Fixing the Mortgage Mess

In an earlier posts, here and here, I discussed ethics and the disconnect between market actors that contributed to the mortgage mess that has in turn contributed to our financial meltdown. Specifically, the fact that mortgage holders now can't even tell who owns their mortgages is causing many of our troubles, because no re-negotiations are possible. I was at a loss as to how to solve it.

Turns out that this problem has been solved in Denmark, of all places. When a Danish mortgage bank makes a loan to a homeowner, it is required to sell a bond of equal value and interest rate (plus a tiny bit extra for its fees). So far, no difference. In Denmark, however, the issuer of the bond is required to continue to make the payments even if the borrower defaults. As pointed out in the Economist article, this maintains the link between those who sell mortgages and those who bear the risk of default. Also, mortgage-holders can buy the bonds in the market in a process similar to re-financing. Danish law also requires borrowers to finance no more than 80% of the purchase price.

A criticism of the system is that it makes it hard for risky borrowers to get loans, albeit at higher interest rates. Excuse me? I find that reassuring. Also, mortgage banks are very quick to seize homes for non-payment, since they are the one's paying on the bonds. However, this leads to very good lending practices.

Amazingly, this whole mechanism has been in place since 1850. However, it has also been updated to take advantage of new lending innovations such as adjustable rate mortgages. Further, the Danes have not seen the free fall in housing prices that plagues the U.S and U.K. Further, because there is a large securities market for mortgage bonds, it obviates the need for the likes of Fannie Mae to create such a market to insure liquidity. That too, is another advantage, because it gets quasi-government agencies out of this business. Even though the Danes regulate this market, no taxpayer money is at risk. But best of all, this system restores the transparency needed for the proper functioning of capital markets.

Why This Fed Solution Won't Work

Ben Bernanke wants foreclosure rates to decline. So do I, but it's not going to happen anytime soon. Forbes online explains why. Before I explain, a pop quiz related to this subject: Who owns the mortgage debt of America's homeowners?
a. Mortgage brokers
b. Banks
c. Foreign governments
d. Who knows?

If you answered d., you are correct. Amazingly, telling banks to stop foreclosures is futile because the loans have been sliced between so many different investors, that no one really knows who owns the debt!

From the article:

Who is supposed to take the loss when these debts are reduced? Servicers don’t have any skin in the game, beleaguered lenders who originated the poorly underwritten loans often quickly sold them and the investors who ended up owning many mortgages through sliced and diced securities called collateralized loan obligations would probably be better off with a foreclosure.

Ultimately, the lack of transparency for all parties involved, along with a lack of accountability for bad practices led to the mortgage mess. If an individual homeowner could go back to the holder of the note and re-negotiate, all parties would be better off. But there is no one with whom to negotiate. This mean this mess will be terribly difficult to clean up. I am a firm believer in free markets, but any economist will say that free markets require transparency to operate properly.

Final quote:

The behind the scenes debate over who should take the loss on mortgage workouts is one of the most important issues that U.S. policymakers and lenders are faced with, and one that they are most loath to discuss. This is because unjustly hurting investors would create an alarming precedent that the American government no longer considers a business contract sacrosanct, which runs the grave risk of alienating those abroad who have looked to the U.S. as an investment haven governed by the predictable rule of law.