Of Mortgages, Accountability and Risks

By now we all know that it was the U.S. housing market that catalyzed the financial meltdown we are still sorting through. It has also become painfully obvious to most that the value of homes has declined at the same time as homeowners’ earnings, thus impairing their abilities to pay or repay their mortgages. In simple English this means that homeowners as a group owe more than they can repay, and it is this rather unfortunate but simple situation that has led our government to much frantic activity to “fix” this problem. In its zeal, the government has effectively nationalized the mortgage business. Returning it to the private sector and extricating the U.S. taxpayers from risk will be quite a challenge.

In the past few years the government has made or guaranteed nearly 100% of every loan originated, and this despite FNMA and FHLMC having both collapsed.  With this unprecedented government involvement one might rightly wonder how the home mortgage market is being funded, and what the implications are for taxpayers and our nation’s future. In the past year the Fed has, for the first time ever, purchased mortgage-backed securities (“MBS”), and a whopping $1.25 trillion at that. Also, through the magic of pushing a few buttons on a computer, banking reserves have been massively increased giving banks virtually no cost capital with which they can buy up the “risk free” MBS, earn a profit margin and re-build their equity bases, all the while serving the public good of stemming the housing market decline. 

We are deep into uncharted waters and the question that permeates most conversations in financial circles today is: “How will this all end?”

Let’s follow the money trail to see if we can clarify this very murky situation and at least discern who it is that owes money to whom. 

In the case of the banks’ MBS holdings and loans, homeowners owe them many trillions of dollars and they in turn owe the Fed who created some money out of thin air and who, if they don’t get the money back and burn it, will have devalued all of our dollars.  Then, this newly created money is leveraged with deposits that are fully guaranteed by the U.S. taxpayers to create the full bank buying power.  Just in case the homeowners don’t repay this money in full, the U.S. taxpayers, through the guarantee they’ve provided to FNMA, FHLMC, the FHA, and the FDIC, has agreed to make up the shortfall.

If that seems circular and confusing and fraught with risk for U.S. taxpayers, it is.  With all of those guarantees, the plan seems to be that one way or another the banks who own MBS will be repaid, their earnings will be strong, their equity capital replenished, and their executives compensated for jobs well done.  Homeowners who can pay their mortgage payments will do so and those homeowners who cannot will be subsidized by the U.S. taxpayers and will become the next cycle’s subprime borrower group. Washington will congratulate itself for skillfully navigating our nation during a very difficult period and avoiding a catastrophic depression, will tweak the old model and will launch FNMA and FHLMC back into the marketplace with historic public stock offerings to an investing public with short memories. And the losses, which are the direct result of a mortgage system that provided too much credit to unqualified borrowers, and which have already reached nearly $1 trillion, will be socialized and borne by all the honest, hard-working U.S. men and women who pay their taxes.

The one chink in this plan, the one risk that could muck it all up and magnify systemic losses, is the age-old risk that, along with bad credit decisions, always undermines financial systems. This is the risk that is introduced when long-term assets are financed with short-term liabilities.  You see, the bank deposits re-price quickly and the MBS they hold are mostly fixed rate for 30 years. If, as is highly plausible given the needs to fund massive government deficits, rates drift higher, then the profitable spread earned by banks today will decrease and could, if rates truly spike, become negative and create losses rather than gains.

An important lesson of this debacle is that if there is a subsidy, implicit or real, it is worth being on the receiving side. This is a very dangerous precedent to have set and we must quickly modify our system so as to insure that we don’t institutionalize that lesson.  Unless the system is modified it would be most prudent for us all to own bank stocks, MBS funds, and to buy the most extravagant home with the largest possible mortgage, ideally one with a nice low teaser rate for as long as possible. 

It would only take a few fixes to bring discipline to the market. First, as is the case in most of the rest of the world, all mortgages should be full recourse obligations. Next, all mortgage originators should remain on the hook for a significant first loss portion of the loan, say 10%-15%, in order to qualify for a government guarantee such as FNMA, FHLMC, or FHA. Importantly, this recourse must be properly accounted for, with an appropriate capital reserve, on the originators’ books.  Finally, we should make depositors bear a first loss if the bank they make their deposit in fails. This can be as low as 5%, but by doing so our nation of depositors will out of necessity become smarter consumers, and ultimately will reward the prudent banks with our deposits and will drive the less deserving out of business.  Of course, the truth is that with the taxpayer guarantee backing deposits and the FDIC kitty nearly dry, we are already self-insuring so this is not as radical a suggestion as it may first seem.

Ethan Penner is executive managing director of CB Richard Ellis Investors and president of CBRE Capital Partners. He joined CBREI in 2008 and has 24 years of experience in the real estate sector and is widely recognized for being a pioneer and innovator in real estate finance.