Friday, January 29, 2010

The Mortgage Market Meltdown & Uncle Sam

There is a lot of troubling discussion about what to do so the mortgage meltdown that occurred in late 2008 does not happen again. Public outrage was first directed at banks in general, then migrated upstream to the big "fat-cat bankers", i.e. those top 19 banks that were told to take TARP funds.

Now, politicians and former Fed officials (namely, former Fed Chairman Paul Volcker) are calling for a reinstatement of Glass-Steagall, that depression era law that separated commercial banking from investment banking. It's worth considering, if it will prevent the rapid housing bubble that caused the mortgage market collapse. But wait...

According to the San Francisco Fed, banking's share of the mortgage market peaked at 75% in the mid 1970's (see for the Fed's letter). That percent shrunk to 35% in 2008. Why? Government Sponsored Entities (GSE) (i.e. Fannie Mae, Freddie Mac, Ginnie Mae) dominated the market, and still do so to a greater degree today.

Government guaranteed bonds (now, post GSE bailout, we know they are government guaranteed) flooded the mortgage market with money, allowing even the diciest of borrowers to own their piece of the American dream. Housing values bubbled, the bubble burst, borrowers defaulted, loans went bad, bonds backed by mortgages were severely devalued.

Now we want to blame the fat-cat bankers and split their trading operations. How about, instead, the government slowly exits the housing market? Here is what I think would happen:

- Mortgage brokers, who originated most of the poor-quality loans, will be squeezed out, leaving only the most reputable in business because the hucksters won't have anyplace to sell their bad loans;

- Banks would utilize underwriting discipline because they will keep the loans on their books or the private mortgage buyers will hold them accountable for misleading underwriting practices;

- Banks will create mortgages that are palatable to their balance sheets (i.e. straight ARMs or 5/1's, etc.). Right now, banks are leery of keeping 30-year mortgages because there is no funding source with that long of a duration... and I predict people will buy them because the 30-year will now be priced with the duration risk it deserves because the government won't be keeping prices artificially low;

- Alt A and sub-prime will rebound, but will be prudently managed as small portions of a balance sheet or private investor portfolios, and will be correctly priced;

- No extreme housing bubbles. There will still be ups and downs, but not like skiing Killington!

The current climate is too politically charged for acting on this proposal right now. But, if our objective is to solve the problem, let's get it right on exactly what caused the problem.

Your thoughts?????

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