Why we need a new private secondary market

Editor's note: This is Part 6 of a seven-part series.

The Obama administration does not know what to do with Fannie Mae and Freddie Mac. While the mixed private/public model under which they had operated has been thoroughly discredited, and the agencies are now in a government conservatorship, they are critically important in today's market.

Because there is a fear of rocking the boat, the issue of what to do with them going forward has been placed on hold. Such delay is a good thing if the time is used to get it right.

In the long run, one of the agencies should be entrusted with developing a private secondary market to replace the one that collapsed during the crisis. In the short run, both agencies need to get on board with the government's policy of stimulating economic recovery.

Developing a new private secondary market: As discussed last week, the new market should have the following major features:

• Firms issuing mortgage securities retain full liability for every security they issue. This makes the market safe for investors.

• New loans are financed by selling them directly into open security issues of the same type. This makes the market efficient.

• Borrowers have direct access to the secondary market, borrowing at the price of the security sold to finance their loan, plus a rate markup and fees charged by the lender. This makes the market transparent, protecting borrowers against being overcharged.

• Borrowers have the right to pay off their mortgage by buying back an equivalent amount of bonds, at the lower of par and the market price. This makes the market stable, protecting borrowers against rising market interest rates.

Fannie Mae and Freddie Mac should compete to determine which will be selected to develop this new market. If there ever was a need for two agencies in the past, there clearly will be no such need in the future. The agency selected to oversee the development of the private market would recast its own secondary market operations so that the markets work in the same way.

The other agency should be placed in liquidation. (An updated version of this article at www.mtgprofessor.com will indicate some of the criteria the government might use in selecting the surviving agency.)

Participating in economic recovery: Although they are now part of the federal government, the agencies are operating at cross purposes to the Federal Reserve, as if they are trying to earn their way out of conservatorship.

While the Federal Reserve has purchased huge amounts of their mortgage-backed securities to lower interest rates for homebuyers and refinancers, the agencies have been adding a series of price add-ons that have raised financing costs to countless millions of potential borrowers. ...CONTINUED

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