The US mortgage system is broken and it may needs a complete overhaul. There is no realistic prospect of stabilizing housing prices right now and the value of mortgage related securities will erode.
Here are four significant flaws with our current system of mortgage financing.
First, the business model of Government Sponsored Entities (GSEs) in which profits accrue to the private sector but risks are underwritten by the public has completely failed. The GSEs need to be replaced.
Second, the incentives to originate sound mortgages and to service them well are inadequate. This is why the quality of mortgages deteriorates.
Third, mortgage backed securities were meant to reduce risk by creating diversified pools of mortgages. However, they actually increased risk by creating an environment where the modification of mortgages would be nearly impossible.
Finally, the US mortgage market is asymmetric. When interest rates fall and house prices rise, mortgages can be refinanced at par value, generating equity cash outs that helped to create the housing bubble. Meawhile, when interest rates rise and house prices fall, mortgages can only be refinanced at par value even though the market price of that mortgage has fallen.
So, what can we do to fix this? Maybe we should look to the Danish model. It is the best performing model in Europe during the current housing and economic crisis.
First, it is an open system in which all mortgage originators can participate on equal terms as long as they meet the rigorous regulatory requirements. There are no GSEs to muddy the waters.
Second, originators are required to retain credit risk and to perform the servicing functions. This would prevent loan officers from originating bad loans and pushing them to someone else to deal with the problem.
Third, the mortgage is funded by the issuance of bonds which creates a large and liquid market.
Finally, the nature of US mortgages is replaced by what the Danes call the "Principle of Balance". Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes. On other words, as home prices decline, the amount that a homeowner must spend to retire his mortgage decreases because he can buy the bonds at lower prices. How does that sound ?!
We can mirror the Danish system with few modifications. We simply need standardized securities which create large pools. In the US, over half of all mortgages are secured by Ginnie Mae, which issues standardized securities. All that is missing is allowing the borrowers to redeem their mortgages at the lower of par or market.
So what do we do next? It will involve modifying the existing mortgages, so that the principal does not exceed the current market value of the houses, and refinancing them with Danish style loans. The modification will have to be done by servicing companies that need to have the appropriate incentives. Modifying mortgages that have been sliced and diced into securities may require legislative authorization. The virtual monopoly of the GSEs would be terminated and they would be liquidated over time.
A plan like this to reorganize the mortgage industry allow a successful recapitalization of the banking system with the help of the recently approved $700 billion package.
Why aren't we doing this already? Are there too many people getting their pockets lined under the current scenario?
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