Playing Risk: Nevada and the secondary mortgage market

Risk game boardThere are some topics which engender eye-rolling and extended yawns, and the secondary mortgage market is one of them.  That peril acknowledged, Nevada’s housing market is precariously balanced on the edge of this subject, so it’s worth risking another foray.  Let’s start with an article in the Las Vegas Sun,  concerning the implications of the Obama Administration’s decision to wind down the Mortgage Twins — Fannie and Freddie — in the backwash of the Mortgage Meltdown.

Blue BookA Quick Review

The focus of the article concerns the (1) possibility of increased mortgage rates in a fully privatized secondary mortgage market, (2) pressures on first time home-buyers which could be exacerbated by a privatized mortgage market, and (3) problems with establishing home values.

What is the Secondary Mortgage Market?

Here’s the standard definition:  “The market where mortgage loans and servicing rights are bought and sold between mortgage originators, mortgage aggregators (securitizers) and investors. The secondary mortgage market is extremely large and liquid.”  [Investopedia]

The mortgage originators (banks & other lenders) sell their home loans to “aggregators” who securitize (package the mortgages into bonds) and sell them to investors.   The second sentence in the definition might well qualify for inclusion in the Understatements Of The Century awards.

The idea behind this “large and liquid” — or Big and Squishy — system is to minimize RISK.  The bankers don’t have to keep all their loans on their own books, thus reducing their exposure to defaults, and the aggregators can re-package loans in ways to attract investors who want yield without too much RISK.  We’ve already covered all those intriguing and creative “financial products” (swaps, etc.) manufactured to further reduce RISK — which in some circumstances (read 2008) can create even more RISK.

Risky Business

There is one crucial point in the Sun article which should point us toward the critical problem with immediately  privatizing the secondary mortgage market:  What’s the value of the property on which the mortgage is based, and is the foundation for the securitization in the secondary phase?

If home values stabilize or increase the homeowners are more likely to be able to pay and not default on the loans.  When home values decline, as we learned to our peril, “underwater” home-owners are more likely to default which, in turn, de-values the aggregated and securitized ‘packages’ sold to investors.

Blue Book

The Rules of the Game

While those interviewed for the article use the term “guidelines,” let’s call those The Rules of the Mortgage Market Game.  One of the functions of the “Mortgage Twins” is to establish basic rules for home loan lending.  The Congressional Budget Office analysis explains:

“They purchase mortgages that meet certain standards from banks and other originators, pool those loans into mortgage-backed securities that they guarantee against losses from defaults on the underlying mortgages, and sell the securities to investors–a process referred to as securitization. In addition, they buy mortgages and MBSs (both each other’s and those issued by private companies) to hold in their portfolios. They fund those portfolio holdings by issuing debt obligations, known as agency securities, which are sold to investors.”

The two essentially risk reduction elements are in the first part of the explanation quoted above. (1) Fannie and Freddie have mortgage lending standards.  (2) Fannie and Freddie operate as aggregators who will re-sell the mortgage packages to investors.

When the banking system collapsed in a heap in 2008, the Mortgage Twins ended up holding most of the bag.

“…in 2009, the two GSEs owned or guaranteed roughly half of all outstanding mortgages in the United States (including a significant share of subprime mortgages), and they financed three-quarters of new mortgages originated that year. Including the 20 percent of home loans insured by federal agencies, such as the Federal Housing Administration (FHA), more than 90 percent of new mortgages made in 2009 carried a federal guarantee.” [CBO]

Not to put too fine a point to it, but when the banking system took on too much risk during the Housing Bubble, the explicit federal guarantee for the secondary mortgage market backstopped the home loan lending process in this country, and in this state.  That’s the good news.  That doesn’t mean there aren’t still some intrinsic problems with the Mortgage Twins.

The Backstop Effect:  Little encourages more risky behavior than the notion that someone else will end up holding the bag.  As long as the federal government assumes responsibility for the home loans, then the bankers can see the system as one that privatizes the profits and socializes the risks.   This rationalizes the practice of offering exotic home loan products to people who might never have qualified otherwise.

The Quis custodiet ipsos custodes?  Factor:  Who was watching the watchers before 2008?  Before 2008 the Mortgage Twin’s regulators lacked the authority to increase the capital requirements for Fannie and Freddie.  Nor could the regulators place the Twins in receivership as the government could in the instance in which a bank went under.  No one should have been surprised when the Twins were placed in conservatorship in the wake of the Housing Bubble deflation.

There’s little appetite from most quarters to leave the current system in place.  However, the next step in the reform process must address some difficult questions.

Blue Book  “Students are required to provide their own 8½ x 11 bluebooks. Do not use the smaller sized bluebooks. Bluebooks are available at the University Bookstore. The exam proctor will also always have some emergency blue books available.”  [Law.Wash.EduAnd the test questions are:

#1.  What configuration for the secondary mortgage market will best ensure a stable supply of mortgage financing?   Consider the consequences of a fully public model, a hybridized public-private model, or a fully privatized system.

#2. How are the underlying assets to be valued? Your answer should give consideration to (a) the standards by which the quality of the underlying loans are to be evaluated, (b) who should establish the standards for this evaluation, and (c) how the housing finance structures might be affected by the needs of the banking sector, the construction sector, and the needs of middle income prospective home-buyers.

— Good Luck —

For a fuller look at some possible answers, see Congressional Budget Office, ” Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market” December 22, 2010.   New York Times, “Washington Steps Warily on Housing,” August 6, 2013.   New York Times, “Obama Outlines Plans for Fannie Mae and Freddie Mac,” August 6, 2013.   Federal Reserve Bank of Atlanta, “Financial Market Update, Volume 14, No. 1: Fannie Mae and Freddie Mac at work in the secondary mortgage market.”  University of North Carolina, Center for Community Capital, “Fannie, Freddie, and the Foreclosure Crisis,” September 2010.

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