José J. Cao-Alvira Associate Professor, Lehman College at the City University of New York Alexander Núnez PhD Candidate, EGAE School of Business at the University of Puerto Rico 2016 Open Seminars of Eesti Pank

1. Bank of Estonia
2016 Open Seminars of Eesti Pank
On TARP and its Impact on the Mortgages
Acquired by Fannie Mae
José J. Cao-Alvira
Associate Professor, Lehman College at the City University of New York
Alexander Núnez
PhD Candidate, EGAE School of Business at the University of Puerto Rico

2. Abstract 1/2
We assess the consequences of the possible competitive
distortions created by TARP on the sector of the banking
system actively engaged in the mortgage swap-program
with Fannie Mae.
We do this by analyzing the mortgages acquired and
securitized by the GSE from banks under the protection
of TARP.

3. Abstract 2/2
Our results suggest that TARP funds effectively increased
the cost competitiveness of the intervened banks
receiving capital transfers and allowed them to offer more
aggressive terms at the origination and procurement of
mortgage credit.
The aggressive behavior of TARP protected banks
manifests in lower mortgage-loan rates, attracting safer
borrowers and, in turn, decreasing the competitive
margins for the banking system as a whole.

4. Outline of the Presentation
Introduction:
- Fannie Mae and Freddie Mac (or GSEs)
- Recent U.S. Government Interventions
Literature Review
Data Description
Empirical Results
Concluding Remarks

5. Fannie Mae and Freddie Mac
Government Sponsored Enterprises (or GSEs)
- Public Corporations with a Social Mandate
- Created in 1938 (FNM) y 1970 (FRE).
- Mission: provide liquidity and stability to the
secondary mortgage market and, this way, promote
access to mortgage credit.
- …While maximizing profit.

6. Fannie Mae and Freddie Mac
TWO ways to fulfill the Social Mandate:
1. “Securitization” and credit guarantee
- Acquiring mortgage pools from originators and
issuing Mortgage-Backed Securities (MBS);
- A GSE guarantees the principal and interest
payments of the MBSs

7. Fannie Mae and Freddie Mac
TWO ways to fulfill the Social Mandate:
1. “Securitization” and credit guarantee (cont.)
- In exchage, sellers provide a “guarantee fee” or an
insurance payment to the GSE
- The seller has the option to continue servicing the
mortgage or sell the servicing contract to another
financial institution

8. Fannie Mae and Freddie Mac
TWO ways to fulfill the Social Mandate:
2. Portfolio Investment
- Acquiring assets on their own balance sheets
• Mortgages
• MBS (Agency and non-Agency)
• Fixed Income Securities

9. Fannie Mae and Freddie Mac
Single-Family Residential Mortgage Holdings
Source: Flow of Funds Accounts of the United States

10. Fannie Mae and Freddie Mac
Source: Financial Statements of Fannie Mae and Freddie Mac

11. Fannie Mae and Freddie Mac
Many adverse consequences:
- The “government sponsored” status of the GSEs
offered an implicit government protection to both
agencies which not explicitly determined.
- The securitization process adds additional layers of
moral hazard and adverse selection to a market already
characterized by assymetric information.
- Undiversified exposure to mortgage credit risk

12. U.S. Government Interventions
Fannie Mae and Freddie Mac:
- September 7 2008 – Conservatorship of FNM & FRE
- Senior Preferred Stock Purchases – ensure solvency
~$190 billion USD
- Purchase of the Agencies’ MBS
~$225 billion USD
- Reduction of the investment portfolio
~10-15% per year

13. U.S. Government Interventions
Troubled Asset Relief Program (or TARP):
- October 2008 – Objective: Improve financial stability
- Assigned up to $700 billion USD for the purchase of
troubled assets.
- Of which, $250b for the Capital Purchase Program:
investment of the U.S. Treasury in the preferred equity
of troubled financial institutions to improve their
capital ratios.

14. U.S. Government Interventions
Troubled Asset Relief Program (or TARP):
- Scandals of executive’s bonuses payments (Mills,
2009), suspicion of credit rationing, and increased risk-
taking (Black & Hazelwood, 2012) have questioned
the effectiveness of the TARP implementation.

15. U.S. Government Interventions
Troubled Asset Relief Program (or TARP):
- Important works suggest that the TARP’s ability to
restore the stability of the financial system was
undermined by both the competitive distortions created
in the banking system and the behavior of banking
institutions reacting to these distortions.

16. U.S. Government Interventions
Troubled Asset Relief Program (or TARP):
- Specifically, it’s been found that TARP banks increased
their market power and gained a competitive advantage
soon after receiving the government capital transfers.

17. U.S. Government Interventions
Troubled Asset Relief Program (or TARP):
- And, albeit the Capital Purchase Program of TARP did
not directly intervened with Fannie Mae and Freddie
Mac… [So, our main hypothesis is:]
repercussions are to be expected on the assets issued,
insured and held by the GSEs if significant
modifications occurred in the mortgage origination and
resale practices of banks under TARP protection.

18. What we do?
We analyze the mortgages acquired by Fannie Mae from
U.S. banks during 2005:1-2011:12.
Assess the consequences of the possible competitive
distortions created by TARP on the sector of the banking
system actively engaged in the mortgage swap-program
with the GSE.

19. Intuition (1/2)
TARP funds created Competitive Distortions in the
mortgage origination/resale sector of the banking system
TARP funds >> Decreased Marginal Costs of TARP Banks
>> Increased Competitiveness and Market Power
TARP banks are able to offer more attractive terms for its
borrowing contracts >> attract better borrowers

20. Intuition (2/2)
TARP banks >> attract better borrowers >> sell to Fannie
Mae better mortgages (with lower Default probabilities)
NOTE: Although Fannie Mae assumes all the credit
risk of mortgages
Incentives still exist for ALL banks to sell
“good” mortgages to Fannie Mae because these
increase a bank’s income from servicing fees.

21. Rest of the Presentation
Literature Review
Data Description
Empirical Results
- H1: Competitive Distortions and Market Power
- H2: More favorable contract terms
- H3: Better loans
- H4: Income from loan servicing (In progress)
Concluding Remarks

22. Literature Review
Related literature:
- On TARP and financial system stability
- On TARP and credit risk
- On TARP and market power
- On Loan Performance and the Servicing of Mortgages

23. Literature Review
- On TARP and financial system stability (brief)
Systemic
Risk
TARP banks reduced their leverage
decreasing their individual contributions
to systemic risk
Berger, Roman and
Sedunov (2015)
Diff-in-Diff method
Although TARP banks reduced
systematic risk (in the short-run), they
found this was at the expense of increases
in the systemic risk of the financial
system as a whole.
Farruggio, Michalak &
Uhde (2013)
Beta factor decomposition

24. Literature Review
- On TARP and financial system stability (brief)
Systematic
Risk
Immediate or Short-run reductions in the
systematic risk of TARP banks
Farruggio, Michalak &
Uhde (2013)
Beta factor decomposition
Event study
Short-run reductions and Longer-run
increases in the systematic risk of the
supported banks increased.
Elyasiani, Mester &
Pagano (2014)
Beta factor decomposition
Event study

25. Literature Review
- On TARP and credit risk
Black and Hazelwood (2013)
Analyzing data on loan originations from the Survey of
Terms of Business Lending and using a dichotomous
measure of risk calculated internally by the Survey, the
authors perform a difference-in-difference analysis on
loan-level data and find that TARP banks increased
significantly their risk taking behavior when issuing these
loans.

26. Literature Review
- On TARP and credit risk
Duchin & Sosyura (2014)
Find similar results performing a linear probability model
where the dependent variable is the likelihood of bank
approving a loan to a potential borrower and the primary
control on borrower’s risk is the loan-to-debt ratio.

27. Literature Review
- On TARP and credit risk
Duchin & Sosyura (2014)
Black and Hazelwood (2013)
Both papers argue that TARP may have created incentives
for excessive risk-taking through moral hazard, based on
the likelihood of future government support if needed

28. Literature Review
- On TARP and market power
Berger and Roman (2015)
Found evidence, using a difference-in-differences analysis,
that banks receiving TARP funds increased their market
power in the banking system over its unprotected
competitors and, with it, their competitive advantage

29. Literature Review
- On TARP and market power
The authors used the Lerner Index as the main proxy of
market power -constructed as the percentage difference
between the bank’s pricing for its financial services and its
marginal cost, i.e. (P-MC)/P.
The authors additionally found that the main source of
market power gains for TARP banks is the decreases in
their marginal costs

30. Literature Review
- On TARP and market power
Hakenes & Schnabel (2010)
develop a model showing that, because a government-
protected bank has the capacity to refinance its capital in
more favorable terms, these banks are induced to behave
more aggressively;
e.g. raising deposit rates or lowering loan rates.

31. Literature Review
- On TARP and market power
Further argue that the impact of the competitive distortion
created by government interventions on troubled banks is
not limited only to government-protected banks, but also
to these banks’ unprotected competitors.
The aggressive behavior of protected banks decreases the
competitive margins in the banking system & hence drives
their unprotected competitors to also assume higher risks.

32. Literature Review
- On TARP and market power
Berger, Makaew and Roman (2016)
Find, using difference-in-differences, that TARP issued
loan contracts offering better terms to all its borrowers and
more so to its “safer” borrowers.
Suggest the market power gained by TARP banks is the
reason for the capacity of these offering better loan terms.
Data source: Dealscan corporate debt contracts.

33. Literature Review
- On Loan Performance and the Servicing of Loans
Frame and White (2012)
The servicing of mortgage loans is usually a routine
electronic process with substantial economies of scale, but
these are significantly reduced if the servicer needs to deal
with loan modifications and delinquencies.
Servicing fees: 25 basis points on the principal

34. Data
The collection of residential mortgages originated by
banking institutions in the U.S. and acquired by Fannie
Mae between January 2005 and December 2011.
We exclusively consider single-family conventional fixed-
rate 30-year mortgages
Source: Fannie Mae Loan Performance Database

35. Data
Data on the Terms of Loans:
- interest rate,
- principal,
- Loan-To-Value,
- date of loan origination, and
- date when Fannie Mae acquired loan
Data on the Borrowers:
- FICO score, and
- Debt-To-Income ratio

36. Data
Data on the Performance of Loans:
- Monthly loan repayment
Name of Seller bank
Name of Servicer bank
U.S. state where the residential property is located.

37. Data – Descriptive Statistics
After intervention
nonTARP banks TARP banks
↓ interest rate
↑ principal
↓ Loan-To-Value
↓ default rate
↑ FICO score
↓ Debt-To-Income
↓ interest rate
↑ principal
↓ Loan-To-Value
↓ default rate
↑ FICO score
↓ Debt-To-Income

38. Data – Descriptive Statistics:
MORTGAGES Previous intervention: After intervention
TARP banks >
nonTARP banks
interest rate
principal
default rate
Loan-To-Value
TARP banks <
nonTARP banks
FICO score
Debt-To-Income
Loan-To-Value
FICO score
Debt-To-Income
interest rate
principal
default rate

40. Data
Data on seller Banks:
Source: U.S. Treasury
- Participant of the TARP-CPP {yes, no}
Source: FDIC Call Reports
- CAMELS
- Bank size
- Deposit growth
- Tier-1 to Total Assets ratio

41. Appendix – CAMELS (1/2)
Capital adequacy is the ratio of total equity capital divided
by gross total assets.
Asset Quality is the ratio of nonperforming loans to total
loans.
Management Quality is the standard deviation of total
assets in three consecutive quarters.
Earnings ratio is the net income to gross total assets
Liquidity is the ratio of cash to bank total deposits.

42. Appendix – CAMELS (2/2)
Sensitivity to Market Risk is the ratio of the absolute
difference between short-term assets and short-term
liabilities to assets.
Bank size is the natural log of the bank’s total assets,
Deposit growth is the quarterly percentage change in
deposits, and
Tier-1 ratio is the value of Tier-1 capital to total assets
Source: Duchin and Sosyura (2014), Berger and Roman (2016), and Liu et al (2013).

43. Data – Descriptive Statistics
After intervention
nonTARP banks TARP banks
↑ Asset Quality
↑ Liquidity
↑ Sensitivity to Risk
↑ Size
↑ Tier-1 Ratio
↑ Capital Adequacy
↑ Asset Quality
↓ Earnings
↑ Liquidity
↑ Sensitivity to Risk
↑ Size
↑ Tier-1 Ratio

44. Data – Descriptive Statistics
BANKS Previous intervention: After intervention
TARP banks >
nonTARP banks
Earnings
Size
Capital Adequacy
Asset Quality
Earnings
Size
TARP banks <
nonTARP banks
Asset Quality
Tier-1 ratio
Asset Volatility
Tier-1 ratio

46. Empirical Results
- H1: TARP>>Competitive Distortions & Market Power
- H2: TARP>>More favorable contract terms
- H3: TARP>>Better performing loans
- H4: Better loans>>Higher likelihood to remain related
to loans thru servicing In progress

47. Appendix – Lerner Index (1/5)
𝑙𝑛 𝐶𝑜𝑠𝑡𝑖𝑡 = 𝛽0 + 𝛽1 ln 𝑄𝑖𝑡 + 𝛽2 ln 𝑄𝑖𝑡
2
+ 𝛾 𝑘 ln 𝑊𝑘,𝑖𝑡
3
𝑘=1
+ ⋯
… + ∅ 𝑘 ln 𝑄𝑖𝑡
3
𝑘=1
ln 𝑊𝑘,𝑖𝑡 + 𝛿 𝑘𝑗ln 𝑊𝑘,𝑖𝑡 ln 𝑊𝑗,𝑖𝑡
3
𝑗=1
3
𝑘=1
+ 𝜇𝑖 + 𝜌𝑡 + 𝜖𝑖𝑡
Where 𝑄𝑖𝑡 represents a proxy for bank output or total assets for bank
𝑖 at time 𝑡, and 𝑊𝑘,𝑖𝑡 are three input prices. 𝑊1,𝑖𝑡, 𝑊2,𝑖𝑡, 𝑊3,𝑖𝑡 indicate
the input prices of labor, funds, and fixed capital, respectively, and
are calculated as the ratios of personnel expenses to total assets,
interest expenses to total deposits and other operating and
administrative expenses to total assets respectively.
Source: Anginer, Demirgüç-Kunt & Zhu (2013)

48. Appendix – Lerner Index (2/5)
𝑙𝑛 𝐶𝑜𝑠𝑡𝑖𝑡 is estimated using panel data analysis for each bank 𝑘 in the
sample. Time effects are also introduced with robust standard errors
by bank to capture the specificities of each one.
Ensure the cost function in HOD 1 in input prices:
Source: Anginer, Demirgüç-Kunt & Zhu (2013)
𝛽3 + 𝛽4 + 𝛽5 = 1
𝛽6 + 𝛽7 + 𝛽8 = 0
𝛽9 + 𝛽12 + 𝛽13 = 0
𝛽10 + 𝛽12 + 𝛽14 = 0
𝛽11 + 𝛽13 + 𝛽14 = 0

49. Appendix – Lerner Index (3/5)
Marginal cost is then computed as:
𝑀𝐶 𝑇𝐴 𝑖𝑡
=
𝐶𝑜𝑠𝑡𝑖𝑡
𝑄𝑖𝑡
𝛽1 + 2𝛽2 ln 𝑄𝑖𝑡 + ∅ 𝑘
3
𝑘=1
ln 𝑊𝑘,𝑖𝑡
Source: Anginer, Demirgüç-Kunt & Zhu (2013)

50. Appendix – Lerner Index (4/5)
𝑃 𝑇𝐴 𝑖𝑡
is the price of assets and is equal to the ratio of total
revenue (sum of interest income, commission and fee
income, trading income, and other operating income) to
total assets.
Source: Anginer, Demirgüç-Kunt & Zhu (2013)

51. Appendix – Lerner Index (5/5)
𝐿𝑒𝑟𝑛𝑒𝑟𝑖𝑡 =
𝑃 𝑇𝐴 𝑖𝑡
− 𝑀𝐶 𝑇𝐴 𝑖𝑡
𝑃 𝑇𝐴 𝑖𝑡
Where 𝑃 𝑇𝐴 𝑖𝑡
is the price of total assets proxied by the ratio
of total revenues (interest and noninterest income) to total
assets for bank 𝑖 at time 𝑡, and 𝑀𝐶 𝑇𝐴 𝑖𝑡
is the marginal cost
of total assets for bank 𝑖 at time 𝑡.
Source: Anginer, Demirgüç-Kunt & Zhu (2013)

52. Empirical Results
𝑀𝐶𝑖,𝑡 is defined as the marginal cost of bank 𝑖 at time t.
𝐷𝑖,𝑡
𝑇𝐴𝑅𝑃
is a dummy variable assuming a value of one at time t
and afterwards if bank i received TARP funds at time t
& zero otherwise.
𝑩𝑖,𝑡−1 is a set of lagged bank-level controls
𝑀𝐶𝑖,𝑡 = 𝜆1 𝐷𝑖,𝑡
𝑇𝐴𝑅𝑃
+ 𝝀 𝟐 𝑩𝑖,𝑡−1 + 𝝁𝑖 + 𝜌𝑡 + 𝜐𝑖,𝑡
H1: TARP >> Competitive Distortions

53. Empirical Results
𝜆1 measures changes in the marginal cost of TARP banks
following the capital transfers, with respect to banks that
did not receive TARP funds.
Including fixed effects identifying the seller bank makes the
identification to be from a within-bank change in the interest
rate of loan originations. The inclusion of time effects
produces a difference-in-differences estimate of mortgage
interest rate from TARP banks relative to non-TARP banks,
controlling for pre-existing differences across banks
ref: Black and Hazelwood (2013)

54. Empirical Results
Evidence is found indicating that Competitive Distortions
were created in the form of cost-advantages for TARP
banks, increasing their market power.
TARP >> ↓ Marginal Cost
(lower costs for funding opportunities) ***
TARP >> ↓ Price
(lower interest rates and fees on loans)
TARP >> ↑ Lerner Index
(higher market power)***

55. Empirical Results TARP >> Competitive Distortions

56. Empirical Results
𝑟𝑖,𝑙,𝑡 = 𝛽1 𝐷𝑖,𝑡
𝑇𝐴𝑅𝑃
+ 𝜷2 𝑴𝑙 + 𝜷3 𝑪 𝑡 + 𝜷4 𝑩𝑖,𝑡−1 + 𝜶𝑖 + 𝛿𝑡 + 𝜀𝑖,𝑙,𝑡
𝑟𝑖,𝑙,𝑡 is defined as the percentage interest rate of loan l,
acquired by Fannie Mae by bank 𝑖 at time t.
𝑴𝑙 is a set of time-invariant loan-level controls
𝑪 𝑡 is a set of time-variant aggregate-economy level controls
H2: TARP >> More favorable contract terms

57. Empirical Results
Evidence is found indicating that the loans acquired by
Fannie Mae from TARP banks offered better terms to their
borrowers, and specially to the “safest” borrowers.
TARP >> ↓ Interest Rate on Loans Acquired ***
All loans
TARP >> ↓ Interest Rate on Loans Acquired ***
Even more so for highest 75% FICO score
TARP >> ↓ Interest Rate on Loans Acquired ***
Even more so for lowest 25% DTI ratio

58. Empirical Results TARP >> More favorable contract terms

59. Empirical Results
TARP >> More favorable contract terms
(even more so for “safer” borrowers)

60. Empirical Results
𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑖,𝑙,𝑡 is a binomial variable denoting the mortgage loan
repayment performance during the first year and the first two
years since origination
Two measures of loan delinquency are considered, e.g. a loan
is considered delinquent when is past due >60 days or, a less
stringent measure, when is past due >90 days.
𝑃(𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑖,𝑙,𝑡 = 1 𝐷𝑖,𝑡
𝑇𝐴𝑅𝑃
, 𝑴, 𝑪, 𝑩, 𝜽, 𝜓
= Φ 𝛾1 𝐷𝑖,𝑡
𝑇𝐴𝑅𝑃
+ 𝛾2 𝑴𝑙 + 𝛾3 𝑪 𝑡 + 𝛾4 𝑩𝑖,𝑡−1 + 𝜽𝑖 + 𝜓 𝑡 + 𝑢𝑖,𝑙,𝑡
H3: TARP >> Better Performing Loans

61. Empirical Results
Evidence is found that the loans sold to Fannie Mae by
TARP banks performed better (lower default rate).
TARP >> ↓ Default rate ***
Failure of Payments at 60days and 90 days,
during the first year after origination
TARP >> ↓ Default rate ***
Failure of Payments at 60days and 90 days,
during the first two years after origination

62. Empirical Results TARP >> Better Performing Loans

63. Empirical Results
𝑆𝑒𝑙𝑙𝑒𝑟𝑖.𝑙,𝑡 = 𝑆𝑒𝑟𝑣𝑖𝑐𝑒𝑟𝑖,𝑙,𝑡 is a binomial variable denoting that
the seller bank i of the mortgage l acquired by Fannie Mae
remained as its servicer during the first year since its
origination at t.
𝑃( 𝑆𝑒𝑙𝑙𝑒𝑟𝑖.𝑙,𝑡 = 𝑆𝑒𝑟𝑣𝑖𝑐𝑒𝑟𝑖,𝑙,𝑡 = 1|𝐷𝑖,𝑡
𝑇𝐴𝑅𝑃
, 𝑴, 𝑪, 𝑩, 𝝓, 𝜚)
= Φ 𝜑1 𝐷𝑖,𝑡
𝑇𝐴𝑅𝑃
+ 𝜑2 𝑴𝑙 + 𝜑3 𝑪 𝑡 + 𝜑4 𝑩𝑖,𝑡−1 + 𝝓𝑖 + 𝜚 𝑡 + 𝑒𝑖,𝑙,𝑡
H4: Better loans >> Higher likelihood to hold on to
loans thru servicing (In Progress)

64. Empirical Results
Evidence exists that seller banks are inclined to hold-on to
the servicing of “better” loans and sell the servicing rights
of “worst” loans.
↑ Interest Rate >> ↓ Prob(seller=servicer)***
↑ Default Probe >> ↓ Prob(seller=servicer)***

65. Empirical Results Better Loans >> Seller=Servicer

66. Concluding Remarks (1/2)
Focusing on the mortgages acquired by Fannie Mae from
U.S. banks during 2005:1-2011:12 and the U.S. banks
which sold the mortgages to Fannie Mae, we found that
…the mortgages sold to Fannie Mae from TARP banks
offered more beneficial terms and lower default ratios that
those acquired from non-TARP banks.

67. Concluding Remarks (2/2)
…TARP banks were able to offer the most beneficial
terms and attract the safer borrowers due to a cost
competitiveness advantage gained from the capital
infusion from TARP funds.
…The incentive for a bank from originating and/or
procuring a “safe” mortgage that is later sold to Fannie
Mae comes derives from the income from future servicing
the mortgage. As banks are more inclined to continue
servicing “safer” mortgages after their sale to the GSE.

68. Bank of Estonia
2016 Open Seminars of Eesti Pank
Thank you for your invitation
and kind attention
José J. Cao-Alvira
Associate Professor, Lehman College at the City University of New York
Alexander Núnez
PhD Candidate, EGAE School of Business at the University of Puerto Rico