How can America revive the housing market and make mortgages more accessible? Government officials and economists have been asking that question for the past eight years. Let's go back to the root of the Great Recession for the answer, which lies within the secondary housing market.
The housing crisis and corresponding economic woes were caused in large part by easy credit and mortgage-backed securities. Too many homeowners were overextending themselves with low or no-down payment loans and alternative mortgage products such as interest-only and negative amortization mortgages, and banks were too willing to accommodate them. These bad loans eventually propagated through the economy via the secondary housing market.
Most homeowners don't realize that there is a secondary mortgage market and how their debt is processed, sold, and resold there. Banks do hold mortgages for the entirety of the debt in some cases, but generally, the debt is sold off to a secondary market to free up the bank's resources for further lending. The largest purchaser of these loans in any given year is Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs) that back loans by purchasing and repackaging them as securities for the open market. Other federal entities back some loans, and the rest are purchased and repackaged by private firms as private mortgage bonds.
The private market caters to homebuyers with challenges, such as those with poorer credit who cannot qualify for a government-backed loan and self-employed individuals who have a difficult time documenting income and predicting future income. These loans are inherently higher risk, and therefore higher reward when securitized. Unfortunately, too many securities based on these loans were spread throughout other financial packages and misrepresented with respect to risk, leaving investors holding the bag once the housing market crashed.
As mortgage servicers began to modify loans or reach settlements with the government, investors were left with the feeling that mortgage servicers were saving themselves at the expense of their investors. Combine this new mistrust of private mortgage bonds with the regulatory crackdown of the Dodd-Frank legislation, and the private mortgage securities market was squeezed from both sides into near non-existence.
For reference, in 2003 there were just over $269 billion in private mortgage bonds issued, compared to $1.67 billion in 2015. That is out of a 2015 total securities market of well over $1 trillion. In 2005 and 2006, before the bubble began to burst, approximately 40% of the nearly $2.5 trillion annual secondary mortgage market was backed by private mortgage bonds.
The lack of private mortgage bonds is making a housing recovery difficult to achieve and depriving homeownership to those on the fringes of acceptable credit. How can officials rebuild trust in private mortgage bonds? The Treasury Department has been seeking help from Wall Street to address the issue, and bond funds have suggested a different form of oversight as the answer.
Bond funds recently issued a set of key principles designed to properly assess and regulate funds, with the key concept being the "deal agent." The deal agent would act as an outside entity to verify that private mortgage backed securities are transparent and free of conflicts of interest. It remains to be seen who would be controlling the transparency and oversight and whether a deal can be reached, but it is in the best interests of all parties to reach an agreement.
In essence, this proposal gets to the root of the problem. High-risk loans that are properly represented will have a market, but it will be limited — and the market will eventually find a comfortable equilibrium that allows some access to higher-risk mortgages without causing another run and subsequent crisis.
All parties will move cautiously in studying these proposals, because everyone understands the stakes involved. Burn private mortgage bond investors a second time, and there likely will not be a third chance.