By JACK GUTTENTAG
The Mortgage Professor
Second of two parts
Last week, I discussed a major weakness of the draft proposal recently released by the Senate Banking Committee to replace Fannie Mae and Freddie Mac with a Federal Mortgage Insurance Corp. wholly owned by the government.
The proposal is critically dependent on attracting private capital from "guarantors" who would a buffer the government against losses. I explained that this is an untested idea that might prove unworkable.
Now I consider an alternative and tested model that would meet the objective of buffering the government's risk exposure and that is much more likely to evolve into a robust, private secondary market.
THE NEED FOR A PRIVATE SECONDARY MARKET
The need arises from the excessively restrictive underwriting rules adopted by Fannie/Freddie after the crisis, which are bound to be adopted by FMIC. Discretion in the loan-underwriting process has been largely eliminated, and large numbers of good loans, including loans to the self-employed and investors in particular, are not being made. A recent study by Laurie Goodman, Jun Zhu and Taz George estimates an annual shortfall of more than a million loans because of reduced availability.
A newly constituted private secondary market would make such loans possible, but that market should be more robust than the one that collapsed during the crisis.
THE WEAKNESS OF THE NOW-DEFUNCT PRIVATE MARKET
The critical weakness of the market that imploded during the crisis was the lack of risk-sharing among securities. Every security had "credit enhancements" designed to allow each one to stand on its own and made no provision for redistributing the enhancements where they were needed. This meant that if nine securities had more credit enhancement than they needed and one had less, that one would fail.
In this structure, the issuer of a security had no liability except for whatever commitments the issuer had contributed to the credit enhancement. The Dodd/Frank legislation attempted to deal with this by requiring issuers to have 5 percent exposure, but there have been no takers.
COULD THE PRIVATE SECONDARY MARKET NOW RE-EMERGE?
On the optimistic assumption that the guarantors required by the draft proposal emerge to do what is required for FMIC to replace Fannie/Freddie, at some point they might well expand their reach into the private market. They would do this by reducing their premiums, liberalizing their underwriting requirements, and limiting their exposure to each security they guarantee, perhaps to 5 percent. Essentially, this would recreate the same type of market structure that existed before the crisis, with every security standing on its own.
In sum, the model designed by the Senate Banking Committee may or may not provide a good replacement for Fannie/Freddie and, even if it did, it would not provide the basis for a robust private market.
A WELL-TESTED ALTERNATIVE
Instead, the committee could adopt the Danish model, which combines originators, aggregators and guarantors into one entity, called a mortgage bank. The mortgage-backed securities issued by the bank would be guaranteed by the government, but as liabilities of the bank, they would also be protected by the capital of the bank.
A major advantage of the mortgage bank approach is that it should evolve into a robust private secondary market. As the banks establish their operating record, they will begin offering securities that carry only their own guarantee, and eventually the government will be out of the picture altogether -- as is the case in Denmark.
There has never been a default on a mortgage security issued by a Danish mortgage bank. During the worst phases of the recent financial crisis, it was business as usual in the Danish market.
In contrast to the U.S. system, in the Danish system, each borrower is funded directly by the secondary market. The mortgage bank places the mortgage directly with investors simply by adding it to an open bond issue covering the same type of mortgage. This means borrowers can shop secondary market prices online to find, leaving only the mortgage bank's markup to be negotiated with the bank.
The system also could be used as an efficient way to channel government support to disadvantaged groups. This could be done by creating one or more special mortgage securities on which the government would bear the risk.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Contact hims at mtgprofessor.com.
