THE HOUSING MARKET IS STILL MISSING A BACKBONE / THE NEW YORK TIMES

August 10, 2013

The Housing Market Is Still Missing a Backbone

By GRETCHEN MORGENSON


IN a speech in Phoenix last Tuesday, President Obama finally entered the debate over the future of United States housing policy. But his talking points offered few details about how to reduce the government’s giant footprint in the mortgage market.

Mr. Obama vowed to keep mortgage costs affordable for first-time home buyers and working families, pleasing those who think that the government should have a large role in this arena. His call for investment in rental housing was a welcome change from past mantras that focused solely on increasing homeownership across the country.

Playing to taxpayers who are angered by the government’s takeover of Fannie Mae and Freddie Mac in 2008, Mr. Obama said he wanted to wind these companies down. That’s an important goal.

But as if to prove how hard this will be, both companies later in the week announced enormous profits for the second quarter of this year, most of which go to the government in the form of dividends. Together, the companies reported $15 billion in profits; with Treasury on the receiving end of this lush income stream, it will be tempting to keep the mortgage finance giants in business.

Yet with the government backing or financing nine out of 10 residential mortgages today, it is crucial to lure back private capital, with no government guarantees, to the home loan market. Mr. Obama contended that “private lending should be the backbone” of the market, but he provided no specifics on how to make that happen.

This is a huge, complex problema.

In fact, there are many reasons for the reluctance of banks and private investors to fund residential mortgages without government backing.

For starters, banks have grown accustomed to earning fees for making mortgages that they sell to Fannie and Freddie. Generating fee income while placing the long-term credit or interest rate risk on the government’s balance sheet is a win-win for the banks.

A coming shift by the Federal Reserve in its quantitative easing program may also be curbing banks’ appetite for mortgage loans they keep on their own books. These institutions are hesitant to make 30-year, fixed-rate loans before the Fed shifts its stance and rates climb. For a bank, the value of such loans falls when rates rise. This process has already begun — rates on 30-year fixed-rate mortgages were 4.4 percent last week, up from 3.35 percent in early May. This is painful for banks that actually hold older, lower-rate mortgages.

Private investors, like mutual funds and pension managers, aren’t hurrying back to the residential mortgage market, either. Deep flaws remain in the mortgage securitization machine, and it needs to be retooled before investors will begin buying these securities again.

Perhaps the largest problem for investors who might otherwise be willing to return to the mortgage market is the lack of transparency in privately issued securities. Investors interested in mortgage instruments are not allowed to analyze the loans going into these pools before they buy them.

The banks putting together the deals typically provide some data, like borrowers’ incomes and credit scores, as well as whether the loans backed primary residences or second homes. But investors don’t get access to actual loan files that can tell them what they need to know about the quality and types of the mortgages packed inside the deals.

A CIVIL case filed by the Justice Department last week against Bank of America highlights the downside of nondisclosure. In that matter, prosecutors accused the bank of misleading investors when it sold them a mortgage security in early 2008. Although the bank contended in marketing materials that the security contained prime loans that met its underwriting standards, more than 40 percent of those loans did not comply with those standards, prosecutors said.

Lawrence Grayson, a Bank of America spokesman, said the bank was fighting the case.

“These were prime mortgages sold to sophisticated investors who had ample access to the underlying data and we will demonstrate that,” he said in a statement last week.

But the Justice Department contends that the bank failed to disclose important facts to investors about the quality of the mortgages in the $850 million pool, which wound up performing badly. As of June 2013, prosecutors said, 15.4 percent of those mortgages had defaulted, indicating that they were of a far lower quality than advertised. The Justice Department estimates that investors will lose more than $100 million on the deal.

Then there’s another issue. Investors are also unlikely to take an interest in mortgage securities because serious conflicts of interest are still embedded in the process.

For example, in the aftermath of the crisis, investors learned that they could not rely on the trustee banks charged with overseeing these loan pools to do their jobs. The trustees are supposed to make sure that firms administering the loans treat investors fairly. These duties include taking in and distributing payments as well as foreclosing on borrowers.

Even though the trustees are supposed to work for investors, these watchdogs are actually hired by the big banks that not only package the mortgage securities but also provide administrative services for them. So it was perhaps not surprising that the trustees failed to make the big banks buy back loans that didn’t meet the quality standards set out when the securities were originally sold. Such buybacks could have prevented billions in losses for investors, and the trustees’ inaction indicated where their allegiances lay.

Yet another reason for investors around the country to steer clear of mortgage securities is the recent action by Richmond, Calif., to seize underwater home loans and reduce the amount of debt outstanding on the properties. Many of the loans that the city officials want to restructure are held by mutual funds and pensions.

Pimco and BlackRock, two huge mortgage investors, are among those represented in a lawsuit filed last week against Richmond, contending that such a plan would violate the contracts that investors agreed to when they purchased the loans. And the Federal Housing Finance Agency, the overseer of Fannie and Freddie, has concluded that Richmond’s action could threaten the safety and soundness of the companies’ operations, harming taxpayers.

Mr. Obama’s views on the path forward for housing finance are welcome. But much work needs to be done before private capital will come back to this market. Eliminating conflicts of interest and increasing transparency in the securitization process will go a long way to achieving that end.