Editor’s note: This is the last in a three-part series.
The previous article in this series critiqued the Obama administration’s proposal for a new federal reinsurance program on the grounds that it did not address the three major structural defects in the current housing finance system: the excessive market power of four mega-banks, the barriers to effective shopping by mortgage borrowers, and the vulnerability of the private secondary market to a contagious loss of confidence. The following is a ramp-up proposal that would deal with these problems.
The major focus is a new type of federally chartered mortgage lender that would lend and securitize simultaneously. I’ll call them "delta mortgage banks," or DMBs, to distinguish them from the kind of mortgage banks we have now (MBs). Both originate mortgages for sale, but there are major differences in how this is done.
- MBs often sell packages of loans, while DMBs sell one loan at a time.
- MBs may hold mortgages for days or weeks before a sale, but with DMBs the granting of the loan and its sale occur simultaneously.
- Sale by an MB, aside from representations and warranties provided to the buyer, terminates the seller’s risk of loss in the event of borrower default; that risk is passed to the buyer. A DMB, in contrast, remains fully liable for the risk of loss after the sale because loans are sold into open-ended bonds issued by the DMB.
DMBs issue such bonds for each type of mortgage that they make. For example, there would be separate bonds for 30-year fixed-rate mortgages (FRMs) and 5/1 adjustable-rate mortgages (ARMs). If a new loan is a $200,000 30-year FRM, the corresponding 30-year FRM bond is increased by $200,000 through sale to investors. Each individual loan is funded by the secondary market.
Authorizing a new type of mortgage lender that would be competitive with mega-banks is the preferred way to deal with excessive market power. DMBs would be competitive because, until they become established, their bonds would be back-stopped by the federal government, and the diseconomies of a small-scale operation would be avoided by cooperative bond-pooling arrangements (see below).
Note that this proposal is very different from those that would authorize depository institutions to issue "covered bonds" against some or all of the mortgages in their portfolios. Covered bonds would benefit existing portfolio lenders, and especially the mega-banks.
Mortgage borrowers would be a major beneficiary of the DMB model, because it would give them access to secondary market prices of the mortgage type they want. The mortgage bond infrastructure would include facilities for providing continuous price information on every bond, which would be available on the Internet.
The rate paid by the borrower is the bond yield plus the DMB’s markup, which would be public information. In this way, the major source of skullduggery in the market — the lender’s knowledge of the market and the borrower’s ignorance of same — would be removed.
Finally, the DMB model is structurally stable. All bonds issued by a given DMB would be full liabilities of the DMB, which means that profitable bonds support unprofitable ones and the DMB’s capital stands behind them all. This is in contrast to existing private mortgage-backed securities, each of which stands alone with no claim on any other, and all are orphaned by their issuers.
These advantages of the DMB system are not hypothetical; the astute reader has already guessed that I have been describing the Danish system, which has the advantages I have described. The prices of all Danish mortgage bonds are shown on the NASDAQ website, http://www.nasdaqomxnordic.com/bonds/denmark.
There has never been a default on a Danish mortgage bond in more than 200 years. During 2008, when the mortgage-backed security market in the U.S. collapsed and the covered mortgage bond market in continental Europe froze, it was business as usual in the Danish mortgage bond market.
To implement this model effectively and rapidly requires an implementing agency, and the best entity to do this would be Fannie Mae or Freddie Mac. I propose that the agencies compete to determine which will be selected to develop this new market. The agency selected would be the one with the best implementation plan as determined by a special interagency group appointed for the purpose. The other agency could be phased out.