Mortgage Morass

The White House remedies for the mortgage meltdown have now been presented. Congress will debate the life extension, death, or rebirth of federal mortgage entities Fannie Mae and Freddie Mac during the coming weeks. When the noise has died down, don’t expect substantial change. But those who hope for genuine financial reform should, nonetheless, listen carefully not only to what Washington says, but to whom it says it. Will the new guidelines call on traditional home-loan bankers to make traditional loans? Or will we hear a shout-out to the investment bankers/mortgage traders who designed the mess? In any new financial structure for home loans, the single most important issue will be the ratio of debt to assets that the government will expect lenders to show. During the real estate boom, lenders were willing—and able—to provide mortgage brokers with financing for 100 percent or more of the value of a property with the expectation that real estate prices would rise. We witnessed the triumph of the trader over the banker: Profit relied on the sale or refinancing of the asset. For a mortgage originator or securitizer with no plans to hold on to the mortgage, what really matters has been the ability to place it, not the depth of the underwriting or the long-term financial prospects of the home resident. A traditional banker, on the other hand, might feel safe with a capital leverage ratio of twelve to one, with careful underwriting to ensure that the borrower would be able to make payments. With equity at risk, something close to that level of underwriting would be essential. The trader-think model virtually eliminated mortgage underwriting. What we saw instead has been succinctly described by L. Randall Wray in a Levy Institute Brief (http://www.levyinstitute.org/publications/?docid=1301): “Property valuation by assessors who were paid to overvalue real estate, credit ratings agencies who were paid to overrate securities, accountants who were paid to ignore problems, and monoline insurers whose promises were not backed by sufficient loss reserves…” Much of the activity didn’t even appear on the balance sheets. Mortgage brokers arranged for finance, investment banks packaged the securities, and the shadow banks — the managed money — held the securities. The debt to assets ratios for mortgages climbed. Investment bankers consolidated their liabilities into a single financial market that could have been called the Mortgages & More Shoppe. Mortgage-backed securities were included with commercial banking, and with other financial services where acceptable capital leverage ratios are much higher than for traditional home loans. (For money managers, capital leverage ratios can be 30 to 1 and up to several hundred, with even higher unknown and unquantifiable risk exposures.) Income flows took a backseat. Except for the home resident, that is. Because ultimately, all of these financial instruments came to rest on the shoulders of some homeowner trying to service her mortgage out of annual income flows which boiled down to, on average, five dollars worth of debt and only one dollar of income to service it. “In an ideal world,” Wray added, “A lot of the debts will cancel, the homeowner will not lose her job, and the FIRE (finance, insurance, and real estate) sector can continue to force 40 percent of… profits in its direction. But that is not the world in which we live. In our little slice of the blue planet, the homeowner missed some payments, the securities issued against her mortgage got downgraded, the monoline insurers went bust, the credit default swaps went bad when AIG failed, the economy slowed, the homeowner lost her job and then her house, real estate prices collapsed, and, in spite of its best efforts to save [the system], the federal government has not yet found a way out of the morass.” Whatever the fate of Fannie Mae and Freddie Mac, the coming federal recommendations need to lift underwriting standards up from that morass and back onto solid ground. According to January’s Financial Crisis Inquiry Commission report, about 13 million US homes have already or will soon face foreclosure. The investment bank traders who securitized those mortgages, with a few notable exceptions, have overwhelmingly escaped such suffering. Financial reform should change that equation by demanding a traditional, appropriate ratio of assets to debts in the real estate markets.