How to restore trust in mortgage-backed securities

Over the past four years, there have been a number of government efforts to spark the rusted engine of the U.S. housing market. These include tax refund incentive programs for borrowers and incentive payments to banks to modify mortgages. The Federal Reserve has run a “quantitative easing” program designed to push mortgage rates to historical lows below 4 percent. And more than 90 percent of American mortgages that originated in 2011 were securitized by government entities using taxpayer funds to guarantee investors against default risk.

Despite these programs, the American housing market remains stalled. This is because there are still millions of mortgages with missed payments waiting to go through foreclosure, while U.S. household debt has not fully deleveraged from its peak in 2006 and 2007.

Once these corrosive elements run their course, though, the housing industry will need to shift from being reliant on the government for financing (currently taxpayers are guaranteeing over $5.8 trillion in housing credit risk) to relying on private sector assumption of mortgage risk. This is one of the few issues in American politics where there is a modicum of bipartisan agreement — both the Obama administration and House Republicans want the private sector to be the primary financer of American mortgages, they disagree, however, over whether there should also be a government guarantee program for extreme mortgage loss scenarios.

While the prevailing view is that private capital should be shouldering the majority of mortgage default risk, there are at least three roadblocks that will severely limit the pace and scope of mortgage finance risk returning to the private sector.

First, the private sector cannot compete with taxpayer-subsidized government-sponsored mortgage institutions (GSEs), i.e., Fannie Mae, Freddie Mac, Ginnie Mae, and the Federal Housing Administration.

Since 2008, Congress has authorized GSEs to purchase mortgages as high as three times the $234,500 S&P/Case-Shiller median housing price in the U.S., using taxpayer bailouts to offer the lowest guarantee rates for mortgage investors. That is a major reason why GSEs have a 90 percent market share. Restrictions will have to be put on these GSEs to reduce their dominance of the housing market.

Even worse, banking regulators plan to exempt the GSEs from new risk retention requirements placed on mortgage-backed securities issuers by the “qualified residential mortgage” provision of the 2010 Dodd-Frank Act. This will give GSEs a significant cost advantage over private issuance of mortgage-backed securities, reducing the pace of private capital taking on mortgage risk.

Second, the legal framework governing residential mortgage-backed securities in the U.S. is highly complex. When the MBS market was flying high, no one much cared about the ambiguity in securities contracts regarding how losses would be distributed. Now that heavy losses in collateral pools have proven to be a reality, tranche warfare — the fight among various classes of investors as to who shoulders these losses — has come to the fore. Until regulatory, judicial, or legislative action is taken to provide clarity, mortgage investors will be reluctant to jump back into the MBS game.

Bills have been introduced in the U.S. Congress to address each of these roadblocks and there has been considerable intellectual capital devoted to these problems in academic circles.