Sometimes reinventing the wheel is an outlandish idea, take for example the current mortgage system. It works in other countries quite nicely and at a low cost. Do you think your Congressperson should know about this? Reforming a broken mortgage systemBy: George Soros March 25, 2010 04:29 PM EDT
Treasury Secretary Timothy Geithner testified Tuesday on a plan to reform Fannie Mae and Freddie Mac, the government-sponsored enterprises now in limbo. But we don’t have to wait years to reform the mortgage system; a better approach could be introduced right away.
The business model of Fannie Mae and Freddie Mac is fundamentally unsound. These public-private partnerships were supposed to serve the public interest and the interest of shareholders. But this was never properly defined and reconciled.
Management’s interests were more closely allied with those of shareholders. They had an incentive to lobby Congress — both to expand homeownership and to protect and use their government-sponsored duopoly status.
The GSEs extended their activities from insuring and securitizing mortgages to building highly leveraged portfolios of securities by taking advantage of their implicit government backstop. They profited from the growth without bearing the risk of collapse: Heads they win, tails you lose.
The GSEs already had a checkered history, riddled with accounting irregularities. Eventually, they blew up — at a huge loss to taxpayers that may exceed $400 billion.
Early in the century, private enterprise had started eating into the government-guaranteed mortgage market. Borrowers once served by the Federal Housing Administration turned to subprime and Alt-A mortgages.
These “non-agency” mortgage securities gained increasing market share. They were sliced and diced, repackaged into CDOs and CDOs squared. Geographic diversification was supposed to reduce risk. But the originate-to-distribute model of securitization actually increased risk by creating a severe agency problem: Agents were more concerned with earning fees than protecting the quality of the mortgages. The housing bubble ended with a crash — and the government was forced to take over GSEs.
With the private sector largely incapacitated, the GSEs and FHA became virtually the only source of mortgage financing. This is a paradoxical situation in which a fundamentally unsound business model holds a quasimonopolistic position. This cannot last.
What needs to be done is clear: The GSEs’ mortgage insurance function must be separated from mortgage financing.
The former, mortgage insurance, is the legitimate function of a government agency, especially when the private sector has collapsed. A mortgage insurance entity should be run as a government agency.
But mortgage financing should revert to the private sector. This would get rid of a business model that has failed.
There is a proven mortgage financing system already up and running. The Danish model has been in use, continuously, since the aftermath of the Great Fire of Copenhagen in 1795. It has not prevented housing bubbles, but it has never broken down. And it proved its worth again in 2008.
In the Danish system, homeowners do not borrow from either a mortgage originator or a GSE. They borrow from the bond market, through a mortgage credit intermediary. Every mortgage is balanced by an equivalent amount of an identical, and openly traded, bond. This is called the Principle of Balance.
In the United States, mortgage securities are separated at birth from the borrower. Thereafter, they lead separate lives. But in the POB system, the link is never broken.
Mortgage Credit Intermediaries operate the POB system. They help homeowners understand and navigate the process. Most important, MCIs bear the credit risk of the mortgages — they remain “on the hook” in the event of delinquency or default.
In Denmark, these mortgages are not insured by a government agency. This would have to be modified in America. Given the current demoralized state of the market, a government agency would have to guarantee mortgages, but the MCIs would be required to keep “skin in the game” with a stake of, say, the top 10 percent.
A key benefit of the POB system is that it offers performing homeowners the opportunity to buy back their loans when interest rates rise. If the price of the associated mortgage bond drops, the homeowner can buy the equivalent face value of bonds at a discount, to redeem the existing home loan.
The homeowner’s ability to lower his mortgage liability reduces the chance that he will be under water when home prices fall because of a rise in interest rates.
This helps forestall foreclosure crises. And it would have a countercyclical effect: Homeowners repurchasing mortgages help moderate upward pressure on interest rates. By contrast, the current system tends to exacerbate upward pressure by lengthening duration, a likely near-term prospect.
This system would have many other advantages over one that has collapsed.
It would eliminate the agency problem that was the primary cause of failure. It would separate the credit risk from the interest rate risk. It would be transparent. And it would be open: The duopolistic position of the GSEs would disappear.
What would remain is a government agency offering mortgage insurance to all qualified MCIs without competing with them.
How to get there from here? Do it in steps.
The first is to introduce mortgage securities based on the Principle of Balance. GSEs could, and should, do this, with the government regulator setting clear and conservative standards. No legislation is required.
The second step is to open the process so all qualified MCIs can issue POB bonds. To make this market work, this means new law requiring that MCIs maintain skin in the game for any federally guaranteed mortgage.
After that, the GSEs could be phased out from their role as MCIs, and the guarantee function hived off to a government agency. Eventually, the GSEs would be liquidated, as their portfolios run off.
Legislation would also be required to extend the POB system to areas that government insurance does not cover.
In fact, legislation authorizing “covered bonds” is making its way through Congress.
But it should better take into account the lessons of the last crisis — and begin the introduction of the Danish model. This should be part of the financial reform package.
We could start rebuilding a stronger mortgage finance system along these lines now.
George Soros, philanthropist and financier, pioneered the introduction of the Danish mortgage finance system in Mexico with the support of then-Treasury Secretary Paul O’Neill. He now participates in a joint venture with the Danish financial system that helps countries use this approach.
© 2010 Capitol News Company, LLC
Please forward this to your member of Congress, now.
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