A Firmer Foundation for Housing

Even if you have a great boat, it can get swamped in a storm. If you have a properly financed house, through no fault of your own, it too can get swamped in a financial storm. That is why you have a vested interest in a properly regulated financial system even if some of it is dry and arcane.

One thing that contributed to this housing and mortgage crisis is a well-intentioned governmental view that even people who really could not afford home ownership should still own homes. The old-fashioned savings-and-loan structure had shrunk and did not have enough capacity to make all of the loans necessary to vastly expand home ownership. To make it work, we needed expanded lending capacity. The financial industry began to package mortgages, much as mutual funds package stocks, so that pension funds and insurance companies and even individual investors could readily buy a portfolio of mortgages.

There was one difference that nobody focused on. When stocks are packaged into a mutual fund, people still pay attention to the fundamentals of the individual stocks. When mortgages are packaged together in one security, nobody has any particular ability or incentive to pay attention to the individual mortgages. The original lender had no remaining incentive to stay in touch with the mortgagee. One regulatory change that I’d favor is that the original lender should have to retain some economic stake in any loan he makes.

These investments worked well for pension funds and insurance companies for a long time. You got a higher yield than you got in Treasury bonds and the risk didn’t seem much different. When a deal is that good, hedge funds tend to get involved. Not only did they start buying mortgage securities, they did so with leverage. If you can borrow $1 billion at 3% and invest it in mortgages at 6%, why not? Unregulated hedge funds could buy $1 billion of mortgage-backed securities with perhaps $50 million down. So now, interest rates rise a little and the price of the mortgage-backed securities drop by 5%. The hedge fund is now under water. In a nutshell, we have instability in our housing market primarily because certain market players are allowed to use such leverage.

If you buy stocks on margin, you have to put 50% down. There should be similar requirements for mortgage securities, some of which can be even more volatile than stocks. But margin regulations here have fallen through the regulatory cracks. Neither the Fed nor the SEC regulates hedge funds. We are all being hurt by a 1930s regulatory structure.

There are other regulatory holes. There is almost no oversight of mortgage brokers. One consequence is that prepayment penalties on certain mortgages are so high that people can’t get out. Let’s say you have a $200,000 mortgage and you are struggling to pay the roughly $1,600 a month. You can’t scrape together the $6,000 necessary to make the prepayment penalty, so you are stuck. Congress ought to cap prepayment penalties. The implications of prepayment penalties as well as changes in a variable rate should be spelled out in numerical terms, and not just legalese. I’m a capitalist, but if you are too dumb to make money other than by ripping people off this way, you don’t deserve to make a living in the banking or mortgage industry.

Congress helped create the casino aspect of the housing market many years ago. It used to be that all interest expenses were tax-deductible. The law was changed to allow deductibility only on mortgages. That encouraged the growth of home equity loans and may have contributed to speculative buying of other homes. The interest regulations should be tightened to allow deductibility only for the first mortgage on a primary residence. If I can afford a beach house, the government should have better uses of its money than to subsidize me. A political reality is that this reform might have to be phased in gradually in order to prevent additional instability in the Florida real estate market.

These suggestions are dry, and are not focused on short-term bailouts. But they would make our economy a whole lot more stable. To summarize: (i) make mortgage lenders retain some economic interest in their loans; (ii) limit the leverage in the secondary mortgage market; (iii) cap prepayment fees; (iv) make sure that disclosure is understandable with numerical examples; (v) limit mortgage interest deductibility to capped amounts on primary residences. None of this is rocket science. Let’s hope Congress acts quickly.

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