Is There Value In Having So Many Intermediaries Between Borrowers and The Secondary Market For Mortgages?

Question

Fannie and Freddie are obviously doing a terrible job of assessing risk for borrowers with their mounds of prescribed paperwork. Apparently the Danes allow borrowers to access loans via the secondary market directly while adding nominal fees via an originating institution. What is to keep us from doing this here and eliminating this big government mess altogether? Are there trade-offs for using a system like the Danish system from a borrower's and policy perspective or is this just a massive jobs program for originators? The whole system seems overly complicated and fraught with frequent underwriting changes to me. It seems like someone is generally either a good credit risk or not a good credit risk. Should the pricing for risk from borrowers really change so dramatically over time? How can someone that runs a business and gets a stated income loan be an excellent credit risk one day and a terrible risk the next day even if they have made solid payments for years?

Am I off base in assuming that the Fannie/Freddie secondary market model is terrible and needs to be abolished post haste? To me the current system is terrible at pricing borrower (and thus bond) risk. Am I off base here?

Don Konipol · Answer

The entire reason Fannie and Freddie were created was so that instead of 1000's of individual lenders each lending on their own unique criteria, which would be impossible to regulate, the government would have only a couple of lending institutions creating criteria which the government could regulate.

This has of course let to social engineering of the lending system (quotas, low income credit access, etc.), which has distorted the system, removed the systems ability to take a loss and adjust, and led to the wonderful state of quasi governmental ownership we are in now.

Vikram C. · Answer

I think there are several inter-related issues here that need fixing.  The current financial "reform" law does not do enough to solve some of these problems, partly because the most influential lawmakers are also the ones that created the old lousy rules in the first place.  (e.g. Barney Frank)

1.  The U.S., unlike some European countries, has an official government policy favoring home ownership.  A good example of this is the mortgage interest deduction while there is no deduction for rents paid.  Fannie and Freddie are part of the same pro-homeownership policy by making home loans cheaper than they would be in a well-functioning free market.  This means that the typical home loan underprices the risk of default.  When an entire industry underprices risk, the industry would normally go bust.  But with the financial services industry, this is not allowed to happen and instead taxpayers foot the bill when there is a bust.  The net effect of all this is a transfer of wealth from prudent to imprudent investors.

2.  The middlemen in the loan industry do more than simple securitization of loans.  They also divide the loans into tranches based on repayment priority with fairly elaborate rules governing each tranche.  The reason this industry came into existence and became so large is that data for several decades had shown that home prices had never declined nationwide while they had declined regionally from time to time.  Some very smart rocket scientists then figured that they could create "free money" by creating nationwide bundles of loans which would presumably have no systemic risk of decline while at the same time earning above-normal returns.  But this very confidence in the strength of the system caused it to weaken.  In finance, the only thing that is needed for a collapse is confidence - as the latter leads to the bubble that is required for the ensuing collapse.

3.  A third leg of the financial mess is the relative lack of shareholder rights.  The U.S., unlike most countries, has a system of state-based corporate laws.  Corporate management is determined more by the laws of the state of incorporation than by federal laws (SEC) and the rules of the exchanges.  This is normally a good thing as it allows different states to compete with each other at enacting better laws.  But with respect to corporate management, the state-based laws have created a disaster for shareholder rights because it is the managements of companies that have determined the state of domicile of a company and typically they have done it to protect the interest of management against the interest of shareholders.  The result has been a race-to-the-bottom between a few important states in enacting laws that make it very hard for shareholders to kick out management or disapprove omanagement's nominee for a board seat, win proxy fights, etc.

4.  A direct consqeuences of the weakened shareholder rights is ridiculous executive compensation.  Management hired compensation consultants, who naturally recommended compensation that would hugely enrich senior executives.  The management's lapdog (aka "compensation committee") would then approve the package.

5.  A favored compensation plan from management's perspective was to get paid based on annual results and annual stock price increases.  They loved this idea because it has the appearance of shareholder-friendliness while being antithetical to actual shareholder welfare.  Shares are priced based on the long-term prospects for a company and it is simply ridiculous to think that management that has tweaked the results for one year has done something good for the company.  The result of this annual-results-based compensation has been a huge increase in the riskiness of companies with managements trying to increase the profits for the next year in order to gain immense bonuses and stock option value.

6.  This compensation scheme tied in beautifully with the loan securitization industry because a lot of the more complex collateralized debt obligations were very hard to value.  The result was the they were valued by the management of companies using models that they had themselevs created, with the result of the models being used in determining their compensation for that year.  The result of this system was what any 8-year-old could have predicted.

This, in a nutshell, is what ails the financial services and loan securitization industries.  A solution that fixes the symptoms and not the underlying disease is simply going to control the problem until the next bust.

(Sorry for the long post - but the problem has complex and inter-related parts that need to be considered together.)

Bryan Hancock · Answer

Yeah...I'm talking PhDs...like the one we have as our Technology Director.  Not the ones that are too busy studying medicine to know about anything else ;-)

Vikram C. · Answer

I will read the article and respond to it separately, though.  It is always possible that there is one financially savvy doctor out there.  :mrgreen:

Bryan Hancock · Answer

The proposed plan above is definitely not mine.  I wish I was smart enough to have figured it out.  Fortunately we have very smart doctors in this country that know how to fix things if we can summon the political clout to make them happen:

The Danish Model That Hasn't Failed In Over 200 Years

Here are some of the highlights, but it would be a disservice not to read the article...it is excellent:

1.  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 sells the mortgage to 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

2.  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

Vikram C. · Answer

Bryan, can you explain your idea more?  I am not sure I understand it clearly.  When you say that you would like the borrower to directly access the secondary market, do you mean something similar to the model used by peer-to-peer lenders such as prosper dot com and lendingclub dot com?
          
          Technically, you cannot have a "secondary" market without a "primary" market but I suspect what you meant was to make the secondary market the primary market.
          
          Who would order appraisals in your proposed system?  I understand that credit can be evaluated remotely but what about appraisals and inspections?  My bank actually sends a bank employee to physically drive by each property that they plan to approve for a loan - it is a conservatively managed bank.  How would this work with your proposed new system?

Bryan Hancock · Answer

Great post Vikram.  I especially like your commentary on shareholder rights or lack thereof.  That is a big reason why I distrust the securities market in general now.  Dividends are at paltry levels and there are all sorts of shenanigans that take place (overly optimistic pension plan modeling, off balance sheet items, etc.) to make the company's profitability look better than it is.

I am assuming that you would be in favor of letting borrowers bypass all of the middlemen and let them access a lender in the secondary market.  It this the case?  This model would seem to rationally price risk for said borrower and eliminate the need for GSEs to set loan purchasing guidelines.  Is that too simple-minded?

I am assuming we can still form tranches, CDOs, and the like with this system and set policy to ensure that the structure of these financial instruments is regulated.  Heck...we could even employ many of the current Fannie and Freddie employees to regulate things with 1/10th of the resources.

Thoughts?  I am all for starting a BP document we can send to Congress to fix this mess if we can put a bunch of minds together and propose a fix for the problem.  This is important for the future health of our nation and the current "financial regulation" is a steaming pile of crapola.

Ted Harris · Answer

Their basis for qualifying folks is so out-dated and at a minimum requires a major overhaul if not outright abolishing - just look at our current crisis for evidence of this.

Is There Value In Having So Many Intermediaries Between Borrowers and The Secondary Market For Mortgages?

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