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Redesigning the Housing Finance System

Written By:
May 27, 2010 at 2:17 PM

Returning to Reality: Redesigning the Housing Finance System

Whether you’ve lost your job or your home as a result of the Great Recession, everyone has been an unwilling victim of the housing finance system crash. Unemployment levels are holding steady at 9.7%; foreclosures continue to haunt neighborhoods. Today, obtaining a mortgage, despite having excellent credit, is nearly impossible.

The U.S. Treasury Department has been wrestling with the dilemma of how to redesign the U.S. housing system, now in shambles. Once upon a time, the U.S. housing system was viewed as a respected model, comprised of federal lending programs and a non-federalized private sector.

Before the market crash of 2007, the non-federalized sector was considerably larger than what is seen today because it was supported by a sizable secondary market. Lenders were not obligated to adhere to federal lending regulations and could sell loans on the private secondary market. The 2007 market collapse shattered plans of secondary market sales, still crippled today.

According to U.S. Treasury Secretary, Timothy F. Geithner, a market redesign is still in question. During a House Financial Services Committee meeting, Geithner testified, “I have not seen an ideal model yet to replace this current system. But we’re going to have to take a careful look at how to design a better form of guarantee and support that doesn’t have the same risks.”

Everything Was Going “So Well”…What Happened?

While everyone continued to live inside the 2004/2006 housing “bubble,” the securities that were tied to real estate pricing skyrocketed. All was well with the world…until 2007.

Questions swirling around bank’s solvency, declines in credit availability and reduced investor confidence contributed toward the housing bubble bust. The real estate securities that were doing so well plummeted, kicking off the worst global financial crisis in over 80 years.

Who is to blame? On one hand, private lenders were extending loans to individuals who did not have the means to pay off the debt. On the other hand, these private sectors went unregulated, void of structure and specific direction.

How the Secondary Market Can Make or Break the Housing Finance Redesign

Before the crash, tying mortgages to individual securities made sense and worked well for investors. However, it had one structural defect—the loss of investor confidence.

According to Jack M. Guttentag, Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania, the U.S. market was standing like a house of cards.

“Every individual mortgage security was a stand-alone entity secured by whatever reserves or insurance protections were embedded in that security. If these reserves turned out to be superfluous, as they always were before the crisis, they were paid out to investors who owned a residual claim to them.”

The market was essentially a proverbial “house of cards” because the securities didn’t back each other to balance the portfolio. One security could have an abundance of reserves, whereas another could be completely starved.

The “house” crashed when a few securities became deficient, creating panic because investors were terrified other securities were not performing either.

Now What?

Currently, the U.S. housing finance market is under examination, but without specific plans for a redesign. Geithner says that one thing must be clear that the government needs to make sure there is “no ambiguity over the status or allowable activities of any private entity which enjoys any benefits or protections from the government.”

While the U.S. Treasury Department decides where to take the shattered market, Dr. Guttentag has some solid ideas. He believes that the Danish model is the perfect example to be transplanted in the U.S.

Doing Things the Danish Way

Dr. Guttentag discusses how the Danish housing finance market weathered the Great Recession versus what Americans experienced. He says that every Danish mortgage security has a bond liability for the firm that issues it.

The new market would be opposite from the “house of cards” the U.S. market was previous based upon. Instead of only a few securities clutching tightly to all the reserves, all of the bank’s assets collaborate during a high loss, maintaining an overall balanced portfolio.

In the current U.S. housing finance market, borrowers don’t have the benefit of being able to shop for mortgages in both the primary and secondary market. Danish borrowers can shop both markets--even online.

Looking for a home in Denmark? Hop on the Internet to find the specific mortgage type and desired rate. During your search you can find a complimentary bond selling for the highest price. The mortgage lender will typically add .5% to the bond price plus a few fees.

Purchasing a home in Denmark also provides you with more refinancing options. When rates decline, both the U.S. and Danish market allow for refinancing at a lower rate. However, when rates creep back up, only the Danish borrower can refinance at the lower price, whereas the Americans’ only option is the current rate.

Guttentag, Jack. Redesigning the GHousing Finance System. The Mortgage Professor’s Website. 26 April 2010.

Christie, Rebecca. Geithner Urges Ending Fannie, Freddie ‘Ambiguity.’” Bloomberg. 23 March 2010.

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