BUSINESS SCHOOL Platform Competition of Government Sponsored Enterprises and Private-Label Securitization: A Two-Sided Market Perspective Quan Gan Discipline of Finance University of Sydney

Two-Sided Market 2 ›A platform that brings buyers and sellers on board. ›E.g. Video games bring consumers and software developers on board ›Google brings ``eyeballs’’ and advertisers on board. ›Typical Literature: ›Rochet and Tirole (2003, 2006), Armstrong (2006)

Mortgage-Backed Securities Market Structure 3

Two Platforms in Two-Sided Market 4 ›Platform 1: Government Sponsored Enterprises (Fannie Mae, Freddie Mac) ›Platform 2: Private-Label Securitization (conduits backed by investment banks) ›GSE and PLS are competing platforms ›Side 1: Mortgage borrowers ›Side 2: Mortgage-backed Securities investors

Business Model: A Two Sided Market Perspective 5

Segmentation of Securitization Market 6 ›Conforming Loans ›Jumbo Loans (loan amount > conforming limit) ›Nonjumbo-nonconforming Loans (e.g. subprime loans) ›GSE can only purchase and securitize conforming loans ›PLS can purchase and securitize all loans

GSE Advantages and Disadvantages 7 ›GSEs are supported by governments ›Advantages: ›1) high credit rating; ›2) implicit/explicit government support when things go wrong ›Disadvantages: ›1) conflicting goals: increasing housing affordability v.s. maximizing shareholders’ value ›2) activity is constrained by conforming criteria

PLS Advantages and Disadvantages 8 ›Advantages: ›1) competing freely with only goal to maximizing profit ›Disadvantages: ›1) hard to compete in securitizing conforming loans ›2) cost to get insurance on loans

Model 9 ›Game Framework for platforms: ›GSE: first mover – setting conforming criteria and dominant conforming loan securitization ›PLS: follower – setting their own securitization standards and try to catch the remaining market ›Both GSE and PLS set mortgage-backed security (passthrough type as to current draft) price to maximize their profit. ›They make profit because pooling decreases the risk for investors (cross externality).

Model II 10 ›Mortgage borrowers: Price takers ›Primary lender: risk neutral ›Interest rate: normalize to 0 (mortgage rate is not zero) ›The Loan amount and payment satisfy following equation:

Model III 11 ›Investors: maximizing profit ›Hotelling type model ›Uniformly distributed on (0, 1) with same amount of available fund M on each density unit. ›Transportation cost proportional (may change to other specification: e.g. quadratic form) to their distance with GSE (located at 1) or PLS (located at 0) ›Here, ``transportation’’ may be seen as the preference to the government backing.

Model IV 12

Results 13 ›Proposition 1: If demand effect is strong (many people want to borrow and buy houses), PLS profit is higher than that of GSE. ›Proposition 2: GSE has tendency to set loose conforming criteria when collaterals are deteriorating. ›Proposition 3: If GSE set loose conforming criteria (as priori) to some point, PLS lose money (on average)