The bureaucrats and politicians continue to roll out their take on the fixes needed to repair the broken home mortgage system that led to the worse financial collapse since the Great Depression. The latest plan, as proposed by the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), requires borrowers to put up a 20% down payment for mortgage loans lenders intend to repackage and sell as “high-quality” mortgage-backed securities. However, this new proposal, long with other ideas and modifications continue to miss the mark in key areas:
- Providing more choice to homeowners for mortgage refinance products
- Eliminating the dominance by the four major banks and allow smaller lenders to compete.
- Restoring trust in the system by eliminating unnecessary risk in private secondary market, which provides the funds for mortgages made to homeowners.
Qualified Residential Loans: Do They Go Far Enough?
The industry has coined the term Qualified Residential Mortgages or QRMs. QRMs must undergo stringent underwriting criteria before lenders can repackage and sell them as securities. On the surface, this may seem like a good idea, but once again - read the fine print, the proposal has more bark than bite. The plan exempt loans sold to Fannie Mae and Freddie Mae from this requirement. This part of the deal seems odd because Government Sponsored Enterprises (GSE) back about 90% percent of home mortgages currently on the market.
This will only give strength to the strategy to build the case against government involvement in the home mortgage system. According to Jaret Seiberg, an analyst at cash and derivatives broker-dealer MF Global Inc., 97% of the mortgage loans made by lenders under this proposal can evade the retention requirements.
Nonetheless, this proposal goes on top of stipulations, under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which mandates home mortgage lenders to retain at least 5% of its mortgage-backed securities. The theory being that lenders would keep some of the risk; therefore, have a greater incentive to implement sound underwriting policies for mortgage refinance loans before packaging them for sell to investors.
The Danish Mortgage System
Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania, and mortgage expert, Jack M. Guttentag thinks a system similar to the model for real property financing in Denmark, would fix the shortcomings inherent in the current home mortgage system. He advocates new federally chartered companies called “Delta Mortgage Banks” (DMBs), which would fund home loans by issuing instruments called “covered bonds.” DMBs would operate much differently than traditional mortgage lenders:
- DMBs would not package loans for securitization, but sell mortgages to investors one at a time.
- These banks would make the loan and sell the loan concurrently.
- Delta Mortgage Banks would retain full liability for the loan after it sells the mortgage loan to an investor.
Furthermore, DMBs would compete with “the big four” banks -- Citigroup, Bank of America, Wells Fargo & Co., and JPMorgan Chase, by pooling their assets. However, unlike its mega-rivals and other mortgage lenders, DMBs would have significant “skin in the game.”
The Mechanics of the Covered Mortgage Bond System
Under the current home mortgage system, lenders make certain representations and guarantees regarding the mortgage-bank securities sold to investors; however, investors take on all the risk when borrowers default on mortgages.
The strength of the covered mortgage bonds system, the lender issues a bond for each loan according to the type of mortgage product -- 30-year fixed rate mortgage, 5 ½ adjustable rate mortgages, etc. The information includes mortgage interest rates or bond yields, the markup by lenders- the total interest rate on the mortgage. Unlike the current home mortgage system, borrowers and mortgage lenders would have nearly equal access to information.
Do We Really Need to Reinvent the Wheel?
These lenders would not only provide solid competition for the big banks, but also give borrowers a variety of mortgage refinance options. In addition, homeowners will have direct access to a continuous stream of transparent data on all mortgages/bonds via the Web. This proven system of providing real property loans has been in place in Denmark for more than 200 years.
The most interesting thing about this proposed covered mortgage bond system of home loan financing -- defaults on Danish mortgage bonds are virtually non-existent. Contrast this to the U.S. mortgage-backed security market, which took a nosedive in 2008, taking the European covered mortgage bond market along for the ride. Even in the midst of this financial meltdown, the Danish mortgage bond market continued to operate unfazed by events in the international crisis.