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FINANCIAL RESTRUCTURING TO SUSTAIN RECOVERY
By MARTIN NEIL BAILY, RICHARD J. HERRING, YUTA SEKI
Brookings Institution PressCopyright © 2013 THE BROOKINGS INSTITUTION NOMURA INSTITUTE OF CAPITAL MARKETS RESEARCH
All rights reserved.
MARTIN NEIL BAILY RICHARD J. HERRING YUTA SEKI1
Introduction: Financial Restructuring to Speed Recovery
THE FINANCIAL CRISIS of 2007–08, which led to what is now known as the Great Recession, caused more widespread economic trauma than any other event in the postwar era. This experience has raised wide-ranging questions about how to reform the financial system to enhance its resilience and prevent the reoccurrence of such episodes. And, because the recovery has been disappointingly slow and uneven, attention has also turned to possible reforms to markets and the financial infrastructure that might speed recovery.
This volume focuses on some of those potential reforms. The Nomura Institute of Capital Markets Research, the Brookings Institution, and the Wharton Financial Institutions Center organized the conference, held in late October 2012, on which this volume was based. This volume contains the revised presentations made at the conference. After this introductory chapter, the second chapter examines potential reforms to the U.S. market for housing finance, the collapse of which played a central role in the crisis and has impeded economic recovery. The third chapter focuses on reform to the U.S. bankruptcy process, which is essential for the efficient reallocation of capital and labor. The fourth chapter considers the market for U.S. initial public offerings, which facilitates the growth of new firms, which are often believed to be the main source of growth in employment and productivity, and has been very slow to revive. The volume concludes with an examination of Japan's experience in attempting to reform the financial sector to resume growth. Japan's real estate market collapsed in the early 1990s and has struggled to recover for the past twenty years. Financial reform has been a central focus of policy and continues to be a challenge. Japan's experience may well hold lessons for the current plight of the U.S. economy. As this conference series has demonstrated over the years, contrasts between the experiences of Japan and the United States can often be illuminating regarding both what to do and what not to do.
In this introductory chapter we provide a summary of the book. A broad theme running throughout is that each of these aspects of the financial services industry can play a useful role in facilitating recovery and the resumption of growth, but the necessary reforms are sometimes subtle and often difficult to implement. Just as the financial sector was the source of many of the problems that caused the Great Recession, it may also have a crucial role to play in economic recovery.
In chapter 2, Franklin Allen of the Wharton School, University of Pennsylvania, James Barth of the Auburn University College of Business and the Milken Institute, and Glenn Yago of the Milken Institute discuss the restructuring of the U.S. housing finance system in a very broad context including both how the system has evolved from historical precedents in Europe and how the United States compares with other leading industrial countries. They begin by noting that the housing sector is an important part of the U.S. economy, with residential investment averaging about 5 percent of gross domestic product (GDP) and housing services averaging about 12–13 percent of GDP. It has always been subject to boom and bust cycles in new construction, but these cycles have not caused widespread problems since the Great Depression of the 1930s. This time, however, the boom and bust in the U.S. housing market contributed to a global financial crisis and the Great Recession. The bust was not widely anticipated in the United States, other countries also failed to see it coming, and so this failure to anticipate the bust cannot explain the unusually painful impact on the U.S. economy. What went wrong? Where was the problem, and how can we fix the system?
Early on, the United States developed a system of housing finance that was similar to that in the United Kingdom. U.S. homeownership was greatly expanded with land grants so that by 1890 two-thirds of farm housing was owner occupied. The early introduction of savings-and-loan institutions (S&Ls) distinguished the development of housing finance in the United States, with the first S&L organized in 1831. The S&Ls were granted tax advantages (and later interest rate advantages relative to other financial institutions) so that the sector developed differently from the banking system. During the Great Depression, the S&Ls did not suffer classic bank runs because they had not issued demand deposits. They suffered withdrawals, nonetheless, as customers tried to maintain their level of consumption by withdrawing their savings. This caused widespread failures. The U.S. government tried to revive and sustain the S&L industry during the Great Depression by establishing the Federal Home Loan Bank system in 1932 and setting up the Federal Savings and Loan Insurance Corporation in 1934.
After World War II, the S&L sector prospered, growing from 3 percent of private financial assets in 1945 to 16 percent in 1975. Interest rates increased sharply in the 1970s, however, which put enormous strain on the S&L sector. By charter, S&Ls held mainly long-term fixed-rate mortgages that were funded largely by short-term obligations. Short-term interest rate increases in the late 1970s and early 1980s caused widespread insolvencies. Despite massive government support and an explicit policy of forbearance, many S&Ls failed. This led to a fundamental change in regulations that enabled S&Ls to become much more similar to commercial banks, and in time the insurance funds for S&Ls and banks were combined and administered by the Federal Deposit Insurance Corporation.
Since the 1930s, the federal government has played an increasingly important role in the allocation of mortgage credit in the United States. This has included loan insurance and guarantees, with the establishment of Fannie Mae, Freddie Mac, Ginnie Mae, and the Federal Housing Administration as well as some provisions of the Community Reinvestment Act. Indeed, the United States is one of a handful of countries in which government plays the major role in the provision of residential mortgage finance, with roughly 50 percent of outstanding home mortgages financed by government-sponsored enterprises. Measured in terms of the ratio of mortgage debt to GDP, government support appears to have succeeded in expanding the availability of mortgage finance. Apart from the special case of Switzerland, the ratio of mortgage debt to GDP is much higher in the United States than in other high-income countries. Yet despite the heavy involvement of the U.S. government and bipartisan emphasis on increasing homeownership rates, the United States has lagged the median for other countries with similar income per capita.
During the 1980s, the United States shifted from reliance on S&Ls for the provision of mortgage finance to reliance on the securitization of mortgages in capital markets. This feature distinguishes the U.S. housing finance system from that of other high-income countries. In most other countries, housing finance is funded largely through deposits held in financial institutions or—especially in Denmark, Germany, and Spain—by covered bonds, which differ from securitized mortgages in one important respect. The holder of covered bonds can rely on the guarantee of the issuing bank in the event that defaults in the underlying portfolio of mortgages jeopardize servicing of the bond. The holder of a securitized claim, however, must rely on the subordination structure of the securitization, which was often opaque, or on the guarantee of a thinly capitalized private mortgage insurer rather than that of a depository institution with access to the safety net.
During the housing bust, the U.S. system was severely tested and found to be much more fragile than most market participants had anticipated. Even though the decline in U.S. housing prices was not substantially greater than that experienced by several other countries or Hong Kong from 1992 to 2008, the impact on the U.S. financial system (and on several major foreign banks, which held large amounts of securitized U.S. mortgage debt) was disproportionately damaging. Although other factors undoubtedly contributed to the Great Recession, many analysts believe that the collapse of the U.S. market for securitized mortgages was at least a proximate cause.
Allen, Barth, and Yago note that, over two centuries, U.S. housing finance markets have worked reasonably well. We have had three great disruptions, but these were more likely caused by unanticipated macroeconomic factors than by weaknesses in the U.S. system of housing finance. Nonetheless, this raises an important question about how housing finance should be redesigned in the United States: what kinds of macroeconomic disruptions should the system be expected to withstand in the future? If the macro environment is expected to be more volatile in the future, the mortgage finance system must be restructured to adapt.
Within North America, housing finance in Canada and the United States has many similarities, but also some important differences. In Canada, more housing finance is provided on the balance sheets of financial institutions than through capital markets. The norm in Canada is the five-year fixed-rate mortgage (versus the typical thirty-year fixed-rate mortgage in the United States), with recourse to the borrower in the case of default (versus no right of recourse in much of the United States) and some prepayment penalties (versus no prepayment penalties in most U.S. mortgages). Canadian residents do not receive a mortgage interest rate deduction in computing taxable income. And, although the Canadian government does provide some mortgage insurance and guarantees, direct government involvement in the housing sector is considerably less than in the United States. Nonetheless, Canadian homeownership rates are similar to those in the United States, and the boom-bust cycles in Canadian housing have been much less pronounced.
Even though we lack robust models of fluctuations in real estate pricing, Allen, Barth, and Yago believe that it should be possible to enhance the resilience and efficiency of the U.S. housing finance system through several innovations. For example, mortgage contracts could be improved to provide risk sharing in the event of unanticipated macroeconomic conditions. They argue that the dominance of large financial institutions could be curbed to reduce the threat to financial stability. Government involvement in the housing sector should be rolled back because it cannot be sustained and has caused serious distortions in the allocation of resources. Eliminating the bias against renters in the U.S. tax code and other federal programs would lead to greater diversification in the U.S. housing stock and provide a better range of options for the highly mobile U.S. society. In the near term, they argue, it is urgent to restore confidence in the structure of securitization and to develop a role for covered bonds in the U.S. market.
Conference participants raised a wide range of questions stimulated by the presentation. How can securitization be restored without some way of ensuring that the risk is not redistributed to institutions that cannot afford to bear a loss? Can prudential regulations aimed at the provision of mortgage finance, such as policy-determined limits on loan-to-value ratios, improve the stability of the financial system? What causes housing bubbles? To what extent did the large current account deficits in the United States contribute to the problem? Is the role of the U.S. government in the housing market really different in substance from the implicit (and, often, explicit) support that foreign governments provide for their key financial institutions? To what extent did the internationally agreed Basel II risk weights on the mortgage lending of banks contribute to the problem by reducing prospective capital requirements?
In chapter 3, Thomas Jackson of the University of Rochester and David Skeel of the University of Pennsylvania extend the discussion to the underlying institutional infrastructure that stimulates growth and recovery. They make a strong case that bankruptcy policy can play a crucial role in economic growth, including recovery from recessions. Indeed, they argue that the efficient operation of markets depends on the existence of an effective bankruptcy process.
In their view, the primary role of bankruptcy law is to reduce the frictions that would otherwise impede the reallocation of assets to their highest-and-best use in the case of firms facing financial failure. They argue that a properly functioning bankruptcy law neatly separates the issue of "who gets what" from the issue of "what is the highest-and-best (most efficient) use of the assets." Two features are particularly important.
First, bankruptcy reduces the coordination problems that would occur if each individual creditor took independent actions against a borrower who was generally defaulting because liabilities exceeded the borrower's assets. Although piecemeal liquidation of a firm's assets may be appropriate in some cases, the rush to seize assets (caused by creditors seeking payment before the assets run out) may, nonetheless, reduce the total value of the firm's assets to be distributed among all creditors. If the firm's difficulties are purely financial rather than reflecting an underlying economic failure, then piecemeal liquidation is not appropriate and the grab for assets may cause the destruction of going- concern value, thereby inflicting a loss on the creditors as well as society more broadly. In effect, attempts by individual creditors to protect the priority of their claims may prejudice decisions about the overall allocation of resources.
Second, bankruptcy facilitates the shift in control (and ownership) from the old owners of equity to the creditors. This is important because as the firm approaches insolvency—and especially once it has become insolvent—the old equity owners (as recipients of upside value but protected by limited liability against downside losses) are likely to make excessively risky decisions. Indeed, they may forgo projects that have a positive present value, but low risk, in favor of much riskier projects with equivalent—or lower—expected returns. The opportunity to gamble for resurrection means that old equity owners have strong incentives to obstruct a change in control as long as possible and to increase the riskiness of the firm's business. Bankruptcy rules address this problem by enabling creditors to initiate (or force) a proceeding in which control is shifted from the old equity owners to the creditors.
Jackson and Skeel argue that American bankruptcy law is probably the most successful in the world in preventing the consequences of insolvency from impeding the allocation of assets to their most productive uses. In addition to the certainty brought about by our nation's long experience with bankruptcy law—and the advantages of a judicially based process adhering to rules known in advance—American bankruptcy law has five key features:
—Once a bankruptcy proceeding has been initiated, an automatic stay is imposed, requiring that creditors cease all efforts to claim the debtor's assets. Creditors are obliged to shift from asset-grabbing mode to negotiation mode. In several other countries, the imposition of a stay is the result of a vote among creditors or some other mechanism that is not automatic.
—Preference rules permit the debtor to retrieve repayments made to creditors within ninety days before the filing for bankruptcy. This is intended to curb the temptation of creditors to "cut and run" rather than to renegotiate their claims on the troubled debtor. Although creditors may still believe that they will do better by withdrawing credit, they must take account of the fact that they may be forced to return the payment if the debtor files for bankruptcy within the next ninety days.
—The debtor is permitted to assume executory contracts—contracts for which performance remains on both sides and that potentially have a net value to the debtor. These contracts are treated like potential assets of the firm, and counterparties are prohibited from terminating them unless the debtor decides not to continue with them, in which case the contract terminates and the counterparty is left with a claim.
Excerpted from FINANCIAL RESTRUCTURING TO SUSTAIN RECOVERY by MARTIN NEIL BAILY, RICHARD J. HERRING, YUTA SEKI. Copyright © 2013 THE BROOKINGS INSTITUTION NOMURA INSTITUTE OF CAPITAL MARKETS RESEARCH. Excerpted by permission of Brookings Institution Press.
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