Houses of Cards

The Obama Administration recently issued what it disingenuously calls a "plan to reform America's housing finance market." In fact, only four of the document's 31 pages constitute anything even resembling a plan, and the three options in those pages are so sketchy, so devoid of any financial analysis, and so lacking in any concrete steps forward that no reasonable person should take them seriously. All three options are variations on a theme: Except for a drastically scaled back role for the Federal Housing Administration (FHA) and perhaps a few other minor federal guarantee programs, the mortgage market, "would be driven by private investment decisions with private capital taking the primary credit risk." But, the plain and simple fact—a fact that the administration's own report, despite itself, makes obvious—is that the housing market in the United States has been, is, and must be dependent on the federal government for its very existence.

The report explains why, for the first time, the federal government intervened in the mortgage business during the Great Depression. In the 1930s, the private sector proved incapable of sustaining widespread home ownership through debt during a severe economic downturn. The Roosevelt Administration and Congress realized that only government could restart the mortgage business. The creation of the FHA, Fannie Mae, and the Federal Home Loan Banks (FHLBs), later joined by Freddie Mac, was necessary to reverse "severe mortgage market disruptions, widespread foreclosures, and sinking homeownership rates," essentially the same situation that exists today. Beyond restoring mortgage volume, the benefits of government involvement were the standardization of terms, conditions, and documentation; and the provision of liquidity to the savings & loan industry by allowing S&Ls to borrow from the FHLBs using mortgages as collateral. But the most sweeping innovation by far was mortgage securitization, which was invented in the 1970s.

Before the advent of securitization, banks and S&Ls held the lion's share of mortgages since they had no efficient way to disperse the mortgages they originated. Securitization opened up mortgages to a broad range of institutional and individual investors, not just in the US but globally. The reason investments in securitized pools of US mortgages became so widespread is that governmental agencies guaranteed the timely payment of principal and interest if the mortgage-holders themselves failed to pay. Mortgages, in their securitized form, were an investment all but free of credit risk. Investors could be certain of getting their principal returned and their interest paid except in the most catastrophic circumstances.

Because of the lack of credit risk, the market for securitized government-agency guaranteed mortgages has remained strong and vibrant through the present moment. This unabated demand has had several important consequences. One was that support for nearly universal homeownership became official US policy, championed by both Democratic and Republican administrations. Today nearly two-thirds of US households are owners, not renters. Another consequence has been huge growth in mortgage debt outstanding. The total now exceeds all US bank deposits by several trillion dollars. Even if banks wanted to fund nothing but single-family home mortgages, to the exclusion of all other types of loans and investments, they could not. Securitization evolved from an adjunct to the mortgage business to its irreplaceable core.

A third consequence was the substitution of market risk in place of credit risk in a way unique to America. For some of you, this may be a new and somewhat difficult concept, but it's critical to an understanding of why the mortgage market depends on government backing. On page 25, the administration's report summarizes research done on government mortgage support in other developed nations. The research provides little practical help: "The US system, however, is one of the only countries in the world where the mortgages are pre-payable, 30-year fixed rate mortgages." Mortgages have all sorts of terms and conditions. Why are these three--the ability of mortgage-holders to prepay at any time, the thirty-year repayment schedule, and the fixed rate of interest—singled out? The answer is that these are the qualities that create substantial market risk for investors in US mortgages.

To understand market risk, let's assume you are a mortgage investor who has bought a pool of mortgages paying 5%. If interest rates rise, the value of your investment will decline, and its long maturity will exacerbate the loss of value. Moreover, if you have to borrow money to support your investment, as a bank does by taking deposits, the rate of interest of your borrowing may come to exceed the 5% paid by the pool of mortgages. On the other hand, if interest rates fall, you as the investor do not get a commensurate benefit. Because the mortgage holders can prepay their mortgages without penalty, many of them will refinance at lower rates, thereby taking your investment away from you.

Nevertheless, the financial markets accommodated themselves to market risk because credit risk was contained. In fact, after government-guaranteed mortgage securitization became firmly established, the private sector began to securitize certain types of non-guaranteed mortgages safe in the knowledge that the health of the mortgage market was sustained by government involvement. Investment banks exploited a niche based on the ceiling Congress set annually on the size of mortgages Fannie Mae and Freddie Mac could insure. Households that could afford these large non-guaranteed mortgages, called jumbos, typically had higher incomes, better credit, and could make large down-payments. But, despite this inherent mitigation of credit risk, investors demanded higher interest rates on pools of jumbo mortgages because they lacked the biggest risk-mitigant of all: government guarantees. This should not be surprising. Credit risk invariably trumps all other risks.

The parameters changed only during a few years in the middle of the last decade when the housing mania was at its peak. Private securitizations began to include smaller mortgages with exotic structures, i.e. predatory loans. As the administration's report notes, Fannie and Freddie's market share of purchases of new mortgage originations declined from the normal 70% to 40%. Forced by the competition, the agencies lowered their standards, although in general they remained higher than the prevailing norm.

What happened when the bubble burst is instructive. Private mortgage securitization collapsed in the fall of 2007 and has never recovered. To quote from the administration's report again, "In the wake of the financial crisis, private capital has not sufficiently returned to the mortgage market, leaving Fannie Mae, Freddie Mac, FHA, and the Government National Mortgage Association (Ginnie Mae) to insure or guarantee more than nine out of ten new mortgages." (Emphasis added)

Here is the crux of the matter. No law requires any non-governmental entity to make or invest in mortgages. Thirty-year, pre-payable, fixed rate mortgages are fraught with market risk. They become a desirable investment only when credit risk is reduced to negligible levels by government guarantees or when the borrowers and properties are of the very highest quality. Without government backing, the combination of market and credit risk drives most private lenders out of the mortgage business. There are simply much less risky ways to make money. This is a fact that has been clearly demonstrated not just in the 1930s and late 2000s, but through all the years in between. The notion that the private sector can substitute for the government in maintaining the multi-trillion dollar US mortgage market is preposterous. It has never happened and there is no reason to suppose it will happen in the future.

The solution is to reconstitute Fannie Mae and Freddie Mac. They were placed into "conservatorship," whatever that means, in 2008 and the government has poured $150 billion into them since. Obviously they are still essential to the mortgage market. Unfortunately, the only definitive conclusion of the administration's report is that the two agencies are unfixable. "Fannie Mae and Freddie Mac's structural design flaws, combined with failures in management, were the primary causes of their collapse." Thoroughly demonized, they are somehow to be "wound down" in a smooth transition to a privately functioning mortgage market. I can't even imagine what morale must be like, though I am certain that every Fannie and Freddie employee is looking for a new employer. Instead of trying to fix Fannie and Freddie, the whole apparatus of government is focused on eliminating them without any credible substitute in place.

The biggest losers will be the American people. The report talks frequently about protecting taxpayers, but taxpayers and homeowners are exactly the same people. Pretending to protect "taxpayers" by making it much harder and more expensive for "homeowners" to get mortgages is a game no one can win. And the Obama Administration knows it. As I mentioned earlier, the government's intervention in the mortgage market led to a policy goal of encouraging near-universal home ownership. But consider these two sentences on pages 2 and 18, both of which follow platitudes of government support for quality affordable housing.

"This does not mean our goal is for all Americans to be homeowners."

"This does not mean all Americans should become homeowners."

They may as well have said, "Wake up! The American Dream is over."

Comments

[home buyer]

"Fannie and Freddie play a central role in our housing finance system and must continue to do so in their current form as shareholde­r-owned companies. Their role in the housing market is particular­ly important as we work through the current housing correction­. The GSEs now touch 70 percent of new mortgages and represent the only functionin­g secondary mortgage market. The GSEs are central to the availabili­ty of housing finance, which will determine the pace at which we emerge from this housing correction­. ...

OFHEO has reaffirmed that both GSEs remain adequately capitalize­d. At the same time, recent developmen­ts convinced policymake­rs and the GSEs that steps are needed to respond to market concerns and increase confidence by providing assurances of access to liquidity and capital on a temporary basis if necessary.­"

[Tauno Wiljakainen]

In different part of the world financial things is one of the main problem for any business,in Finland country mortgage increase and debt also is increase i can say it is a bad thing that the higher is the foreclosure and mortgage the higher the risk,but this one really seem plan well.

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