Tuesday, March 30, 2010

Reforming a broken mortgage system - By George Soros

Found via Simoleon Sense.

With the private sector largely incapacitated, the GSEs and FHA became virtually the only source of mortgage financing. This is a paradoxical situation in which a fundamentally unsound business model holds a quasimonopolistic position. This cannot last.

What needs to be done is clear: The GSEs’ mortgage insurance function must be separated from mortgage financing.

The former, mortgage insurance, is the legitimate function of a government agency, especially when the private sector has collapsed. A mortgage insurance entity should be run as a government agency.

But mortgage financing should revert to the private sector. This would get rid of a business model that has failed.

There is a proven mortgage financing system already up and running. The Danish model has been in use, continuously, since the aftermath of the Great Fire of Copenhagen in 1795. It has not prevented housing bubbles, but it has never broken down. And it proved its worth again in 2008.

In the Danish system, homeowners do not borrow from either a mortgage originator or a GSE. They borrow from the bond market, through a mortgage credit intermediary. Every mortgage is balanced by an equivalent amount of an identical, and openly traded, bond. This is called the Principle of Balance.

In the United States, mortgage securities are separated at birth from the borrower. Thereafter, they lead separate lives. But in the POB system, the link is never broken.

Mortgage Credit Intermediaries operate the POB system. They help homeowners understand and navigate the process. Most important, MCIs bear the credit risk of the mortgages — they remain “on the hook” in the event of delinquency or default.

In Denmark, these mortgages are not insured by a government agency. This would have to be modified in America. Given the current demoralized state of the market, a government agency would have to guarantee mortgages, but the MCIs would be required to keep “skin in the game” with a stake of, say, the top 10 percent.

A key benefit of the POB system is that it offers performing homeowners the opportunity to buy back their loans when interest rates rise. If the price of the associated mortgage bond drops, the homeowner can buy the equivalent face value of bonds at a discount, to redeem the existing home loan.

The homeowner’s ability to lower his mortgage liability reduces the chance that he will be under water when home prices fall because of a rise in interest rates.

This helps forestall foreclosure crises. And it would have a counter cyclical effect: Homeowners repurchasing mortgages help moderate upward pressure on interest rates. By contrast, the current system tends to exacerbate upward pressure by lengthening duration, a likely near-term prospect.

This system would have many other advantages over one that has collapsed.

It would eliminate the agency problem that was the primary cause of failure. It would separate the credit risk from the interest rate risk. It would be transparent. And it would be open: The duopolistic position of the GSEs would disappear.

What would remain is a government agency offering mortgage insurance to all qualified MCIs without competing with them.