August 27, 2012

The first two articles in this series indicated that there was no quick way to replace Fannie Mae and Freddie Mac without seriously disrupting the market. An expansion of portfolio lending by depository lenders cannot fill the void, and revival of the private secondary market that collapsed during the crisis is neither feasible nor desirable.  

The best available option is a slow fix where existing mortgage banks and perhaps other firms converted to Danish style mortgage banks, with temporary assistance from Fannie and Freddie, This would create a robust secondary market in which mortgage banks retain full liability for every security they issue – as opposed to  the fair-weather market we had before in which the firms issuing securities took their money from investors and washed their hands of further involvement.  

This article considers the favorable features of the Danish style secondary market for mortgage borrowers.  

Direct Linkage Between the Primary and Secondary Markets

In the US system, the primary market where loans are made to borrowers is separated by time and process from the secondary market where the loans are eventually funded permanently. For example, a loan closed by a small (“correspondent”) lender is sold to a larger wholesale lender who sells it to an investment bank who places it in a new mortgage security. Months may pass between the date when the loan is closed and the date when the loan becomes collateral for a security.

In the Danish model, in contrast, there are no transfers of ownership, because each individual borrower is funded directly by the secondary market. The mortgage bank places the mortgage directly with investors simply by adding it to an open bond issue covering the same type of mortgage. If the new loan is a 5% 30-year FRM, for example, it is added to the outstanding bond secured by 5% 30-year FRMs.

Reflecting these differences in the relationship between primary and secondary markets, borrowers in the US face far more challenges in shopping for mortgages than borrowers in Denmark. Borrowers in the US don’t have access to secondary market prices, and if they did, it would do them no good because there would be no way to use it. They are on their own in dealing with loan originators, many of which use a variety  of tricks of the trade to extract as much from them as possible.   

In Denmark, borrowers can price their loan by accessing secondary market prices on-line. They enter the type of mortgage they want and the interest rate, and find the corresponding bond selling for the highest price. The prices of all Danish mortgage bonds are shown on the NASDAQ web site, http://www.nasdaqomxnordic.com/bonds/denmark.  (Alternatively, they can go to a broker or loan officer who is paid by the lender selected, who has access to the same bond data with consumer-friendly add-ons.) The borrower pays the bond price plus a .5% rate add-on by the lending bank, plus some out-of-pocket fees that are set competitively. 

Refinancing Options

When market interest rates drop, borrowers in both the US and Denmark, can refinance at par to lower their interest rate. When market interest rates rise, however, only borrowers in Denmark can refinance at the lower market price. Borrowers in the US must pay off their old loan at par.

For example, Doe has a $200,000 balance on his 5% mortgage, and he expects to sell his house for $250,000 in a market in which home buyers pay 5%. But before he can sell, market rates jump from 5% to 7.5% and potential buyers can now only afford to pay $200,000, wiping out Doe’s home equity. However, because of the rate increase, the market price of Doe’s 5% mortgage has dropped from 100 to 85. If Doe is a Dane, before selling his home, he can refinance into a 7.5% loan by paying $170,000 to retire his old loan; by so-doing, he retains 3/5ths of his equity. If Doe is from the US, his entire equity is wiped out.

Given the already substantial depletion of home equity in the US, the need to reduce the further losses that will occur when interest rates begin their inevitable ascent, is compelling.

Postscript

On August 17, 2012, the US Treasury and Federal Housing Finance Agency announced “further steps to expedite wind down of Fannie Mae and Freddie Mac.” The steps, we are told, will “support the continued flow of mortgage credit during a responsible transition to a reformed housing finance market.”

Mostly, the new program has to with inconsequential bookkeeping involving the relationship between the agencies and the Treasury. The only thing worth noting about these bookkeeping changes is that they make 100% clear that the agencies are on the road to liquidation. But the planned liquidation process will do nothing to “support the continued flow of mortgage credit”, it can only dampen the flow.

Further, the liquidation process would be a responsible transition to a reformed housing market only if it was accompanied by a concrete plan to replace the dysfunctional and now defunct private secondary market with a robust one that works. No such plan has emerged. Fannie and Freddie are being phased out but nothing is being phased in to take their place.