance analysis.
These estimates are based on in-depth discussions
with their pension clients. Bigman
also finds that an internationally diversified
real estate portfolio outperforms a domestic
portfolio.
As can be seen by the extensive number of
papers listed in Tables A1 and A2 and discussed
in these two sections, this area of
international real estate diversification from
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1126 ​ELAINE WORZALA AND C​. ​F​. ​SIRMANS


both the mixed-asset and the real-estate-only
portfolio perspective has been a major focus
for many researchers both in the traditional
academic setting and the ‘real world’ of real
estate investment research. Even though the
studies use a number of different return series
and countries, the conclusions are almost
unanimous in indicating that an international
real estate stock investment strategy provides
diversification benefits. That is, efficient
portfolios that include international real estate
stock in the opportunity set for a mean–
variance analysis outperform those that do
not. Most of the research is either done with
a local return series (which assumes a costless
hedge) or the returns have been adjusted
from an investor’s perspective and an investor
experiences the full brunt of the currency
risk. Only a few researchers have attempted
to analyse the effects of hedging the currency
risk.
Although the results are interesting and
consistent, it is necessary to provide the same
cautions found in Sirmans and Worzala (this
issue) and elsewhere (Lizieri and Finley,
1995). That is, the use of the mean–variance
framework is questionable, given the typical
reliance on ​ex post ​data that are not necessarily
stable over time and therefore not
necessarily a good predictor of the future.
Many of the researchers examine the stability
of the data and note that the results are
dependent on the time-period analysed. In
addition, the majority of the data series used
in these studies are less than 15 years. Therefore,
the mean returns, standard deviations
and correlation coefficients between countries
may not be accurate indicators of expected
or ​ex ante ​real estate performance.
The next section summarises additional research
that has used alterative techniques to
analyse the international real estate stock
markets to gain a better understanding of its
performance and its potential role as an investment
alternative.
Alternative Analysis of International
Investment Opportunities
In the last decade or so, some authors have
examined the use of modern portfolio theory
for the real estate asset class and have concluded
that it may not be the most appropriate
tool for measuring the diversification
benefits of adding real estate. Table A3 (see
Appendix) chronologically summarises many
of the studies that have used alternative
analyses of the international real estate stock
markets. Due to space limitations, the text in
this section groups some of the studies by
type of analysis used and the discussion of
the research is limited.
Eichholz ​et al. ​(1993) examine indirect
real estate shares for 12 countries and 3
continents from 1985 to 1990 looking for
evidence of a common factor across the continents.
They use principal component analysis
to ascertain if there is a common
continental factor based on the economic
fundamentals of the individual markets. Results
indicate that a continental factor for the
European and North American property markets
exists, but not for Japan. The UK has
similarities with both continental Europe and
the Far Eastern countries. These results lead
to a conclusion that most investors need to
consider investments across continents for
optimal international diversification.
Eichholz ​et al. ​(1998) re-examine this issue
and find that Europeans should invest in
Asia and to a lesser extent North America,
while North Americans should go to Europe.
Again, they provide evidence that continents
and the nationality of the investors matter.
Hamelink and Hoesli (2002) also find a continental
factor but in their analysis they find
evidence that the type of company, value or
growth, is also an important consideration.
Finally, Ling and Naranjo (2002) find evidence
of a world-wide factor impacting the
international real estate returns. However,
after controlling for this risk, the authors
find that a country-specific factor is highly
significant in many of the countries, suggesting
that international real estate stock
investments can provide diversification
opportunities.
Hartzell ​et al. ​(1993) examine the economic
base of various areas to see if there are
regional differences that should be included
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INVESTING IN INTERNATIONAL REAL ESTATE STOCKS ​1127


in the investment decision-making process.
These authors analyse employment data from
12 European countries, 11 industrial sectors,
3 geographical regions and 74 regions in
Europe in 1990. They use a chi-squared
statistical approach to analyse the employment
data provided by Eurostat to classify
the country and region as specialised or diversified.
Given the strong agricultural base
of many European regions, the employment
data are examined with and without the agricultural
component. Without agricultural employment,
some regions are found to be
specialised as they have very similar economic
base structures (London, Paris, Amsterdam
and Rotterdam are concentrated in the
FIRE industries). However, 42 of the 74
regions are diversified and would be less
subject to sector-specific effects. At the
country level, 4 of the 12 countries are specialised.
When agricultural employment is
included, 8 countries are specialised rather
than diversified. These results provide
significant evidence that regional diversification
does not necessarily imply
economic diversification.
Barkham and Geltner (1995) are some of
the first researchers to examine the relationship
between the performance of direct and
indirect real estate with the more general
stock market in the US and the UK. They
examine price changes across time and find
the real estate stock investment to be correlated
with the stock markets. The direct real
estate investment in the UK is also positively
correlated with the British stock market. The
authors conclude that price discovery from
stock markets can be found, first in the real
estate stock markets and, after a year, in the
direct real estate markets.
In an attempt to show the advantage of
local knowledge, Eichholtz ​et al​. (1997) use
publicly traded property company data and
compare the performance of the companies
concentrated on domestic investments with
the companies that trade more internationally.
They analyse 18 companies as international
companies because they have 25 per
cent or more of their properties outside their
domestic market. The international firms are
then compared with the rest of the firms in
the GPR–LIFE Global Real Estate Securities
database.
Results suggest that the domestic firms
outperform the internationally diversified
firms from 1983 to 1995; domestic firms
produce average returns of 14.1 per cent
compared with 7.7 per cent for international
firms. This stark difference is not compensated
by risk reduction. International firms
have only a slightly lower standard deviation
than the domestic firms over this time-period
(4.98 per cent to 5.33 per cent). These results
suggest that the domestic firms may have an
information advantage over the international
firms.
To investigate this hypothesis, the authors
construct an index for each of the international
companies that mimics their portfolio
composition using the performance of
the domestic firms. They examine the Sharpe
ratio and Jensen’s alpha in a CAPM framework
and find superior performance for their
‘mimicked’ portfolios of domestic firms over
the international firms (10.4 per cent compared
with 7.7 per cent). Only 4 of the 18
international firms outperform the customised
index when using the Sharpe ratio.
In terms of Jensen’s alpha, only 5 firms have
positive alphas and only 1 is statistically
significant. The authors conclude that direct
international investment gives a lower riskadjusted
return than indirect international
real estate investment. They attribute the
lower performance to the increased information
costs of establishing contacts, obtaining
information and overcoming barriers to
making global investments. A second rationale
for lower performance is the premium
paid for ‘one-stop shopping’. That is, investors
are willing to accept lower returns to
acquire an internationally diversified portfolio
with a single purchase, therefore avoiding
search and transactions costs. It is likely
that this ‘one-stop shopping’ advantage will
be eroded with the recent surge in development
of international investment funds that
are strategically investing in domestic property
companies world-wide.
Several recent studies have included cross-
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1128 ​ELAINE WORZALA AND C​. ​F​. ​SIRMANS


country comparisons of the indirect real
estate investment ability to hedge inflation.
Early proponents of real estate investment
into mixed-asset portfolios cite the improved
hedging capability of real estate as a major
motivator for including real estate. Liu ​et al.
(1997) examine real estate markets in seven
countries from 1980 to 1991. They use the
Fama and Schwert model, the Fisherian direct
causality model and the Geske–Roll
model to test the inflationary hedging capabilities
of real estate securities over common
stock. The authors find no evidence that real
estate stocks are any better than the general
stock, with the exception of France. As far as
predicting future inflation is concerned, results
indicate that the two asset classes are
comparable for all of the countries but
France and Switzerland where the real estate
stocks appear to be better predictors of future
inflation.
Hamelink ​et al. ​(1997) also focus on
inflation hedging and find the REITS are the
best inflation hedge in the US but in the UK
it is common stock investments. They also
find that the lower the holding-period, the
fewer negative returns and the less volatile
are these returns. For most of the assets, US
investors need a holding-period of 7 years to
get a positive return. Direct real estate is the
exception and it requires a holding-period of
10 years. In the UK, the holding-period is
much more variable across asset classes: 3
years for stocks, 5 years for bonds, 7 years
for direct real estate and 8 years for the
indirect real estate asset. These results provide
evidence that the assets have different
performance characteristics, which in turn
suggests potential diversification benefits.
Stevenson (2000) also tests for inflation
hedging and finds that only US REITs act as
a perverse hedge against inflation in his
study.
Conover ​et al. ​(1998) focus on the size
effect as it relates to international property
companies. They use the S&P Global Vantage
data-set and compare 20 countries using
data from 1985 to 1996. The authors find that
the larger firms have better performance (in
terms of higher returns and lower risk).​3 ​The
results hold with and without currency adjustments
to a US investor’s perspective and
contradict previous firm size research on US
REITs.
Several other authors have employed regression
techniques to analyse more closely
and compare performance characteristics of
the real estate stocks in different countries.
Lizieri ​et al. ​(1998) use a threshold autoregressive
(TAR) technique to separate the US
REITs and UK property companies into different
regimes defined by the real rate of
interest. They use monthly data from the
DataStream Property Index for the UK and
the NAREIT Equity Index for the US. They
find that the TAR model does a better job of
predicting returns than a traditional linear
regression model. They also find that the
regime switch occurs at different times for
the two countries, providing evidence that
these two markets behave differently and are
possibly in different cycles. In the US, the
regime switch occurred at the real interest
rate level of 2.9 per cent while in the UK the
switch is at a higher rate of 5.5 per cent.
Giliberto ​et al. ​(1999) take the analysis a step
further and use a similar modelling technique,
QTARCH, to partition the historical
data for the alternative investments. The partitions
are then used to test out of sample
investment strategies. The authors find that
this approach is superior to the conventional
asset allocation models.
Gordon and Canter (1999) are reviewed
earlier in the mixed-asset portfolio section,
but they also examine the correlation
coefficients, finding them to be unstable over
time and shifting. Depending on the country
and the time-period, some markets are becoming
more integrated thereby possibly losing
their diversification effect. The authors
try to find some determinants to help classify
a country’s real estate stock market as being
integrated with the stock market or segregated.
They examine the relative weight of
property companies within the stock market
index and find that it has some influence. If
the relative weight is high, the two markets
are more likely to be integrated. They also
find evidence that the more internationally
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INVESTING IN INTERNATIONAL REAL ESTATE STOCKS ​1129


based the real estate companies are, the less
likely it is that the real estate stock market is
integrated with the country’s general stock
market. Finally, the authors examine the distribution
of earnings and test the hypothesis
that the more REIT-like the investment structure
of the property companies, the less integrated
the two markets will be. About half
the countries have a distributed earnings
vehicle similar to the US REIT. The correlations
between the stock and the real estate
markets are lower for these companies, providing
initial evidence that these markets are
more segmented.
Wilson and Okunev (1999) also examine
the relationship of real estate stocks to the
general stock market on an international basis.
They use spectral analysis to examine
cycles within and between the property and
stock markets in the US, the UK and Australia
over the past 30 years.​4 ​The time-span
varies, depending on the country, but they
find in all three countries that there is some
small evidence of cycles. However, the pronounced
cycles often found in direct real
estate markets are not evident in the real
estate stock and general stock markets. They
also find relatively weak evidence of cocycles
between the real estate stock and general
stock markets. This integration, however
slight, becomes an important issue when
making asset allocations in a mixed-asset
portfolio.
Finally, Lizieri ​et al. ​(2002) examine the
effects of European monetary integration on
both the property stock market and the general
stock market within the 12 European
Union member countries. They find that
European real estate stocks are much less
correlated across Europe than stocks in general.
In addition, their research shows that
the real estate stocks have not converged as
rapidly as general stocks in the run-up to
European monetary union in 1997. They
attribute their findings to three different factors.
First, the primarily local nature of property
holdings means that most firms hold
geographically specific and undiversified
portfolios. They also cite the generally lower
market capitalisations of property companies
so that these companies do not appear in
European tracker funds and they are also not
covered by many analysts. Finally, they point
out that property markets are not subject to
the same convergence forces that are evident
in capital markets so they should not be
expected to behave in the same way.​5
Conner ​et al. ​(1999) examine many of the
myths associated with international real estate
investments. They emphasise that there
are three categories of risk: country, real
estate market (size of market, development
of market, transparency, liquidity) and deal
risk (leverage, tenant credit, currency denomination
of rents). They also break the investment
universe into three types of country:
core (well-developed, low long-term risk),
core-plus and emerging countries. The latter
two, they conclude, have higher countrylevel
risk but also higher growth potential
from an investment perspective. They dispel
the myth that foreign investment provides a
risk premium in core markets but, for coreplus
and emerging investments, investors are
taking on greater risks and should expect a
higher return on an absolute basis. However,
they should not expect it on a risk-adjusted
basis over the long term.
Like Baum (1995), these authors suggest
that global investors can create value by
exporting their expertise. The developed
market investors have more developed systems
that can be exported to other markets,
adding value to a real estate investment. Additionally,
some markets do not have the
required capital so international investors can
create opportunities that otherwise would not
have been available. In addition, the authors
cite the obvious currency risk. However, they
agree with some of the early researchers and
suggest that a long-term holding-period for
real estate might mean minimal currency risk
for the investor, particularly for mixed-asset
portfolios with other international investments.
Liang and McIntosh (2000) focus their
analysis on trying to estimate country risk
premiums for investing in global real estate.
They examine the credit scores of 44 countries
that are reported in the ​Institutional
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1130 ​ELAINE WORZALA AND C​. ​F​. ​SIRMANS


Investor ​since 1979. The country risk premium
is defined as the difference between
the annualised return expectations of an international
market compared with the return
for a similar US investment. Returns range
from 11.7 per cent for Switzerland (meaning
a slight discount off the US return of 12 per
cent) to a high of 34.9 per cent for Russian
investments. They conclude that the country
risk is virtually zero for developed Western
economies, implying no adjustment to hurdle
rates for investments in these countries.
However, the required returns are substantially
higher for the emerging economies.
Campbell and Sirmans (2002) provide an
interesting analysis of the policy implications
of bringing the US REIT tax-advantaged
public property company structure to European
markets and the potential development
of a pan-European REIT structure. The authors
conclude that the US REIT structure
has advantages, but it is also characterised by
a restrictive institutional structure that can
limit the competitive advantage of these investment
vehicles over taxable firms. Flexibility
is reduced that could potentially impair
performance of the company, particularly
during times of economic contraction.
Conclusions and Areas for Future
Research
Kateley (2002) provides an excellent review
of the basic risks of international real estate
investments. Most of these complex issues
are assumed away by the research summarised
in this paper. However, they are
important and the research investment community
must begin to take them seriously if
international real estate investing is truly to
be understood. The research summarised in
this paper clearly advocates the inclusion of
international real estate stocks, but there is
still a lot to learn about the real estate asset
class. Country selection is clearly a key determinant
of performance, but Kateley acknowledges
that it is somewhat of an art
rather than a science, depending on an investor’s
risk appetite. However, he suggests, and
the present authors agree, that major red flags
for investments include high current account
deficits, overvalued exchange rates, high
inflation, large short-term dollar denominated
debt, low capital formation, poor regulation
of the banking system and corrupt government
oversight/cronyism. All of these are
important factors for minimising the political
and economic risks associated with international
investing.
A second major risk is lack of transparency
and includes the lack of data on performance,
lack of data on investments and
lack of property rights. Each of these is an
important area for future research. Although
some researchers argue that the data are getting
better, because times series are longer
and more countries are analysed, there is still
a lot to be learned. One fundamental question
is: what are international real estate stocks?
Are they stocks or are they real estate? If
they are the former, their role as a diversifier
may be limited, as indicated by some of the
findings summarised in this study. In addition,
many of the earlier studies used publicly
traded companies as their proxy for a
real estate investment. These companies are
not solely involved in real estate investments,
so their relevance as a proxy for the real
estate asset class is uncertain. There is still a
significant lack of data really to be comfortable
that real estate stock performance characteristics
are understood, particularly on an
international scale.
Kateley also cautions that in most markets
there is a large degree of liquidity risk. Property
is typically in short supply, closely held
and infrequently traded. There have been
some international acquisitions in the past
few years, but few investors have tried to exit
their investments. This is another very fruitful
area of research, since most real estate
investments returns are highly dependent on
the reversion value. In addition, the change
in property price is difficult to hedge completely,
thus creating a major source of currency
risk. This is another area where
additional research is necessary.
Liquidity is a major risk for international
investors and depends on the availability of
debt and equity capital as well as the tax
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INVESTING IN INTERNATIONAL REAL ESTATE STOCKS ​1131


regime that exist in the various countries.
Globalisation should help to level the playing-
field and investors need to factor these
risks into their analyses. To date, none of the
research has focused on this aspect of international
real estate investment strategy. Additional
major risks that are ignored in most
studies are the tax, accounting and legal risks,
as well as ownership, entitlement and local
police powers. All of these are important areas
for future research in order to have a better
understanding of the role of international real
estate to the investment community.

THE FUTURE OF THE GOVERNMENT SPONSORED ENTERPRISES:


THE ROLE FOR GOVERNMENT IN THE U.S. MORTGAGE MARKET
Dwight Jaffee
John M. Quigley

ABSTRACT
This paper analyzes options for reforming the U.S. housing finance system in view of the failure of
Fannie Mae and Freddie Mac as government sponsored enterprises (GSEs). The options considered
include GSE reform, a range of possible new governmental mortgage guarantee plans, and greater
reliance on private mortgage markets. The analysis also considers the likely consequences of adopting
alternative roles for government in the U.S. housing and mortgage markets. We start by reviewing
the history of the GSEs and their contributions to the operation of U.S. housing and mortgage markets,
including the actions that led to their failure in conjunction with the recent mortgage market crisis.
The reform options we consider include those proposed in a 2011 U.S. Treasury White Paper, plans
for new government mortgage guarantees from various researchers and organizations, and the evidence
from Western European countries for the efficacy of private mortgages markets.

I. Introduction
The two large Government Sponsored Housing Enterprises (GSEs),​1 ​the Federal
National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage
Corporation (“Freddie Mac”), evolved over three quarters of a century from a single
small government agency, to a large and powerful duopoly, and ultimately to insolvent
institutions protected from bankruptcy only by the full faith and credit of the U.S.
government. Between 2007 and Q2 2011, the two GSEs had realized losses of $247
billion, and they required draws of $169 billion under the Treasured Preferred Stock
Purchase Agreements to remain in operation. (See Federal Housing Finance Agency
2011). This paper traces the transformation of the GSEs from privately held institutions
with powerful direction and political influence to vassals reporting to an administrative
agency in the Department of Housing and Urban Development (the Federal Housing
Finance Agency, FHFA).
Within the next few years, the agencies will have to be restructured. Proposals for
reform include recapitalizing them in some form as Government Sponsored Enterprises
(GSEs), reconstituting them as agencies of the federal government with more narrowlyspecified
missions, or privatizing the organizations. There are also proposals to replace
the GSEs with a variety of new government mortgage guarantee/insurance programs. The
GSE reform and mortgage guarantee proposals are both nested within the larger question
of what are the likely consequences of alternative roles for government in the U.S.
housing and mortgage markets. This paper is intended to help in the deliberations about
1 ​Athird, much smaller, Government Sponsored Housing Enterprise is the Federal Home Loan Bank
System (FHLBS). The issues for reforming the FHLBS are similar to many of the issue raised in this paper
for Fannie Mae and Freddie Mac, although we have not analyzed separately the FHLBS or other nonhousing
government enterprises.
3
“what to do” about these costly failures. We briefly review the history of the housing
enterprises and their performance, including the recent housing crisis. We document the
contributions of Freddie and Fannie to the operation of U.S. housing markets, and we
analyze the role of the agencies in the recent housing crisis. We search for evidence on
the importance of Freddie and Fannie in achieving other important housing goals. We
compare U.S. policies with those adopted in other developed countries.
This is not the first time we have provided some analysis of the reform options in
housing finance, either individually (Jaffee, 2010b, 2011; Quigley 2006) or jointly (Jaffee
and Quigley, 2010). However, it is our first attempt to consider all the history and all of
the options.
In section II below we discuss the background and origin of the GSEs and of the
federal role in supplying housing credit. Section III provides a brief summary of
homeownership and government policy. Section IV describes the broader objectives and
goals of the GSE institutions and analyzes the most recent failures of the credit market
and the secondary housing market. Section V links the current housing crisis to the
insolvency of credit institutions. Section VI describes likely the consequences of a series
of plans concerning the restructuring of these institutions and alternative mechanisms for
government support of the U.S. mortgage market. It also provides a brief summary of the
GSEs under their government conservatorship since September 2008.
II. Background
With the public sale of its stock and its conversion into a government sponsored
enterprise in 1968, the Federal National Mortgage Association (FNMA) emerged from
obscurity as an agent in the market for home mortgage credit. The FNMA had been
4
established in 1938, based on provisions in the 1934 National Housing Act, after the
collapse of the housing market during the Great Depression. The 1934 Act had
established the Federal Housing Administration (FHA) to oversee a program of home
mortgage insurance against default. Insurance was funded by the proceeds of a fixedpremium
charged on unpaid loan balances. These revenues were deposited in Treasury
securities and managed as a mutual insurance fund. Significantly, default insurance was
offered on “economically sound” self-amortizing mortgages with terms as long as twenty
years and with loan-to-value ratios up to eighty percent.
Diffusion of the new FHA product across the country required national
standardization of underwriting procedures. Appraisals were required, and borrowers’
credit histories and financial capacities were reported and evaluated systematically. The
Mutual Mortgage Insurance Fund, established to manage the reserve of FHA premiums,
was required to be actuarially sound. This was generally understood to allow very small
redistributions from high income to low income FHA mortgagees. By its original design,
the FHA was clearly intended to serve the vast majority of homeowners.
In the 1934 Act, Congress had also sought to encourage private establishment of
National Mortgage Associations that would buy and sell the new and unfamiliar insured
mortgages of the Federal Housing Administration. By creating a secondary market for
these assets, the Associations sought to increase the willingness of primary lenders to
make these loans. No private associations were formed, however. When further
liberalization of the terms under which associations could be organized was still
unsuccessful, the Federal National Mortgage Association was chartered in 1938 by the
Federal Housing Administrator following the request of the President of the United
5
States. Federal action was precipitated particularly by concern over the acceptability of
new FHA ninety-percent twenty-five-year loans authorized that year.
At first, the Association operated on a small scale, but its willingness to buy FHA
mortgages encouraged lenders to make them. A 1948 authorization to purchase
mortgages guaranteed by the Veterans Administration led the Association to make
purchases, commitments, loans, and investments that soon approached the
congressionally authorized limit of $2.5 billion. Since the maximum interest rate on VA
mortgages was below the market rate, FNMA’s advance commitments to buy VAguaranteed
mortgages at par assured windfall gains to private borrowers or lenders. The
1954 Housing Act reorganized Fannie Mae as a mixed-ownership corporation with
eligible shareholders being the federal government and lenders that sold mortgages to
Fannie Mae. FNMA was then able to finance its operations through sale of its preferred
stock to the U.S. Treasury, through sale of its common stock to lenders whose mortgages
it bought, and by the sale of bonds to the public.
The Housing and Urban Development Act of 1968 transferred FNMA’s special
assistance and the management and liquidation of part of its portfolio to the newly
constituted Government National Mortgage Association. Its secondary market operations
remained with FNMA, now owned entirely by private stockholders. Commercial banks
were the primary beneficiaries of FNMA’s secondary market activities in FHA and VA
mortgages -- since the banks specialized in originating the government-guaranteed
mortgages. In contrast, the mortgages originated by Savings and Loan Associations
(S&Ls) and Mutual Savings Banks (“Thrift Institutions”) were primarily “conventional”
mortgages, meaning they received no government guarantee. The thrift institutions
6
lobbied for equal treatment, and were rewarded in 1970 with the establishment of the
Federal Home Loan Mortgage Corporation (“Freddie Mac”) under the regulatory control
of the Federal Home Loan Bank System, the S&L regulator. Freddie Mac stock first
became publicly available in 1989, although shares owned by Freddie Mac’s financial
partners had been traded on the New York Stock Exchange starting in 1984.
III. Homeownership and Government Policy
According to de Tocqueville (1835), Americans have long been obsessed with
owner-occupied housing. Richard Green (2011) sees this as a political issue, as societies
are less disposed to make revolution when personal and real property is augmented and
distributed among the population. Other recent work emphasizes the external benefits of
owner-occupied housing, and a large social science literature has developed exploring the
connection between higher levels of homeownership and the economic and social
outcomes of households. Appendix Table A1 reports some of the findings linking
homeownership to social outcomes. Two other papers (Dietz and Haurin, 2003; Haurin,
Dietz and Weinberg, 2002) provide an exhaustive comparison of the economic and social
consequences for those living in owner-occupied and rental housing.
Most of the research supports the conclusion that homeownership has some
positive effects upon the social outcomes for individuals and households. But the
research does not conclude that the effect is very large. But even if the effect were large,
nothing supports the conclusion that homeownership should be supported by the
institution of the GSEs or their policy choices. In particular, the primary impact of
instruments that focus on lowering the cost or expanding the availability of mortgages
7
will be larger mortgages, which makes those instruments ineffective and costly relative to
direct subsidies for homeownership.
This is important -- for as noted below many of the popular arguments in support
of subsidies for the GSEs are based upon the promotion of homeownership in the
economy.
IV. Policy Objectives for the GSEs
A. Primary Objectives
The GSE charters are quite explicit in stating the goals and responsibilities of the
enterprises, but they do not state homeownership goals directly. Instead, they seek to:
1) provide stability in the secondary market for residential mortgages;
2) respond appropriately to the private capital market;
3) provide ongoing assistance to the secondary market for residential mortgages
(including activities relating to mortgages on housing for low- and moderate-income
families involving a reasonable economic return that may be less than the return earned
on other activities) by increasing the liquidity of mortgage investments and improving the
distribution of investment capital available for residential mortgage financing;
4) promote access to mortgage credit throughout the Nation (including central cities,
rural areas, and underserved areas) by increasing the liquidity of mortgage investments
and improving the distribution of investment capital available for residential mortgage
financing; and
5) manage and liquidate federally owned mortgage portfolios in an orderly manner,
with a minimum of adverse effect upon the residential mortgage market and minimum
loss to the Federal Government.
8
This section reviews the key activities of the GSEs with respect to providing
stability, assistance, and liquidity to the secondary market for residential mortgages. The
specific objectives of the secondary market activities have varied over time, including
operations to reinforce or offset fiscal and monetary policy, to increase residential
construction, to make a market in federally underwritten mortgages, to reduce regional
yield differentials, and to act as a mortgage lender of last resort. (See Guttentag, 1963, for
an extensive discussion of these key activities.)
A.1 Quantitative Impact of the GSEs on the U.S. Home Mortgage Market
Table 1 reviews the quantitative role of the GSEs in the US mortgage market over
the recent past. The top panel reports the outstanding amounts of whole home mortgages
at the end of each decade from 1950 through 2010. Through 1960, all whole home
mortgages were directly held in portfolios, and even by 1970 the only exception was $3
billion of mortgage-backed securities (MBS) issued by the newly established
Government National Mortgage Association (GNMA). The largest portfolio investor has
always been the set of depository institutions, commercial banks and thrift institutions
(savings and loan associations, savings banks, and credit unions).​2 ​The market investor
portfolios include capital market investors ranging from pension funds and mutual funds
to insurance companies. Starting in 1980, increasing amounts of whole home mortgages
have been held within MBS pools. The top panel of Table 1 separates the three main
categories of MBS pools: pools issued by the GSEs, by GNMA, and by private label
securitizers (PLS).
2 ​The
GSE category covers the Fannie Mae on-balance-sheet portfolio through 1970 and the sum of the
Fannie Mae and Freddie Mac portfolios thereafter.
9
The middle panel of Table 1 shows each of the investor categories for whole
home mortgage holdings as a percentage of the total amount outstanding. One major
trend is apparent; portfolio holdings declined steadily from 100 percent of the total in
1960 to 37 percent of the total by 2010. Among the portfolio investors, both depository
institution and market investor holdings declined steadily starting in 1970. The GSE
portfolio holdings of whole home mortgages, five percent of the total in 2010, remained a
small percentage of the total throughout the history, with fluctuations within the narrow
band of three percent to eight percent of the total.
The second major trend reported in the middle panel of Table 1 is the steady rise
in mortgage pool holdings as a percentage of the total, starting at one percent in 1970 and
reaching 63 percent of the total by 2010. GSE pools show the most rapid rise, reaching 41
percent of total outstanding home mortgages by 2010. The PLS pools also grew steadily,
reaching twelve percent of the total by 2010. The GNMA pool share of total outstanding
mortgages, ten percent at year-end 2010, fluctuated in a narrow range between ten
percent and fifteen percent of the total from 1980 to the present.
The bottom panel of Table 1 shows the direct GSE share of the home mortgage
market, computed as the sum of whole mortgages held in the GSE portfolios and their
outstanding MBS. While this GSE share rose steadily from 1950, the primary increase
started in 1990, with the share reaching 46 percent of all outstanding home mortgages in
2010. This direct share does not include MBS from other issuers that were held in the
GSE portfolios, a topic to which we turn below.​3
3 ​Quantitatively,
including the GSE holdings of other MBS would raise the total GSE share to 47 percent
and 48 percent for 2000 and 2010 respectively. This ratio actually peaked in 2003, reaching fifty percent.
10
While Table 1 accounts for all outstanding home mortgages, it does not
distinguish among the investor groups holding the MBS instruments created by the
mortgage pools. This issue is addressed in Table 2, in which ownership of the MBS pools
has been allocated among the various investor classes. These values are then combined
with the portfolio holdings of whole mortgages to determine the ownership structure of
all home mortgages, whether held as whole mortgages or as investment in MBS pools.​4 ​It
is apparent from Table 2 that, starting in 1980, market investors were expanding relative
to the depository institutions and the GSEs, and that by 2010 the market investors were
the largest investor class for the sum of whole mortgages and mortgage securities.
Figure 1 reports the percentage of outstanding whole mortgages held directly in
portfolios for each of the three investor classes. The depository institutions have always
been the predominant holder of whole mortgages. At year-end 2010, the depository
institutions held 76 percent of all whole mortgages that were directly held in portfolios,
with the market investors and the GSEs each holding a twelve percent share.
Figure 2 reports the percentage of outstanding MBS for the three holder classes.​5
It is apparent that the market investors have always been dominant in holding MBS
positions. At year-end 2010, market investors were holding 67 percent of the outstanding
MBS, with depository institutions holding 21 percent and the GSEs twelve percent.
Figure 3 combines the results for Figures 1 and 2, reporting the share for each
holder class of their combined positions in whole mortgages and MBS. By 2010, the
market investors had the largest position, representing 47 percent of all home mortgages,
4 ​As far as we are aware, this integration of whole mortgage portfolio holdings and MBS pools by investor
has not been available previously.
5 ​The graphs start in 1970, since there were no outstanding MBS before that year.

11
with depository institutions in the second position, holding 41 percent of all home
mortgages. At the same time, the GSEs were holding twelve percent of all home
mortgages (as either whole mortgages or MBS) a share just below their average over the
last three decades.
Figure 3 indicates that the GSE combined holdings of whole mortgages and MBS
has always represented a relatively small share of total U.S. home mortgages outstanding.
In this sense, closing the GSEs now, in an orderly way, would have a minor impact on the
U.S. mortgage market. That is, the twelve percent GSE share could be readily replaced by
a combination of market investors and depository institutions (who are already holding
88 percent of U.S. home mortgages). There are, however, two other measures of potential
GSE benefits with regard to outstanding whole mortgages and MBS: (1) the contribution
of MBS issued by the GSEs, and (2) stabilization of the U.S. home mortgage market
through countercyclical activities by the GSEs. We now consider these in turn.
A.2 The Role of GSE-Issued MBS
Figure 4 shows the relative shares of outstanding home mortgage MBS by issuer
class. The GSE share has been dominant since 1990, representing 65 percent of all
outstanding MBS in 2010. The share of private label securitizers (PLS) has been steadily
rising, but still represented only 19 percent of outstanding MBS at year-end 2010. The
GNMA share has been steadily declining, reaching a 16 percent market share by year-end
2010.
The dominant historical position of GSE MBS in the current U.S. home mortgage
is sometimes used to justify a future role for the GSEs in the market. But, at its core, the
GSE dominance of the MBS market for home mortgages has been largely derived from
12
the assumption of market investors—reinforced by GSE marketing--that the GSE MBS
had an implicit government guarantee (and which turned out to be correct, after
imposition of the GSE Conservatorships in 2008). In this sense, the dominant GSE MBS
position is just an example of ​crowding out​, whereby any asset with a low-cost
government guarantee against loss will likely replace private activity in the same market.
If the government guarantee were eliminated, there is every reason to expect that private
market activity would simply replace the activity of the government entity.
A brief review of the history of U.S. MBS development is valuable for
understanding the limited contribution of the GSEs to MBS innovations:​6
​1968: GNMA creates first modern MBS by securitizing FHA/VA mortgages;
​1970s: GSEs expand MBS market based on their implicit government guarantee;​7
​1980s: Salomon Bros. securitizes multi-class, non-guaranteed, MBS instruments;​8
​1990s: Multi-class (structured finance) mechanism is first applied to wide range of
asset-backed securities, including auto, credit card, and commercial mortgage loans;
​2000s: Subprime lending becomes the most important application of MBS/ABS
methods.
6 ​US mortgage securitization probably actually began soon after the founding of the Republic. Following
the war of 1812, the US federal government was desperate for revenue and extended loans to homesteaders
for property on the Western frontiers. Without the resources to make and hold these loans, the government
pooled and sold these loans to investors. By the 1920s, securitization was already a well accepted format
for selling loans to investors. These mortgage-backed securities failed during the real estate crisis of the
1930s, and it was decades before U.S. securitization was reactivated in 1968. See Quinn (2010) for a new
history of the U.S. housing policy and the origins of securitization.
7 ​The GSEs could point to their $2.25 billion line of credit at the US Treasury as backing for their
guarantee, a significant factor only in the early years when their scale of operations was relatively small. It
also helped the GSE case that the US government never firmly and officially rejected the notion of an
implicit guarantee.
8 ​The colorful development of private-label MBS under Lewis Ranieri at Solomon Brothers is wonderfully
chronicled in ​Liars Poker ​by Lewis (1990).
13
Credit for the modern innovation of single-class MBS belongs to the government
itself with the creation of the GNMA MBS. GNMA was, and remains, an agency within
the Department of Housing and Urban Development. Likewise, credit for the innovation
of the multi-class MBS belongs to the private sector with the development of structured
MBS by Salomon Bros. in the 1980s. In fact, the GSEs have always been followers, not
innovators, in the MBS market. The success of the GSEs in establishing the market for
their own MBS depended entirely on the perception of capital market investors that they
faced no credit risk as the result of the implicit federal guarantee. Absent this government
guarantee, the single-class GSE MBS would have simply lost out in the marketplace to
the multi-class, private-label, MBS.
GSE proponents often argue that the GSEs reduced securitization costs and
mortgage interest rates. Here, too, the reality is that the GSEs provide no benefit other
than the implicit guarantee. A case in point is the TBA (“to be announced”) forward
market for GSE and GNMA MBS. While this market arguably expands the liquidity of
the traded MBS, the benefit depends completely on the market’s perception that the
guarantees—explicit for GNMA and implicit for the GSE MBS—make credit risk
irrelevant in the pricing and trading of the securities. It is equally noteworthy that the
markets for ​asset-backed securitization​, for the securitization of credit card, auto, and
commercial mortgage loans, and other loan classes as well, expanded rapidly starting in
the early 1990s without any contribution from the GSEs. Indeed, as with the original
GNMA MBS, the GSEs benefited from the innovation by others, creating their own
14
structured finance offerings once the market demand for such securities had been
expanded through private market innovation.​9
Finally, the claim is sometimes made that the GSE MBS activity is critical for the
survival of the thirty-year, fixed-rate, residential mortgage. This claim is unwarranted. In
fact, two features of the GSE MBS instrument were clearly detriments to the expansion
of the long-term, fixed-rate, mortgage:
First, the GSE MBS transferred the entire interest rate risk imbedded in the fixedrate
mortgages to the market investors who purchased the instruments. The GSEs took no
action to mitigate this risk;
Second, the GSE MBS generally disallowed prepayment penalties on all the
mortgages they securitized. While borrowers may have felt they benefitted from this
“free” call option, it greatly magnified the interest rate risk imposed on investors in the
GSE MBS, and led to higher interest rates on the fixed-rate mortgages.
Finally, a number of Western European countries successfully use long-term,
fixed rate, mortgages, but have no entity comparable to the GSEs, Denmark is the most
conspicuous example. The use of covered bonds allows European banks to hold longterm
mortgages on their balance sheets, while passing a substantial part of the interestrate
risk to capital market investors. We further discuss the experience of Western
European countries in Section A5 below.
9 ​See
Downing, Jaffee, and Wallace (2009) for a discussion of how the GSEs profited by restructuring their
simple passthrough MBS into more complex multi-tranche securitizations.
15
A.3 The Limited GSE Contributions to Mortgage Market Stability
The GSEs also claim credit for taking actions to stabilize the U.S. mortgage
markets. The U.S. Government Accountability Office (2009), however, finds little
evidence of such benefits:
“… the extent to which the enterprises have been able to support a stable
and liquid secondary mortgage market during periods of economic stress,
which are key charter and statutory obligations, is not clear. In 1996, we
attempted to determine the extent to which the enterprises’ activities
would support mortgage finance during stressful economic periods by
analyzing Fannie Mae’s mortgage activities in some states, including oil
producing states such as Texas and Louisiana, beginning in the 1980s.
Specifically, we analyzed state-level data on Fannie Mae’s market shares
and housing price indexes for the years 1980–1994. We did not find
sufficient evidence that Fannie Mae provided an economic cushion to
mortgage markets in those states during the period analyzed.”
Reports by the Congressional Budget Office (1996, 2010) come to similar conclusions.
The academic literature also generally concludes that the GSE contribution to U.S.
mortgage market stability has been modest at best. This view is stated in early studies by
Jaffee and Rosen (1978, 1979) and more recent studies by Frame and White (2005) and
Lehnert, Passmore, and Sherlund (2008). In contrast, Naranjo and Toevs (2002), a study
funded by Fannie Mae, found evidence of effective stabilization by the GSEs, as did
other studies carried out internally by the GSEs. Unlike the previous studies, Peek and
Wilcox (2003) focused on the flow of mortgage funds, and not on mortgage interest rates,
and found the GSE contribution to be countercyclical. Of course, this research was all
conducted before the subprime housing bubble and its collapse. In this event, as we now
document, the GSE participation was decidedly destabilizing.
A.4 The GSE Role in the Subprime Mortgage Boom and Crash
The losses reported by the GSEs starting in 2008 leave no doubt that the GSEs
acquired a significant volume of risky mortgages during the subprime boom. However,
16
the extent, timing, and significance of these acquisitions is debated. For example, Jaffee
(2010) describes the GSE role as “expanding” the subprime boom, especially in 2007,
whereas Wallison (2011, p.2) concludes that GSE activity, based on their housing goals,
was a primary “source” of the crisis. In this section, we evaluate the role played by the
GSEs in the subprime mortgage boom and crash.
A quantitative evaluation of the GSE role in the subprime crisis faces a number of
significant data issues:
1) Definitions for ​subprime ​and ​Alt A ​mortgages differ across data sets, and certain highrisk
mortgages are not included under either label.
2) Defining ​high-risk mortgages ​(including subprime and Alt A instruments) is
necessarily complex because mortgage default risk arises from numerous factors
including borrower and property attributes (FICO scores, loan-to-value ratios, etc.),
special amortization options (interest only, negative amortization, etc.), and fixed-rate
versus adjustable-rate loans.
3) The GSEs could not acquire any mortgages with an initial loan amount above the
conforming loan limit (so-called jumbo mortgages).
Our analysis starts by reviewing a newly compiled mortgage origination dataset
from the GSE regulator, the Federal Housing Finance Agency (2010a).​10 ​These data
compare the risk characteristics of all mortgages acquired by the GSEs (whether
securitized or held in retained portfolios) with the risk characteristics of all conforming,
conventional, mortgages that were included in private label securitizations (PLS),
tabulated by year of mortgage origination. Because the dataset has nearly complete
coverage and is restricted to conforming mortgages, it provides the best available direct --
10 ​We thank Robin Seiler of the Federal Housing Finance Agency for providing us with a roadmap for the
intricacies of these data.
17
“apples to apples” -- comparison of the GSE acquired mortgages relative to the
comparable market. Nevertheless, there are two limitations. First, while the FHFA data
include all the conforming mortgages that collateralized PLS MBS instruments, the GSE
holdings of PLS tranches are not so identified. We do not expect a significant bias in the
comparisons from this source, however, because the GSE PLS holdings were almost
entirely AAA tranches with little ​ex ante ​credit risk.​11 ​Second, the FHFA data exclude
conforming mortgages that were not securitized (​i.e.​, they were retained in lender
portfolios). To the extent that lenders did retain conforming mortgages with high-risk
attributes, the FHFA dataset will undercount the high-risk dimensions of the overall
conforming origination pools, and will therefore overstate the GSE share of all high-risk
originations. Here too, we do not expect a significant bias in our comparisons, because
most subprime and Alt-A mortgages were securitized, and the securitization rate was
even higher among those high-risk loans that were also conforming mortgages.​12
Panel A of Table 3 shows the dollar amount of the conforming mortgages by
origination year and various risk attributes. Rows (1) to (3) report on loans with one of
the identified high-risk factors: high loan-to-value (LTV) ratios, low FICO scores, and
adjustable rate mortgages (ARMs) respectively. However, there is some double counting
11 ​See Thomas and Van Order (2011) for further discussion. PLS tranches as a share of total GSE
acquisitions reached its high point at 22.9 percent in 2005, but had fallen to 7.4 percent by 2007.
Furthermore, actual cash flow losses on GSE PLS positions have been modest to date, although the GSEs
have recognized significant mark to market valuation losses on these positions.
12 ​For example, 2007 data from ​Inside Mortgage Finance ​indicate that only $33 billion (or 7%) of the
subprime/Alt A mortgages originated that year were not securitized. Even if these were all conforming
mortgages, their share of total conforming originations that year would be less than 3 percent. Furthermore,
Inside Mortgage Finance ​indicates that over 31% of subprime MBS and 9 percent of Alt A MBS in 2007
were “GSE eligible”—i.e. conforming mortgages eligible for GSE purchase--further reducing the incentive
of portfolio lenders to hold these mortgages in unsecuritized form. It is also noteworthy that while there is
no consensus conclusion from the expanding literature on whether securitization created lax underwriting
standards—see for example the contrast between Bubb and Kaufman (2009) and Keys etal. (2010)—there
is no finding that portfolio lenders were systematically retaining high-risk mortgages.
18
since some loans have more than one of these attributes. The aggregate high-risk
originations shown in row (4) net out all double counting.​13 ​Row (6) shows the
percentage of high-risk mortgages as a share of total conforming mortgages (in row 5).
This high-risk share of total conforming originations rose steadily through 2004 and then
declined steadily thereafter.
Panel B of Table 3 computes the share of the conforming mortgages acquired by
the GSEs—whether as backing for guaranteed MBS or to hold on their balance sheets--
for each risk attribute. For example, in 2001, the GSEs acquired about 92.2 percent of all
conforming mortgages with LTV ratios above 90 percent. For all 3 of the risk attributes,
the GSE share fell steadily through 2005 and then expanded rapidly through 2007. By
2007, the GSEs were acquiring 79.9 percent of the high-risk, conforming, mortgage
originations. In interpreting these numbers, however, it must be recognized that, as shown
in row (11), the GSEs represent a large share of the overall conforming mortgage market;
as their overall market share approaches 100 percent, their share of each risk attribute
would necessarily do the same.
Panel C corrects for the large GSE share of the conforming market by computing
a “relative intensity,” dividing the GSE market share for each risk attribute in Panel B by
the overall GSE market share in Row (11). A coefficient of one indicates the GSEs are
holding the “market portfolio,” whereas coefficients below one indicate they are avoiding
risky mortgages and coefficients above one indicate the GSEs are actively acquiring risky
mortgages. The pattern for each of the three risk attributes shows the relative intensity
13 ​Forexample, for the fixed-rate mortgage originations in 2007, 2.2 percent had LTV > 90 percent and
FICO score < 620. For adjustable rate mortgages in 2007, 19.2 percent had either LTV > 90 percent or
FICO score < 620. Overall, in 2007 4.7 percent of the originated mortgages had more than one of the highrisk
attributes.
19
rising steadily starting in 2005. In each case, the high point of the seven-year history was
reached in 2007. Since the relative intensities over the full time span are generally less
than one, it would appear the GSEs were not leading the market for high-risk lending as
the subprime boom took off.​14 ​But the jumps in the relative intensities in 2007 for most of
the indicators suggest that the GSEs then rapidly expanded their participation in the
subprime boom. This is one key basis for our conclusion that the GSEs were a
destabilizing influence on the conforming mortgage market as the subprime boom headed
to its peak in 2007.
The analysis has so far focused on the GSE acquisition of high-risk mortgages as
a share of the overall conforming mortgage market. We now consider the GSE
acquisition of high risk mortgages as a share of their total acquisitions. Table 4 reports
the first three attributes high LTV ratios; low FICO scores; and ARMs; as reported in
Table 3. The time pattern is again distinctive, with the share of the GSEs new business
dedicated to mortgages with these high-risk attributes generally rising starting in 2004,
the only exception being the declining share of ARM acquisitions by Fannie Mae. The
companies also reported their acquisitions of interest-only, condo/coop, and investor
mortgages; and here too the pattern is generally rising from 2004. 2007 represents the
year of maximum share for each high-risk mortgage attribute with the exception of
Fannie Mae ARMs and Freddie Mac interest-only mortgages. These data thus present a
second independent basis for our conclusion that the GSEs were a decidedly destabilizing
influence on the conforming mortgage market as the subprime boom headed to its peak in
2007.
14 ​Thomas and Van Order (2011), although using different datasets, come to the same conclusion.
20
A.5 Mortgage Markets Without GSEs
The analysis above leaves little doubt that the GSEs destabilized the U.S.
mortgage market during the later stages of the subprime boom, but there is a further
question how the U.S. mortgage markets would function without the GSEs. To help
answer this, in this section we consider evidence from two sources: (1) how the U.S.
mortgage markets have performed without GSEs, and (2) the performance of the
mortgage markets in Western European countries.
The evidence that private mortgage markets have operated effectively in the U.S.
economy can be summarized with three comments on the historical role of private
markets within the U.S. mortgage market. First, private markets have always originated
100% of U.S. mortgages, and closing the GSEs would not affect this. Second, the GSEs
have never held a significant share of the outstanding U.S. home mortgages, this share
being, for example, 12 percent at year-end 2010. Third, the GSE MBS share of total
home mortgages first exceeded 30% only in 2007. This confirms that the private
markets—depository institutions and capital market investors--are capable of holding or
securitizing the large majority of U.S. mortgages. It is also noteworthy that the market for
jumbo mortgages—mortgages that exceed the conforming loan limit--has generally
functioned quite satisfactorily.
Turning to the European evidence, the European economies and housing markets
are sufficiently similar to the U.S. to provide a potentially interesting comparison, while
they have the key distinction that government intervention in these housing and mortgage
markets is far less than for the U.S.; in particular, none of these countries has entities with
21
any significant resemblance to the U.S. GSEs.​15 ​This conclusion is stated very clearly by
Coles and Hardt (2000, p. 778):​16
“There is no national or European government agency to help lenders fund
their loans. Mortgage loans have to be funded on the basis of the financial
strength of banks or the intrinsic quality of the securities. EU Law (Article
87 and 88 of the EC treaty) outlaws state aid in the form of guarantees as
there may be an element of competitive distortion.”
Table 5 compares the U.S. and Western European mortgage markets for a range
of quantitative attributes from 1998 to 2010 based on a comprehensive data base of
housing and mortgage data for fifteen European countries from the European Mortgage
Federation (2010). Column 1 compares the most recent owner occupancy rates for the
U.S. and European countries. The U.S. value is 66.9 percent, which is just below its peak
subprime boom value. It is frequently suggested that the high rate of homeownership is
the result of the large U.S. government support of the mortgage market, including the
GSEs. It is thus highly revealing that the U.S. rate is just at the median— eight of the
European countries have higher owner occupancy rates—and slightly below the average
value for the European countries. Furthermore, the lower owner occupancy rates in some
of the countries, Germany for example, appear to be the result of cultural preferences
rather than government inaction. A full analysis of the determinants of owner occupancy
rates across countries should also control for the age distribution of the population, since
younger households, and possibly the oldest households, may have lower ownership rates
in all countries. Chirui and Jappelli (2003) provide a start in this direction, showing that
lower downpayment rates are a significant factor encouraging owner occupancy after
15 ​SeeEuropean Central Bank (2009) for an extensive review of housing finance in the European Union
countries.
16 ​Hardt was the Secretary General of the European Mortgage Federation at the time.

22
controlling for the population age structure in a sample of fourteen OCED countries. The
U.S. has also generally benefitted from very low downpayment rates, but it still has an
average ownership rate, reinforcing the conclusion that the government interventions
have been largely ineffective in raising the U.S. home ownership rate relative to its peers.
Column 2 measures the volatility of housing construction activity from 1998 to
2010 based on the coefficient of variation of housing starts as a measure of relative
volatility. The U.S. relative volatility is third highest out of the 16 countries, implying
that the government interventions have failed to reduce U.S. housing cycles relative to
those in Western Europe. Column 3 measures the volatility of house price changes based
on the standard deviation of the annual house price appreciation from 1998 through 2010.
Here the U.S. stands fifth, meaning the country has faced a relatively high rate of house
price volatility. This negative result is all the more significant because the U.S. is far
larger than any of the individual European countries, and thus the benefits of regional
diversification should have lowered the observed U.S. volatility.
Column 4 compares the level of mortgage interest rates in Western Europe and
the U.S., using “representative variable mortgage rates” for Europe and the Freddie Mac
one-year ARM commitment rate for the U.S. The column shows that the U.S. has the
sixth highest average mortgage interest rate from 1998 to 2010, and exceeds the Western
European average by 27 basis points. Since overall interest rates also vary across
countries, as a further test, column 5 shows the average spread between the mortgage rate
and the Treasury bill rate for each country. The U.S. ranks third highest based on the
spread and exceeds the Western European average by 70 basis points. Of course,
numerous factors determine these mortgage rates and spreads, including the precise terms
23
of the variable rate mortgages, other contract features such as downpayment
requirements, and the generally greater credit risk of U.S. mortgages. Nevertheless, the
fact remains that despite the government subsidies and other interventions in the U.S.
residential mortgage markets, U.S. mortgage rates have remained among the highest
levels compared with the countries of Western Europe. Finally, Column 6 shows the
20109 ratio of home mortgages outstanding to each country’s annual GDP, a standard
measure of the depth of a country’s mortgage market. The U.S. ratio is 75.5 percent
which puts it sixth within this group of sixteen developed economies. A relatively high
U.S. result would be expected, given the large mortgage subsidies provided through the
GSEs and other channels. It is noteworthy, therefore, that five Western European
countries achieved even higher ratios without substantial government interventions in
their mortgage markets
The overall conclusion has to be that Western European mortgage and housing
markets have outperformed the U.S. markets over the full range of available measures.
Although data are not provided here, a similar conclusion would hold for the Australian
and Canadian mortgage markets; see Lea (2010). There are, of course, a wide range of
possible explanations for the superior performance of the European mortgage markets.
The key point for present purposes is simply that the superior performance of the
European mortgage markets is ​not ​explained by greater government intervention. In the
absence of GSEs, almost all Western European mortgage lending is carried out privately
by banks, primarily funded by bank deposits or covered bonds. Other indirect forms of
government support, such as the tax deductibility of mortgage interest and property taxes
are also notably absent in most European countries.
24
B. Other Justifications for GSE Subsidies
The activities of the GSEs are justified by the particular benefits accruing to
specific classes of borrowers, or more specifically, to all home purchasers and
homeowners from the activities supported by these institutions. As noted above, benefits
have been claimed for the stabilization of the mortgage supply and corresponding
reductions in the volatility of housing construction and home sales. But there are at least
three other classes of potential benefits arising from the GSE:
Increases in the extent of mortgage credit accruing to income and demographic
groups that policy-makers appear to have deemed particularly deserving -- credit which
augments that supplied by the private marketplace;
Increases in the lending support provided to builders, owners, or residents of
specific types of housing, ​e.g.​, multifamily rental housing, which would otherwise not be
provided in the market;
Subsidies accruing more broadly to housing market participants, for example, to
all home purchasers in the form of lower interest costs arising from the increased
liquidity afforded by the GSEs and the implicit guarantee of repayment provided by those
institutions;
This section reviews the evidence on the extent and distribution of these benefits.
1. Increased Credit to Targeted Groups and Geographical Areas
The original charter establishing Fannie Mae as a GSE in 1968 recognized a
“national goal of providing adequate housing for low and moderate income households,”
and it authorized the Secretary of the Department of Housing and Urban Development
(HUD) to require that a reasonable portion of Fannie Mae’s purchases of home
25
mortgages be related to this goal. Although regulations requiring the GSEs to allocate a
fixed percentage of mortgage purchases to lower-income households were advanced in
the 1970s, mandatory rules were not proposed in Congress until after the passage of the
Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989.
Ultimately, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992
modified and made more explicit the “housing goals” to be promoted by the GSEs. The
Act directed the HUD Secretary to establish quantitative goals for mortgages to “lowand
moderate-income” households and for mortgages originated in “underserved areas.”
It also imposed a “special affordable housing goal” for mortgages for low-income
housing in low-income areas. The 1992 legislation stipulated two-year transition goals,
but after that period, the HUD Secretary was empowered to promulgate more detailed
regulations.
Under the HUD regulations, finalized in December 1995, the first goal (“low- and
moderate-income housing”) directs that a specified fraction of new loans purchased each
year by the GSEs be originated by households with incomes below the area median. The
second goal (“underserved areas”) requires that a specified fraction of mortgages be
originated in census tracts with median incomes less than 90 percent of the area median,
or else in census tracts with a minority population of at least 30 percent and with a tract
median income of less than 120 percent of area median income. The third goal (“special
affordable housing”) targets mortgages originated in tracts with family incomes less than
60 percent of the area median; or else mortgages in tracts with incomes less than 80
percent of area median and also located in specific low-income areas. Any single
mortgage can “count” towards more than one of these goals. (For example, any loan that
26
meets the “special affordable housing” goal also counts towards the “low- and moderateincome”
goal.)
The numerical goals originally set by HUD for 1996 were modest – requiring, for
example, that 40 percent of the GSEs’ mortgage purchases be loans made to households
with incomes below the area median. Over time, the goals for new business set by HUD
have been increased.​17 ​The goal for mortgages to low- and moderate-income households
has been increased from 40 percent in 1996 to 56 percent by 2008. Until 2007, mortgage
originations by both Fannie Mae and Freddie Mac had reached their primary goals every
year. The HUD goal for “underserved areas” was increased from 21 percent in 1996 to 39
percent in 2008. Originations by the larger GSE, Fannie Mae, exceeded this goal in every
year; originations by Freddie Mac exceeded the goal in each year until 2008. The “special
affordable” housing goal was increased by HUD from 12 percent in 1996 to 27 percent in
2008. Both GSEs surpassed this goal in loan originations each year until 2008.
Figures 5, 6, and 7 report the HUD goals and GSE progress in achieving those
goals from their publication in 1995 to the federal takeover of the GSEs in 2008.
Figures 8, 9, and 10 provide another perspective on the magnitude of the goals set
by HUD for the GSEs. They report each of the three goals as well as an estimate of the
share of all newly-issued mortgages in each of the categories. For example, in 2000 the
HUD-specified “low- and moderate-income goal” was to reach 42 percent of new
purchases for the GSEs. However, in 2000 low- and moderate-income mortgages,
according to the same definition, constituted about 59 percent of all new mortgages. At
17 ​Note,
however, that at the time that the 1992 act was debated in Congress, only 36 percent of Fannie
Mae’s single-family deliveries were for housing whose value was below the area median. (See FHFA
Mortgage Market Note, ​The Housing Goals of Fannie Mae and Freddie Mac​, February 1, 2010.)
27
that time, the “underserved areas” goal was 21 percent of GSE mortgages, while these
mortgages constituted more than a 30 percent market share of new mortgages. In virtually
all cases, the goals imposed were a good bit lower than the share of mortgage loans of
that type originated in the economy. There is no evidence that the goals were set so that
the GSEs would “lead the market” in servicing these groups of households.
2. Increased Credit to Targeted Housing Types: Multifamily
Numerical goals for purchases of multifamily mortgages are not mentioned in the
Financial Safety and Soundness Act of 1992, but there was considerable concern at the
time that the GSEs were not financing their “fair share” of multifamily housing,
especially small multifamily properties. For example, in 1991, small multifamily units
accounted for less than five percent of Freddie Mac’s multifamily unit purchases. At that
time, small multifamily units constituted 39 percent of all recently-financed multifamily
units. (See Herbert, 2001.) Thus, the first rules for implementing the 1992 Act put
forward by HUD also included explicit goals for multifamily housing.
These goals have been in the form of dollar-based targets. Goals in 1996-2000
were approximately 0.8 percent of the mortgage purchases of Fannie Mae and Freddie
Mac recorded in 1994; goals in 2001-2004 (2005-2007) were 1.0 percent of each GSE’s
estimated mortgage purchases in 1997-1999 (2000-2002). Beyond the achievement of
these numerical goals, multifamily mortgage purchases also qualified for “bonus points”
towards the achievement of the three goals specified in the 1992 law. It has been argued
that these “bonus points” (discontinued in 2004) were a major inducement leading to an
increase in participation by the GSEs in the multifamily housing market, particularly in
their financing of small multifamily properties. (See Manchester, 2007.)
28
Figure 11 reports the dollar goals for multifamily dwellings specified by HUD
regulations and the performance of each of the GSEs. As noted in the figure, until quite
recently purchases of multifamily dwellings exceeded the HUD goal by a substantial
amount.
V. Broad Benefits to Homeowners and Purchasers
a. The Effectiveness of the GSE Goals in Directing Mortgage Credit
Of course, the finding that the GSEs have achieved the annual goals specified in
regulations need not imply that Freddie and Fannie have been very effective in increasing
mortgage credit to targeted groups. For example, many suggest that the numerical goals
set for the GSEs have been far too low (​e.g.​, Weicher, 2010), and that, as a result the
GSEs have simply followed the market with a lag of a few years. Indeed, the data in
Figures 5, 6 and 7, provide no evidence that Freddie Mac or Fannie Mae purchased more
than their “fair share” of mortgages in any of these areas of congressional concern. GSE
purchases of mortgages that satisfied any of these congressional goals – as a fraction of
all new purchases – were consistently smaller than their “market share” in all newlyissued
mortgages.
Similarly, Figure 11 indicates that the GSEs’ new purchases of “special
multifamily” mortgages greatly exceeded the dollar goals mandated by HUD in every
year.
Finally, Figure 12 demonstrates that the GSEs’ multifamily housing business was
only a small fraction of the mortgage purchases of the GSEs in any year. It never
amounted to even seven percent of either GSEs’ purchases.
29
Figure 13 reports the aggregate amount of commercial mortgage backed security
(CMBS) and multifamily originations between 2003 and 2009 as reported by the
Mortgage Bankers of America. Mortgage originations by Freddie Mac and Fannie Mae
were small – less than $9 billion in any year. Until 2008, GSE originations were less than
twenty percent of all such mortgage banker mortgage originations. Note, however that in
2008-2009, CMBS and commercial banks left the market entirely; originations by life
insurers declined as well. Since the conservatorship in 2008, virtually all multifamily
mortgages have been originated by the GSEs.
These simple comparisons suggest that any causal effect of the GSEs on lending
to specific income classes, neighborhoods, and property types is not likely to be large –at
least before 2008. Economic analysis of the potential impacts of the GSEs is also
complicated by other public programs in effect. For example, in 1977, the Community
Reinvestment Act (CRA) was passed to encourage banks to exert further efforts to meet
the credit needs of their local communities, including lower-income areas. In identifying
neighborhoods of special concern in administering the CRA, neighborhoods (census
tracts) with median incomes below 80 percent of the area median income are targeted. As
noted above, “underserved areas” of concern in GSE regulation are census tracts with
median incomes below 90 percent of the area median income. In addition, many
borrowers targeted under GSE criteria are also eligible for Federal Housing
Administration (FHA) loans or Veterans’ Administration (subsidized) loans.
The existence of parallel government programs under the CRA, FHA, and VA
raises the possibility that the GSE purchases of qualifying mortgages simply displaced
lenders who would have made the same mortgage under one of the other programs. To
30
the extent that this has been the case, the GSE purchases would have had no noticeable
impact on the mortgage market for the qualifying borrowers. Of course, it is a subtle
empirical problem to determine whether the GSE purchases were simply displacing loans
from the other programs. Nevertheless, a number of academic papers have sought to
identify and quantify the effects of the GSE goals on local and neighborhood housing
markets and on classes of borrowers.
Table 6 summarizes much of this research.
An early paper by Canner, Passmore and Surette (1996) examined loans eligible
for insurance under the FHA. The authors evaluated how the risk associated with these
loans is distributed among government mortgage institutions, private mortgage insurers,
the GSEs, and banks’ in-house portfolios. The results indicated that FHA bears the
largest risk share associated with lending to lower-income and minority populations, with
the GSEs lagging far behind. Bostic and Gabriel (2006) analyzed the effects of the GSE
mortgage purchase goals upon homeownership and housing conditions in California. A
careful comparison of neighborhoods just above the GSE cutoff for “low-moderateincome”
and “special affordable” designation with nearby neighborhoods just below the
cutoff found essentially no differences in the levels and differences in home-ownership
rates and housing conditions during the decade of the 1990s.
In a more sophisticated analysis using a similar comparison of neighborhoods
“just above” and “just below” the GSE cutoff, An, ​et al​, (2007) focused on three
indicators of local housing markets: the home ownership rate, the vacancy rate, and the
median home value. The authors related (an instrument for) the intensity of GSE activity
in a census tract to these outcomes, using a variety of control variables. The results
31
indicated that increases in GSE purchase intensity were associated with significant but
very small declines in neighborhood vacancy rates and increases in median house values.
The authors conclude that the “results do not indicate much efficacy of the GSE
affordable housing loan-purchase targets in improving housing market conditions (2007,
p. 235).”
Two papers by Bhutta (2009b, 2010) adopted a regression discontinuity design to
test the effects of the “underserved areas” goal upon the supply of credit to those areas.
Rather than attempt to match similar neighborhoods for statistical analysis, Bhutta
exploited the facts that census tracts qualified for CRA scrutiny if their median incomes
were 80 percent of the local area, and they qualified for scrutiny under the HUD GSE
goals if their median incomes were 90 percent of the area median design. Bhutta merged
tract-level data on mortgages (from the Home Mortgage Disclosure Act) with
neighborhood (census) data. Bhutta’s results (2009a) do find a significant effect of the
“underserved area” goal on GSE purchasing activity – but the effect is very small (2-3
percent during the 1997-2002 period).
A more recent paper by Moulton (2010), also using a regression discontinuity
approach, finds no effect of the GSEs -- on individual loans rather than aggregate credit
allocations. Moulton uses micro data on mortgage loan applications to examine whether
the GSE’s affordable housing goals altered the probability that a loan application was
originated by a mortgage lending institution or that a loan was purchased by one of the
GSEs. The analysis led to the conclusion that the GSE affordable housing goal had no
effect at all on mortgage lending or on GSE purchases.
32
The consistent finding of little or no effect of the GSE goals on housing
outcomes, mortgage applications, or mortgage finance could suggest that there is little
effect of the GSE rules upon FHA lending as well. But several papers have reported that
an increased market share of GSE mortgages in a census tract is associated with a decline
in the FHA share of mortgages (An and Bostic, 2008; Gabriel and Rosenthal, 2010).
These results may explain why the increases in lending mandated by the HUD
regulations to achieve the congressional goals of the 1992 Act have had very little net
impact on housing and neighborhood outcomes. Small increases in GSE activity have
been offset by roughly comparable declines in FHA activity.
The extent to which an expansion of GSE activity simply crowds out private
mortgage purchases remains an open research question. For example, Gabriel and
Rosenthal (2010) argue that increased GSE activity in the mortgage market involved little
or no crowd-out until about 2005. After that, GSE activity crowded out private activity
until the crash in mortgage markets in 2007.
But even if there were a complete crowd-out of private mortgage activity arising
from GSE behavior , it is hard to attribute any of this to the goals set by the 1992 Act –
especially since the goals were substantially less than the share of these new mortgages in
the market.
To summarize: the academic and scientific literature has generally found little
effect from housing goals as they operated through the GSEs. The goals were low.
Despite appearances, they provided no incentive for the GSEs to “lead the market” in
providing credit to potentially riskier housing investments. They accomplished nothing in
increasing credit for riskier loans.
33
But there is a view that the housing goals were actively harmful in facilitating the
subprime housing crisis.
This position has been put most forcefully by Peter Wallison (2011) in his rebuttal
statement to the Financial Crisis Inquiry Commission. He argues that the requirement to
meet the housing goals “forced” the GSEs to make substandard loans, which is why they
ultimately acquired such large positions in subprime mortgages and subprime mortgage
securities. Indeed, Wallison claims that the HUD goals actually “caused” the subprime
crisis. There is no question that the GSEs ultimately acquired large portfolios of subprime
mortgages and securities -- see our discussion in Section IV.A.4 above -- but Wallison
provides no evidence at all that these subprime portfolios had anything to do with the
GSE goals.
However, an impressive journalistic account of recent history in the mortgage
market argues forcefully that the housing goals in the 1992 act led directly to the
subprime mortgage debacle of 2008 (Morgenson and Rossner, 2011). Our analysis of the
academic literature supports no such claim. It is certainly possible that the passionate
rhetoric from the GSEs provided a convenient “cover” for the trend towards lower
quality, even toxic, mortgages by 2004-2005. However, there is no evidence that this
rhetoric increased GSE lending to targeted groups during the 1990s. Ironically (or
perhaps diabolically), the rhetoric about “affordable housing” from the GSEs had little
effect upon ​their own mortgage purchases ​until the subprime crisis was well underway.
As noted above, the empirical evidence simply fails to support a claim that the
GSE housing goals were a primary source of the subprime crisis. First, there are simple
questions of timing. The GSE goals were enunciated in a law passed in 1992; it is
34
implausible that their effect was not felt until a quarter century had elapsed. Further, as
noted below, the GSE accumulation of subprime mortgages accelerated only in 2007, too
late to have “caused’ the subprime bubble (but certainly early enough to have accelerated
it).
Second, as noted above, it appears that the GSE mortgage purchases in support of
the housing goals were principally loans that would otherwise have been made by other
lenders.
Most importantly, the subprime crisis has a long list of proximate causes,
including U.S. monetary policy, a global savings glut, the error of assuming a national
housing pricing collapse was highly unlikely, etc. (see Jaffee, 2009 for further
discussion.)
b. Benefits to all housing market participants
There has been active research seeking to establish the value of the enhanced
liquidity and subsidy to homeowners. In principle, the subsidy provided by the implicit
guarantee can be calculated. Freddie Mac and Fannie Mae issue debt in the same market
as other participants in the banking and finance industry participate. The yield difference
(“spread”) between the debt of the GSEs and that of other firms can be applied to the
newly issued GSE debt to compute the funding advantage in any year arising from the
GSE status. Of course, it is not quite straightforward to apply this principle and to
produce credible estimates. The relevant benchmark estimate (​i.e.​, the appropriate sector
and bond rating) is not without controversy, and a comparison with broad aggregate
indices combines bonds containing a variety of embedded options. Pearce and Miller
(2001), among others, reported comparisons of GSE and AA-rated financial firms,
35
suggesting that the agencies enjoyed a 37 basis point (bps) spread. More sophisticated
comparisons by Nothaft, ​et al​, (2002) suggest that the relative spreads are about 27 bps
(vis-à-vis AA-minus firms). Table 7 summarizes available comparisons. A careful
analysis of yields at issue for GSE debt and the option-free debt issued by a selection of
finance industry corporations (Ambrose and Warga, 2002) concludes that the GSEs enjoy
a spread of 25-29 bps over AA bank bonds and 37-46 over AA financials. Quigley (2006)
provides a terse summary of available estimates.​18
The substantial subsidies arising from the funding advantage of the GSEs means
that mortgage rates for all homeowners can be lower than they otherwise would be, that
is, the subsidy can improve the well-being of homeowners and home purchasers.
But of course, in the first instance the subsidy is provided directly to private
profit-making firms with fiduciary duties to their shareholders. It is thus not obvious that
all, or even most, of the funding advantage provided by the public subsidy is passed
through to homeowners. As documented by Hermalin and Jaffee (1996), the secondary
market for mortgage securities (at least for those securities composed of loans
comparable to the rules under which Fannie and Freddie operate) is hardly a textbook
model of atomistic competition. The two GSEs are large, and each has a large market
share of the conforming segment of the market. There are high barriers to entry, and the
MBS product is more-or-less homogeneous. Moreover, mortgage originators have an
inherent first-mover advantage in deciding which newly-issued mortgages to sell to
Fannie and Freddie. This may force the GSEs to pay a premium for the mortgages they
18 ​These
estimates are in the range of the spreads which have been assumed (41 bps) by the Congressional
Budget Office (CBO, 2001) in estimating the annual federal subsidy to the GSEs. They are similar to the
estimates of spreads (40 bps) used by Passmore, (2005) in a more recent exercise.
36
purchase in the market. These factors, duopoly and adverse selection, may mean that
much of the subsidy accrues to the shareholders of the GSEs or to the owners of other
financial institutions, not to homeowners or home purchasers.
The effects of the GSEs upon mortgage rates can be calculated by estimating the
spread between the interest rates on mortgages which conform to the loan limits and
underwriting guidelines of the GSEs and the rates on otherwise comparable mortgages.
As in the analysis of funding advantages, it is not quite straightforward to apply this
principle and to produce credible estimates. (For example, most research compares the
rates paid by borrowers with loans one dollar below the conforming limit with rates paid
by borrowers with loans one dollar above the limit. But the latter group of borrowers
differs from the former group, or else they surely would have made an additional cash
payment and taken a conforming loan.)​19
Early analyses, ​e.g. ​by Hendershott and Shilling (1989) comparing interest rates
on jumbo and conforming mortgages, indicated that this spread was 24-39 bps. More
recent studies, ​e.g.​, by Passmore, ​et al ​(2002), by McKenzie (2002), and by the CBO
(2001), conclude that the spread is 18-23 bps. These more recent studies differ mostly in
their application of more complex screens to insure comparable data for conforming and
nonconforming loans. Table 8 summarizes these comparisons. More recent work by
Passmore, ​et al ​(2005) suggests that this spread may be as low as 16 bps.
19 ​Ofcourse, other reasons besides the greater liquidity provided by the GSEs could explain some of an
observed spread between jumbo and conforming mortgages. Jumbo mortgages are generally prepaid more
aggressively -- borrowers have more at stake, if nothing else. This means that investors will require higher
rates on jumbos merely to compensate for the increased prepayment risk. On the other hand, borrowers
with jumbo mortgages have better credit, and they make larger down payments, which should create lower
rates on jumbo mortgages. See, also, Ambrose, ​et al ​(2001), Heuson, ​et al ​(2001), or Woodward (2004b).
37
In summary, it appears that the GSEs’ funding advantage is about 30-40 bps, and
the effect of this is to reduce mortgage rates by 16-25 bps. Stated another way, on the
order of half of the subsidy rate to the GSEs is transmitted to homeowners in the form of
reduced mortgage interest rates. Presumably, the remainder is transmitted to the
managers of the GSEs, the shareholders of the enterprises or to the owners of other
financial institutions.​20
VI. Where Do We Go From Here?
As noted in the introduction, most commentators agree that the current structure
of the housing finance system must be reformed in the very near term. A question of firstorder
importance is then the likely consequences of the role of government in support of
the U.S. housing and mortgage markets, whether as a modification or replacement of the
GSEs.
The research results reported in this paper make it clear, we think, that the public
benefits arising from the GSEs have been quite small. The establishment of Fannie Mae,
a half century ago, and the establishment of Freddie Mac, forty years ago, did stimulate a
more stable national market for housing finance and did substantially improve the
liquidity and access of the market. As reported above, however, the specific benefits
arising from the GSE structure have been minor. In any event, these benefits -- with some
contributions from the GSEs -- were achieved by the 1980s. There now exists a national
market for home mortgages. The GSEs have followed reform in the secondary market
and have benefited from private innovation.
20 ​Of
course, the net effects of the GSEs upon public welfare and the economy has greatly exceed the three
effects upon housing market participants discussed here. Indeed, the evidence suggests that the macro
economic effects of the structure and operation of the GSEs during the past half decade has been much
more important for the economy than the direct housing-market effects of the institutions.
38
There have been surprisingly few benefits to deserving households or
neighborhoods which can be attributed to the GSEs. There has been more political or
partisan attention to the cause of homeownership among lower-income households as a
result of powerful advocacy by the interests of GSEs, but there is little evidence that
lower-income homeownership was stimulated at all, at least not until the run up to the
housing bubble.
It is true that the GSE structure has reduced interest rates on home mortgages, by
about a quarter percent or so. But this benefit to homeowners has arisen from the federal
guarantee for GSE debt. And the public cost of the subsidy has been far more than the
benefits of lower interest rates to homeowners. About half of the overall subsidy has
accrued to GSE employees, shareholders, and other market intermediaries. These large
losses are directly attributable to the GSE structure which was created in 1968.
As noted below, we also conclude that the structure of the GSEs themselves has
made regulation of the housing market far less transparent and has extended some of the
consequences of the housing bubble of the past half decade.
A. The Appropriate Role for Government in the U.S. Residential Mortgage
Market
If the GSEs in current form are to be closed, the fundamental policy question is to
decide which government interventions, if any, should replace GSE functions and which
should be performed by the private sector? Once that is decided, there is also the delicate
issue of how to manage the transition from the current GSE conservatorship. Fortunately,
there are two quite flexible instruments available to close down the GSEs in a smooth,
safe and dependable manner: (i) steadily reduce the conforming loan limit until it reaches
39
zero; and (ii) steadily raise the fee charged by the GSEs for guaranteeing MBS. Although
we will return to questions of the dynamic transition below, the key question is to
determine the appropriate role of government in the U.S. mortgage market.
A large number of proposals have been offered for the reform of the U.S.
mortgage market, ranging from a mortgage market managed primarily by private sector
entities to recreation of the GSEs as public/private hybrids (albeit with new controls).
Summaries and analyses of the general approaches are available in U.S. General
Accountability Office (2009), Congressional Budget Office (2010), and Bernanke (2008).
The following is an annotated list of the three primary proposals scrutinized:
​Reestablish GSEs with tighter controls and explicit guarantees. The entities would
continue their organization as public/private hybrids, but with tight government
controls, sometimes described as a “public utility” model. In most plans, the
government guarantees would apply to the underlying mortgages, not the newly
created entities. A cooperative structure such as that of the current Federal Home
Loan Banks is an alternative version. The number of entities to be chartered varies by
proposal.
​Restructure GSE functions explicitly within a government agency. A simple version
would create a government agency that would explicitly insure mortgages up to some
conforming limit and then securitize pools of these mortgages, very much as the
current FHA and GNMA agencies operate. The support for underserved borrowers
and areas, including multi-family housing, currently covered under the GSE housing
goals, would then continue in a revised form as explicit government programs.
40
​Privatization of the U.S. mortgage market. This proposal would create a fully
privatized mortgage market, with no special federal backing for the secondary
mortgage market, although this could include spinning out the GSEs as new private
entities.
More recently, in February 2011, the U.S. Treasury and Housing and Urban
Development agency, U.S. Treasury/HUD 2011), issued a white paper that offered an
alternative list of three policy options. The policy options were based on three principles
(White paper, p. 11):
1. Pave the way for a robust private mortgage market by reducing government support for
housing finance and closing down Fannie Mae and Freddie Mac on a responsible
timeline;
2. Address fundamental flaws in the mortgage market to protect borrowers, to help ensure
transparency for investors, and to increase the role of private capital;
3. Target the government's vital support for affordable housing in a “more effective and
transparent manner.”
In effect, these principles rule out the reestablishment of the GSEs as
private/public hybrids.
The White paper then offers three options for long-term mortgage market reform:
Option 1: A privatized system of housing finance with the government insurance role
limited to FHA, USDA and Department of Veterans’ Affairs’ assistance for narrowly
targeted groups of borrowers.
41
Option 2: A privatized system of housing finance with assistance from FHA, USDA and
the VA for narrowly targeted groups of borrowers and a guarantee mechanism to scale up
during times of crisis.
Option 3: A privatized system of housing finance with FHA, USDA and the VA
assistance for low- and moderate-income borrowers and catastrophic reinsurance behind
significant private capital.
Since the publication of the White paper, most discussions of specific proposals
among academics, public interest groups, and market participants have centered on
versions of the “Option 3.” The alternative views expressed in these discussions mainly
concern the extent and form in which the government’s mortgage guarantees would be
provided. Of course, if the government guarantee is sufficiently limited, “option 3” is no
different from “option 2.” While these discussions have focused on the form of the
government mortgage guarantee, most commentators agree that the abusive mortgage
market practices that evolved during the subprime boom must be ended through
regulation; see U.S. Treasury/HUD (2011, pp.15-18). In fact, Federal Reserve (2008)
actions to modify the Truth in Lending Act and a wide range of requirements in the
Dodd-Frank Act have already gone a long way to eliminating any possible replay of such
abusive practices in the U.S. mortgage market. Most commentators also appear to agree
that the GSE housing goals should be replaced with an explicit and transparent system of
targeted support for access and affordability. An obvious solution, and one endorsed by
the White Paper, is to strengthen and expand the FHA for this purpose. The White Paper
also proposes a public commitment to affordable rental housing.
42
B. Government Insurance of U.S. Mortgages
We now review the major issues and differences among the plans that are
proposed as the mechanism to replace the GSEs with a program of federal government
mortgage insurance. Specific versions are available from Acharya, Richardson Van
Nieuwerburgh, and White (2011), the Center for American Progress (2010), Ellen, Tye,
and Willis (2010), and Hancock and Passmore (2010). While the plans differ in details
and specificity, a composite can be summarized:
1) The plans anticipate government regulations will set the underwriting standards to be
met by all mortgages that underlie the qualifying MBS, roughly comparable to the
standards historically applied by the GSEs. The plans also generally anticipate a size limit
roughly equivalent to the conforming loan limit historically applied to the GSEs;
2) Investors in the qualifying MBS will be protected from all default risk by a
combination of private capital and government guarantee. The government guarantee
component is considered essential. The various plans differ primarily in the split between
private capital and government guarantee;
3) Risk-based insurance premia will be paid to the private capital and the government as
compensation for the risks they bear.
For simplicity, we refer to this structure as the “government insurance proposal.”
A key feature of the insurance proposal relative to any plan that would recreate the GSEs
is that the government would set the underwriting standards and be compensated for the
risk it bears.
The immediate question is whether the government can be effective and efficient
in carrying out such a mortgage insurance program. Evidence is available from a variety
43
of existing government insurance programs. Perhaps the most positive evidence is the
FHA program itself. As noted earlier, this program has existed since 1934, sets its
premiums on an actuarial basis, and has never required a government subsidy or bailout
for its self-supporting programs. Most interestingly, as documented in Jaffee and Quigley
(2010), the FHA effectively sat out the subprime boom, allowing its overall market share
to fall from a peak share of twenty-five percent in 1970 to under two percent by 2006.
Even more dramatically, its market share of loans to minority borrowers, which had been
close to fifty percent of this market as recently as 2000, fell to well below ten percent by
2006. In effect, the FHA took no action to deter its traditional clients from switching to
private market lenders and the GSEs as the source of their mortgage loans. While this
inaction could not protect the FHA from the rising loss rate that is now affecting most
segments of the U.S. mortgage market, it has certainly minimized the dollar amount of
the losses that the FHA could still potentially impose on U.S. taxpayers.
The FHA thus provides a model, or even a precise mechanism, for a broad
government guarantee program, possibly covering the same market share—at times fifty
percent of the overall market—that was traditionally served by the GSEs. Indeed,
operating within its traditional programs, the FHA market share of total mortgage
originations has already jumped dramatically from under two percent in 2006 to over
twenty percent in 2010. The issue is whether the FHA mechanism, which has worked
well serving a well-defined set of lower-income clients, can scale efficiently to serve
what could be as much as three quarters of the entire U.S. mortgage market (summing a
50 percent GSE share with a traditional 25 percent FHA share). The major concern is
whether the FHA -- or any comparable government insurance plan -- can resist the
44
political ​pressures to reduce its underwriting standards and to subsidize its risk-based
insurance premiums. The evidence here is not encouraging.
An interesting and comparable case is the National Flood Insurance Program
(NFIP). The NFIP was created in 1968, following a series of disastrous mid-western
floods that caused a large part of the private insurance industry to stop offering flood
coverage. The NFIP legislation required premiums to be set on an actuarial basis,
including risk-based premiums, to discourage the construction of new homes in flood
zones. This noble goal floundered, however, when the owners of existing properties in
dangerous flood plains successfully lobbied to obtain special “grandfathered” premium
reductions. This all become evident when there were insufficient reserves to pay the
losses created by Hurricane Katrina, thus requiring taxpayer bailout of the NFIP on the
order of $22 billion. Further discussion of the NFIP see Michel-Kerjan and Kunreuther
(2011) and of failed government insurance programs in general see Jaffee and Russell
(2006).
The Terrorism Risk Insurance Act (TRIA) provides an alternative approach to
government insurance and may provide a useful structure for a government mortgage
insurance program. TRIA was first passed by Congress in 2002, following the terrorism
attack of September 2001. The issue was that, as a result of their World Trade Center
losses, virtually all property insurers were refusing to renew policies on large commercial
buildings unless there was a substantial government reinsurance program to cap their
potential losses. TRIA accomplished this goal with a structure in which the government
provides the insurers protection against possible catastrophic losses while placing the
insurers in the first-loss position with a series of deductibles and coinsurance
45
requirements. Roughly speaking, TRIA 2002 required the industry itself to cover most of
the losses that would have resulted from another event comparable to the sabotage of
2011, but provided quite complete government protection against any losses above that
level. TRIA has now been renewed two times, and both times the deductible and
coinsurance requirements have been raised, so a taxpayer loss would now occur only with
truly extreme events.​21
The specific proposals offered by Acharya, Richardson, Van Nieuwerburgh, and
White (2011) and Hancock and Passmore (2010) both reference “catastrophe insurance”
as the coverage to be provided under their plans. A particular concern, however, is that
MBS investors might not consider government catastrophe coverage to be a sufficient
inducement for them to take the first-loss positions on portfolios of U.S. mortgages. For
example, while the property insurers may have been most concerned with the last twenty
percent of the tail risk from terrorist attacks, investors in residential mortgage pools may
be primarily concerned with the first twenty percent of the risk distribution. In that case,
for a government mortgage insurance program to be effective, it may have to mimic the
NFIP more than TRIA. In other words, even if the starting point were the principle of a
backstop to catastrophe, the political process may create a plan that covers high-risk
mortgages at subsidized rates, i.e., GSEs with a different “cover.”
This appears to be the conundrum for creating a feasible program for government
insurance of U.S. mortgages. While a true catastrophe government insurance plan appears
feasible, investors and other market participants will, of course, have incentives to push
as much of the first-loss risk as possible under the government’s coverage. If the political
21 ​On the other hand, the government’s TRIA coverage is provided without charge.
46
process can stand firm on the issue, then it is quite possible that private incentives will
create an efficient market for U.S. mortgages. After all, it is hard to believe that only the
countries of Western Europe have the ability to create effective mortgage markets while
maintaining a low level of government intervention.
C. The Role of GSE Mortgage Market Activity under the Conservatorship
In concluding, it is relevant to comment on the role of GSE mortgage market
activity since the two firms were placed under a government Conservatorship in
September 2008. Relevant data on the home mortgage acquisitions of the GSEs and for
the total home mortgage market are shown in Table 9 for 2009 and 2010. The raw
numbers suggest a significant GSE and overall government role. For 2009 and 2010,
annual GSE mortgage acquisitions as a percentage of total home originations was 63
percent. FHA and VA activity averaged 24 percent of total home originations over the
same period, so government programs participated in 87 percent of all mortgage
originations for 2009 and 2010.
The high GSE market share under the Conservatorship, however, can be
misleading. First, 80 percent of all GSE mortgage acquisitions were refinanced loans, so
only 20 percent of the GSE activity represented loans for home purchase. The GSE
refinancing activity includes the refinancings that occurred under the Home Affordable
Refinance Program (HARP). In comparison, for the overall mortgage market, home
refinancings represented 68 percent of total mortgage originations, leaving 32% of the
originations for home purchase activity. The conclusion is that while the GSEs dominated
U.S. mortgage market activity in 2009 and 2010, most of this activity was simply the
refinancing of mortgage loans that had already been guaranteed by the GSEs. To be clear,
47
refinancing activities are certainly beneficial to the borrowers, and generally so for the
GSEs as well (since they reduce the likelihood of default on these loans for which the
GSEs are already at risk). On the other hand, refinancing is a zero-sum game, since the
investors who are holding the higher rate mortgages will have to reinvest their money at
the now lower market rates. Indeed, the Federal Reserve, U.S. Treasury, and GSEs are
major holders of these GSE mortgage securities, so the HARP program is far from costfree
for the government itself.​22
The GSEs also participate in the Home Affordable Modification Program
(HAMP), along with servicers for non-GSE home mortgages. As of September 2011, the
GSE share of total HAMP modifications was 52 percent, only slightly above the GSE
share of all outstanding home mortgages. This suggests that the participation rate in
HAMP modifications was about the same for GSE and non-GSE mortgages. Perhaps
more importantly, the HAMP program is widely considered to be a disappointment: as of
September 2011, just over 800 thousand loans had been modified, compared to the earlier
hopes of 3 to 4 million loans.
The overall conclusion is that the primary mortgage market result of maintaining
the GSEs under the government Conservatorship through 2011 appears to have been their
role as a catalyst for the refinancing of their existing mortgages. In terms of funding for
home purchase loans, private market lenders have actually been more active than the
GSEs, even without the benefit of a government guarantee.

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