Nothing will send me into the arms of the Democratic Party faster than a statement like this from a Republican, like Senator Dean Heller (R-NV):
“Heller believes that private capital, not the federal government, as the primary source of mortgage financing housing market is essential to long-term stability. As a conservative, Dean supports financial regulatory reforms that stop taxpayer-funded bailouts and addresses the growing liabilities of Fannie Mae and Freddie Mac.”
Let’s guess that the awkward phrase “mortgage financing housing market” means the secondary mortgage market in more common parlance. The idea of a secondary mortgage market is that banks cannot keep all the mortgages on their own books and still be able to provide financing for the housing demand in their communities, and to still be able to satisfy other demands from their customers and clients.
When people keep their heads about them the secondary mortgage market is a good way for banks to off-load some risk (of defaults) and to augment their capacity to keep up with demand for loans from real estate developers and prospective home buyers. When people don’t keep their wits about them we end up with players in the secondary markets securitizing mortgages into ever more incomprehensible financial paper “products” and then betting on whether these will “pay off.” The results in 2007-08 were predictable and painful.
A capitalist would surely agree that private investment in this secondary mortgage market would ensure “long term stability?” Not. So. Fast.
There is nothing intrinsically wrong with private investment in the secondary mortgage market —as long as it is a Free and Fair Market. And, therein lies the problem: How to we make certain the secondary mortgage market is Free and Fair?
In a free and fair market each participant, buyer and seller, have as much information as possible about the value of the item begin offered and bought. Without getting too deeply into the nuanced differences between “cost,” “value,” and “price,” let’s assume that one of the problems during the Housing Bubble was that while everyone seemed to know the “price” of various deals, few — if indeed any — knew the underlying “value” of the bonds or other securities being acquired or sold.
The expression “toxic asset” came into popular use because while these bits of paper were often costly — they were so arcane that it was difficult, if not impossible, for an value to be assigned to them. This is old news, but bears repeating because it goes to the heart of what Senator Heller, and many of his cohorts, are advocating.
Heller’s “free market” advocacy for the secondary mortgage market, and presidential candidate Newt Gingrich’s proposal to eliminate Fannie Mae and Freddie Mac and to replace them with “smaller,” free market (private) entities, are cut from the same cloth. Both deny any need for government in the operation of this secondary mortgage market. So, why would this send a capitalist into the arms of the Democrats?
Because — in order for capitalism to work there must be free and fair markets in which buyers and sellers have as much information as possible about what is being bought and sold, and this, of course, includes the value of the assets being exchanged. So, how would governance enhance this market?
(1) Government can, and should, enforce at least minimal underwriting standards for mortgages. Federal Reserve Board data indicate that more than 84% of all the subprime mortgages in 2006 came from private sector lending. 83% of the mortgages sold to lower and middle income borrowers in 2006 came from private lenders. What went wrong?
“Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.” [McClatchy]
In other words, Fannie and Freddie were losing market share in the secondary mortgage market during the housing bubble to private firms, and their reduction in standards for conforming loans — in order to make up market share — made a bad situation worse. What happens when there’s a race to the bottom in underwriting standards as private firms scramble for a larger share of the pie?
“Competitive mortgage securitization has been tried three times in U.S. history – during the 1880s, the 1920s, and the 2000s – and every time it has failed. Most recently, competition between mortgage securitizers led to a race to the bottom on mortgage underwriting standards that ended in the late 2000s financial crisis. This article provides original evidence that when competition was less intense and securitizers had more market power, securitizers acted to monitor mortgage originators and to maintain prudent underwriting. However, securitizers’ ability to monitor originators and maintain high standards was undermined as competition shifted market power away from securitizers and toward originators. Although standards declined across the market, the largest and most powerful of the mortgage securitizers, the Government Sponsored Enterprises (“GSEs”), remained more successful than other mortgage securitizers at maintaining prudent underwriting.” [Simcovic]
Contrary to the free-for-all markets advocated by Gingrich and Heller, the GSE’s did manage to be a bit more successful at “maintaining prudent underwriting” standards than the private sector investors who were eagerly grabbing up a larger share of the secondary mortgage market. One of the tip offs that things were going south should have been the reduction in Fannie and Freddie’s underwriting standards in a questionable effort to recoup market share.
Prudent underwriting is one of the factors that gives investors better information about the value of the securitized assets being offered for sale. If the private mortgage originators are unwilling to maintain those prudent underwriting standards — who will? And, how better to maintain standards for mortgage origination than to tell the originator (banker) we will not take the mortgages off your hands if you don’t keep your underwriting standards reasonable?
If we do want a secondary mortgage market, then in order for it to be free and fair there must be some way in which we can enforce standards that tell us something about the underlying value of the assets. Otherwise, we get Bear Stearns, Lehman Brothers, Countrywide, Merrill Lynch, and the rest of the parade of failures.
What capitalist purpose is served by a system that allows a seller of securitized assets to hand pick “loser” mortgages, stack them into a deck of items of equally indeterminant value, and then pawn them off on a “sophisticated” investor who doesn’t know — and probably can’t find out — what’s actually IN the package. We become outraged when toxic ingredients are allowed into baby food and pet food, but we “excuse” toxic ingredients in financial transactions because, “Gee, there were two parties?”
What capitalist purpose is served by a system in which parties who have no relationship to the original transactions are allowed to “bet” on the value of un-valuable assets (like synthetic CDOs) without any oversight or restrictions whatever? Some of the transactions that took place during the housing bubble were tantamount to my purchase of a fire insurance policy on your property — to be paid off when your home burned.
(3) Government can, and should, ensure the freedom and fairness of markets by requiring prudent standards for financial products. The Consumer Product Safety Commission can pull cribs off the market if they tend to strangle infants. Government ought to be able to put the brakes on the sale of “creative” mortgages which have surprise balloon payments, or have fine-print provisions remarkably different than what the home buyer was advised during the transaction. Similarly, in the secondary mortgage market the government can play a productive role in (a) eliminating those dubious mortgages from the pool, and (b) supervising how their derivatives are traded.
Why all this “interference” in the free market? So that it doesn’t disintegrate into a free-for-all market. So that concepts like “price” and “value” don’t become illusive and the parties and counter-parties know what they are buying and selling. So that it doesn’t degenerate into a Financial Jungle in which individualism and Financialism subvert our capitalist system.
Desert Beacon 