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Mortgage Market Fix – A Rebuttal

Today, I stumbled upon an op-ed on Bloomberg by Laurence Kotlikoff, a Professor of Economics at Boston University, on his plan to fix the mortgage mess in three steps. He presents some new ideas that I haven’t heard before, so I thought it would be worth sharing. While I agree with some of what he says, there are portions of his plan that I question.

 

From Kotlikoff’s op-ed…

 

Step 1: Set up a new government agency -- the Federal Financial Authority. The FFA would hire companies to verify, rate, appraise and disclose mortgage applications. These contractors would work exclusively for the FFA, eliminating any conflict of interest. Liar loans and no-doc loans would be history.

 

I’ve read many plans for revamping the residential home mortgage system, and I am immediately skeptical of any that start off with creating a new Federal Agency, especially one whose aim is, “eliminating any conflict of interest”. Layering more federal regulation only does the opposite. Concentrating on creating an environment where underwriters of loans are incentivized to do a better job of verifying, rating and disclosing data, would better serve the market in my opinion. I get more into underwriter’s incentives later.

 

No-doc and liar loans existed because people wanted to buy them, plain and simple. While you can outlaw certain products with reactionary regulation, it does little in terms of a sustainable solution. Investors were willing to lend money to people for home purchases without any income verification because a widespread drop in home values of 5% was seen as impossible, a number that we all know now was just the tip of the iceberg. Any true reform of the home lending process must begin with an acceptance of why the collateral for those loans was so grossly mispriced. Perverse incentives from the GSE’s and the Federal Reserve, were both major players. The author recognizes subsidies from the GSE’s as an issue, but is ignoring how much of an influence excessive liquidity from the Fed had on the development of the real estate bubble.

 

Step 2: Limit buyers of home loans to doing so only through closed-end mortgage mutual funds. If a fund manager chooses poor mortgages, the value of his fund’s shares will fall, but the fund itself won’t go broke. Mortgage defaults will never again lead to financial-sector collapse.

 

That last sentence really gets me… man that’s a doosie of a claim! The financial sector must have exposure to real estate for two main reasons. First, if they don’t have exposure to how debt performs, what responsibility will they have to underwrite anything worth buying? That’s the exact problem we have now. Second, the mortgage market is just too big to be supported without the banking system owning most of it. It’s not realistic to think everyone’s IRA can buy a few shares of a closed-end fund and alleviate banks of all risk. Kotlikoff may not be assuming that, but the exposure to the banking sector is necessary and cannot be avoided.

 

I think Kotlikoff’s third point on increased transparency is a good one. Better disclosure of data would be necessary for the market to transition to more private (non-guaranteed) securitization.

 

An electronic trading system could be built, to better improve liquidity, but the industry will need to make strides toward more standardization before a more uniform trading platform can be developed. This can better happen in a post-Fannie/Freddie market, where investors will demand more details when the loss of principal to the investor becomes a real factor. I would love to see a world where mortgage bonds trade more efficiently.

 

The best model in my opinion would center around winding down Fannie Mae and Freddie Mac, and move toward a market where underwriters are exposed to losses alongside investors. The immediate effect would be a large increase in the cost of financing a home, which would be a hard pill for the US housing market to swallow after thirty years of below market interest rates. By getting rid of the guarantee and developing a loss sharing policy you will not prevent bad loans, but you will improve the market’s ability to stomach losses in a normal scenario and help prevent future bubbles.

 

Ultimately, I agree with Kotlikoff that the current model is in need of change, but if the true source of the problem isn’t dealt with, we are just kicking the can further down the road.

 

Have a great weekend.

 

Cliff J. Reynolds Jr., Investment Analyst

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: The views expressed do not necessarily represent the views of Acropolis Investment Management, LLC. or its members.