Four years ago, the financial crisis marked the climax of what had started as an apparently isolated problem in the subprime mortgage market. Ever since then, investors have been leery of once-popular asset-backed securities, relying almost entirely on bonds backed by government-sponsored enterprises Fannie Mae and Freddie Mac.
Recently, though, the government has tried to reawaken the private market for mortgage-backed bonds. With proposals that would give investors incentives to take on part of the potential risk from loans that go bad, Fannie and Freddie, and by implication the U.S. Treasury and its implicit guarantee of those entities, wouldn't be solely responsible for any consequences of future mortgage crises.
Sharing the risk
As an article in this weekend's Wall Street Journal (may require subscription) described at length, Fannie and Freddie have been trying to offer a new type of mortgage-backed security. Currently, existing mortgage bonds come with the full guarantee of the respective agencies, leaving investors without any liability if problems arise with the underlying loans backing the bonds.
The new securities, however, would change that. By giving bond buyers the risk of partial loss in the event that a loan went bad, Fannie and Freddie wouldn't be completely on the hook. The trade-off would be that investors would demand higher interest rates in exchange for taking on the risk of partial loss, but by putting a market-determined price on that risk, it would be easier for everyone to tailor risk-management schemes to true estimates of the value of whatever risk investors wanted to transfer among themselves.
Fixing another problem
Policymakers hope that risk-sharing bonds will restart the private mortgage market, which has languished. Although a few players, notably mortgage REIT Chimera Investment (NYS: CIM) , have dabbled in non-agency-backed mortgage securities, Annaly Capital (NYS: NLY) , American Capital Agency (NAS: AGNC) , and most of their mortgage REIT peers invest exclusively in agency-backed securities. Whether risk-sharing bonds would fall under their ambit remains to be seen, but either way, it's likely that either they or other mortgage REITs would come in to buy these securities.
The Journal article noted that a question of regulatory oversight might scuttle plans to offer risk-sharing bonds. Under new rules, it's not entirely clear whether risk-sharing bonds would be treated as if they included explicit swaps, which could put them under the jurisdiction of the Commodity Futures Trading Commission.
Can anyone trust the mortgages?
But the true issue that everyone should focus on is whether a change in the way mortgages get packaged into asset-backed bonds will change the way that those mortgages get originated in the first place. Admittedly, having private participation at the mortgage securities level will increase private oversight of the loans included as collateral for the bonds. But by waiting until Fannie and Freddie package the loans, it may create too much separation between that private oversight and the loan origination process.
It's only natural to be skeptical of the mortgage loan process. After Bank of America (NYS: BAC) , Citigroup (NYS: C) , and several other banks committed to a collective $25 billion settlement of allegations connected to foreclosure practices, you'd think that Fannie and Freddie would be more interested in forcing mortgage lenders to retain some of the risk of their loans. After all, with their own money at risk, they'd be far less likely to try to squeeze their customers into Fannie and Freddie's requirements, only to sell their loan to the government-sponsored enterprises, reap their transaction income, and move on to the next loan.
Fix the real problem
Only by leaving mortgage-originating banks on the hook for at least a portion of the loans they make will investors truly have confidence that the system can work. Until that happens, the Band-Aid approach of risk-sharing mortgage-backed securities and other similar ideas will leave the root cause of the underlying problem unsolved.
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The article How to Prevent the Next Mortgage Crisis originally appeared on Fool.com.
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