Part 3: Will government ever get its act together on housing?
The housing industry is suffering, in part because the structure of our nation’s financial markets does not allow us to escape from past mistakes. To a significant degree, this inability to break with the past can be directly blamed on a federal government that clings to its own ineptness and forces the marketplace to adjust for the mismanagement of the two GSEs, Fannie Mae and Freddie Mac.
As discussed last week, I propose the creation of a new type of mutual fund, the mortgage market mutual fund (MMMF). So, precisely how would an MMMF function?
At least initially, the loans purchased by the MMMF would not be existing loans, but rather newly-minted loans which banks and other mortgage originators choose to sell. And the mortgages purchased by MMMFs would not be mortgage backed securities (MBSs), but rather entire packages of loans fully owned by the MMMF. At the point of purchase, the MMMF would decide whether to continue using the bank as a mortgage servicer — so as to hold down operating costs — or to develop those servicing capabilities in-house.
As purchasers of packages of mortgages, MMMFs would rely upon the due-diligence efforts of mortgage originators (e.g., banks) to insure that only financially responsible borrowers are provided new mortgage monies. At least two ways seem feasible to insure responsible loan-granting decisions by originators. First, the MMMF could challenge purchased loans that are later deemed irresponsible in a court of law. One need merely examine the poor performances of mortgage originators up through 2007 to see the need for such MMMF protection.
A second safeguard would be for loan originators to reinvest some funds in the MMMF for each package of mortgages sold. So, for example, mortgage originators might reinvest 3 to 5 percent of the loan package’s price back into the MMMF. In that fashion, the mortgage originator has some “skin in the game” and is more likely to be thorough in providing sound, secure mortgage loans.
With the establishment of MMMFs the need for Fannie and Freddie could come to a much-desired end. And like the S&Ls of old, this 21st century model would provide an environment for people (savers) to loan funds to other people (mortgage borrowers) through a private-sector entity (the MMMF) without involvement by government. It would also provide savers a new outlet for investing their monies. In addition to the huge volume of financial assets held in mutual funds, small savers now have nearly $6 trillion in savings accounts and certificates of deposit (CDs). Presently, the interest rates on such savings vehicles are preposterously low, such as the average 5-year CD rate on Feb. 2 at 1.16 percent. Not only does this abysmally low rate not even cover likely inflation, it fails to accommodate for the taxable nature of interest income. So why do some people still invest? Because there are no reasonably safe alternatives. That’s where an MMMF could provide much-needed competition to banks for the funds of savers.
How might an MMMF be structured to serve potential investors? While the precise structure of any MMMF would be established in a prospectus, at least a couple of generalized forms seem reasonable. Whether for a direct investment or for those who invest through a tax deferred savings vehicle, the MMMF might simply be part of a family of mutual funds from which to choose, with the MMMF monies growing over time.
As an alternative, some MMMFs may be structured to permit a “pass-through” type of arrangement where, after the purchase of a package of mortgages, both principal and interest are repaid to investors over time. Such an MMMF arrangement may be attractive to investors largely interested in generating income rather long-term asset growth.
Should this solution to the on-going funding crisis in housing be utilized, it must be recognized that as a pre-condition for MMMFs to exist and prosper, the Federal Reserve would need to end its active manipulation of interest rates. In the same way that America’s savers are being punished by current Fed policies, such manipulative efforts might easily harm MMMF investors.
The time has come for our nation’s leaders to set aside political posturing and eliminate the role of Fannie and Freddie in mortgage markets through a market-driven replacement such as the MMMF. With the costs to taxpayers now north of $150 billion and climbing, the timely deaths of Fannie and Freddie will likely be mourned by few Americans.
Dr. James Newton serves as chief economic advisor to Commerce National Bank and is an auxiliary faculty member in economics and statistics at OSU-Marion and OSU-Newark. Dr. Newton’s views do not necessarily reflect those of Commerce National Bank or OSU-Marion/Newark.