Mortgage Professor: Three defects of mortgage privatization
Editors note: This is the second column in a series on the Obama administration’s mortgage reform plan. the series appears Sundays in Homes Plus.
Last week’s article described the Obama administration’s plan for scaling down the federal government’s involvement in housing finance. The plan calls for a phasing out of Fannie Mae and Freddie Mac, and for a smaller FHA.
Liberals are dismayed by the administration’s scale-down plan because it will result in higher interest rates and tighter qualification requirements, with a disproportionate impact on disadvantaged groups. Conservatives are pleased with the prospect of reprivatizing most of the market. Independents (which is how I like to characterize myself) accept the desirability of privatization, but believe it should be accompanied by structural changes that will make the private market work better. This is what the administration’s ramp-up proposals should do but don’t.
The administration’s proposal is to authorize “private mortgage guarantor companies” that would guarantee mortgage-backed securities with a last-resort backstop by government. Providing last-resort protection against another financial crisis is a good objective but we already have mortgage insurers who can and have guaranteed mortgage securities. Adding a government backstop to their operations might be a good way to go but would not address other major structural deficiencies. There are three.
Ÿ Excessive market power: Unless concrete measures are taken to prevent it, assuming a phaseout of Fannie and Freddie, the four mega-banks that now dominate a sliver of the market will dominate most of it. These four banks now account for half of the strictly private market and almost three-fifths of total loan originations, according to Guy Cecala of Inside Mortgage Finance.
The market power of the big four outside of the strictly private market is now constrained by agency support to several thousands of smaller loan originators. As this support is removed, the dominance of the big four will grow. The ramp-up should prevent this by creating new loan origination channels that small players can exploit as well as large ones.
Ÿ Barriers to effective shopping by mortgage borrowers: The administration’s proposal has nothing in it that would make it easier for borrowers to shop the market. Probably their underlying premise is that improved disclosure requirements under Truth in Lending (TIL) and the new Consumer Protection Agency (CPA) will deal with that problem. However, no combination of restraints on lender practices and mandatory disclosures is an adequate substitute for empowering borrowers to protect themselves.
The problem is that the prices paid by borrowers in the primary market are determined by prices in the secondary market, but borrowers have no way to access the secondary market prices that affect the prices they have to pay. If they did, they wouldn’t need CPA or TIL. The ramp-up should provide access by borrowers to relevant secondary market prices.
Ÿ Vulnerability of the private secondary market: A third major lack in the administration’s proposal is any plan to fix the major structural defect of the private secondary market. Every individual mortgage security is a stand-alone entity secured by whatever reserves or insurance protections are embedded in that security. If these reserves are excessive on 99 securities and deficient on one, that one will fail. The excess reserves in the 99 securities are not available to the one that fails, and neither the issuer nor anyone else is obliged to rescue it. This can raise questions about the soundness of all the others, making the market extremely vulnerable to a contagious loss of confidence.
The ramp-up should address that problem by requiring that all mortgage-backed securities be full and unconditional liabilities of the issuers.
The interesting thing is that all three of these structural defects can be addressed by one strategic initiative, which I will outline next week. That initiative should be made the operating responsibility of the federal entity best fitted for the task. That entity is ... either Fannie Mae or Freddie Mac!
A complete phaseout of the agencies would involve a tremendous loss of human and institutional capital that could be redirected toward constructive ends. Since the malefactors who brought the agencies to their knees are long gone, it makes no sense to punish those that remain by giving them nothing to work for except their own extinction.
Next week: What the ramp-up could be.
Ÿ Contact Jack Guttentag via his website at mtgprofessor.com.
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