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posted: 4/19/2014 12:01 AM

Robust secondary market needed to replace Fannie, Freddie

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Editor's note: This is the conclusion of a two-part series that began last week in HomesSaturday.

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 operate as a buffer against loss to the government. This is an untested idea that might well prove unworkable.

In this article I consider an alternative and tested model that would meet the objective of buffering the government's risk exposure, and which 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 over 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 financial crisis.

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" that were designed to allow each one to stand on its own feet, and there was no provision for redistributing the enhancements to where they were most 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 re-emerge under the draft proposal?

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 prior to the crisis, with every security standing on its own bottom.

In sum, the new model designed by the Senate Banking Committee may or may not provide an adequate replacement for Fannie/Freddie, and even if it did, it would not provide the basis for a robust private market.

A thoroughly tested alternative model

The committee has another way it can go. It can 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 total 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.

The Danish model should appeal to the right side of the political aisle because the risk exposure of the government is buffered by 100 percent of mortgage bank capital, and over time the government's exposure will disappear altogether. The Danish model should appeal to the left side of the political aisle because it drastically simplifies the mortgage lending process for borrowers.

In contrast to the U.S. system, where months may pass between the date when a loan is closed and the date when the loan is converted into a security, 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 that borrowers can shop secondary market prices online to find the best price for their loans, leaving only the mortgage bank's markup to be negotiated with the bank.

The system could also 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.

In short, the Danish mortgage bank model could provide the basis for a true bipartisan approach to mortgage reform.

• Contact Jack Guttentag via his website at

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