How to Fix Mortgage Mess in Three Steps: Laurence Kotlikoff
Fannie Mae and Freddie Mac. What cute-sounding names. They suggest adorable siblings, not twin financial disasters that may cost $1 trillion when we get the final bill.
According to Edward Pinto, Fannie Mae’s former chief credit officer, in 2008 the two government-supported mortgage finance companies, along with the Federal Housing Administration and other U.S. agencies, were holding or guaranteeing some 19 million subprime home loans, or about 70 percent of all such debt.
Much of these toxic assets, as well as many of Fannie and Freddie’s prime mortgages, aren’t performing or will likely default. Nationwide, 8 million mortgages -- or one in 10 -- are under water, with the property’s value at least 25 percent below what’s owed.
The Federal Housing Financing Agency puts Fannie and Freddie’s losses at about $300 billion. But industry experts, like Janet Tavakoli, suggest the real number is closer to $700 billion. And if home prices fall another 20 percent to return to their long-term trend, the tab might climb to $1 trillion.
The asset-level data needed to get a more precise handle on Fannie Mae and Freddie Mac’s losses aren’t available. U.S. taxpayers, who now own both companies lock, stock, and barrel, and have to cover their losses, can’t, it seems, be trusted with these details. Taxation without representation is a no-no, but taxation with misrepresentation is just fine.
Where does the Constitution instruct Uncle Sam to act as the people’s inept investment banker? Where does it tell him to borrow gargantuan sums to make subsidized loans to dicey borrowers whose credit, collateral and employment he can’t be bothered to check?
It’s one thing for the government to assist deserving first-time homebuyers by paying, in broad daylight, a share of their home price. It’s another thing for the U.S. to induce people, whether deserving or not and whether first-time homebuyers or not, to go into debt. Incredibly, Fannie Mae, Freddie Mac and the FHA are still making a significant number of subprime mortgages with extremely low down-payments.
It’s time to get the government out of the mortgage business before it loses more of our money and induces more people to borrow beyond their means. If Uncle Sam wants to help the housing sector as opposed to the borrowing sector, let him restore the First-Time Home Buyers Tax Credit that expired last April.
But, hold on!
We can’t rely on the same private mortgage system, which specialized in the production and sale of fraudulent securities and almost vaporized the global financial market. The Dodd-Frank law notwithstanding, credit-rating companies are still on the take, regulators are still on the make, and boards of directors are still on a break. They won’t protect us from Wall Street’s sale of snake oil.
We need a new limited-purpose mortgage system, which confines banks and other mortgage makers to doing just one thing -- connecting lenders with borrowers, not leveraging the taxpayer. And we need the government to directly oversee the mortgage initiation process, organize a competitive market in home loans, and fully disclose all the details of mortgages on the Web so investors in these loans will know what they are buying.
This is remarkably easy to accomplish.
Step 1: Set up a new government agency -- the Federal Financial Authority. The FFA would hire companies to verify, rate, appraise and disclose mortgage applications. These contractors would work exclusively for the FFA, eliminating any conflict of interest. Liar loans and no-doc loans would be history.
Mutual Funds’ Role
The government would neither endorse nor accept responsibility for appraisals and ratings, and would let borrowers add privately purchased appraisals and ratings to disclosures.
Step 2: Limit buyers of home loans to doing so only through closed-end mortgage mutual funds. If a fund manager chooses poor mortgages, the value of his fund’s shares will fall, but the fund itself won’t go broke. Mortgage defaults will never again lead to financial-sector collapse.
The mutual funds would sell shares up to a closing date, use the proceeds to buy mortgages of the type in which they are specializing, and pay out the cash flow to stockholders. The funds would terminate when the loans mature.
Step 3: Establish an electronic mortgage auction and require mutual funds to purchase loans at this market so borrowers receive the best price (lowest interest rate).
While mutual funds would buy and hold mortgages, their shares would sell in a secondary market so investors would have liquidity even though their funds’ assets were illiquid. For this secondary market to operate well, it would need to maintain real-time disclosure of all information relevant to the valuation of a given loan.
The mutual funds would, themselves, represent securitizations. But unlike yesterday’s complex mortgage securities, investors would know what they were buying.
Investors seeking safety would purchase funds specializing in loans with larger down payments and shorter maturities. Investors seeking higher returns at the price of more risk would buy funds focused on mortgages with low down payments and longer maturities.
It’s time for the government to move from making home loans to making a mortgage market that works. The limited purpose mortgage system does both.
Laurence Kotlikoff is professor of economics at Boston University, president of Economic Security Planning Inc. and author of Jimmy Stewart Is Dead.” Richard Field is managing director of TYI LLC, a disclosure compliance database and risk- management firm. The opinions expressed their own.)
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