By George Soros
Treasury Secretary Timothy Geithner testified Tuesday on a plan to reform Fannie Mae and Freddie Mac, the government-sponsored enterprises now in limbo. But we don’t have to wait years to reform the mortgage system; a better approach could be introduced right away.
The business model of Fannie Mae and Freddie Mac is fundamentally unsound. These public-private partnerships were supposed to serve the public interest and the interest of shareholders. But this was never properly defined and reconciled.
Management’s interests were more closely allied with those of shareholders. They had an incentive to lobby Congress — both to expand homeownership and to protect and use their government-sponsored duopoly status.
The GSEs extended their activities from insuring and securitizing mortgages to building highly leveraged portfolios of securities by taking advantage of their implicit government backstop. They profited from the growth without bearing the risk of collapse: Heads they win, tails you lose.
The GSEs already had a checkered history, riddled with accounting irregularities. Eventually, they blew up — at a huge loss to taxpayers that may exceed $400 billion.
Early in the century, private enterprise had started eating into the government-guaranteed mortgage market. Borrowers once served by the Federal Housing Administration turned to subprime and Alt-A mortgages.
These “non-agency” mortgage securities gained increasing market share. They were sliced and diced, repackaged into CDOs and CDOs squared. Geographic diversification was supposed to reduce risk. But the originate-to-distribute model of securitization actually increased risk by creating a severe agency problem: Agents were more concerned with earning fees than protecting the quality of the mortgages. The housing bubble ended with a crash — and the government was forced to take over GSEs.
With the private sector largely incapacitated, the GSEs and FHA became virtually the only source of mortgage financing. This is a paradoxical situation in which a fundamentally unsound business model holds a quasimonopolistic position. This cannot last.
What needs to be done is clear: The GSEs’ mortgage insurance function must be separated from mortgage financing.
The former, mortgage insurance, is the legitimate function of a government agency, especially when the private sector has collapsed. A mortgage insurance entity should be run as a government agency.
But mortgage financing should revert to the private sector. This would get rid of a business model that has failed.
There is a proven mortgage financing system already up and running. The Danish model has been in use, continuously, since the aftermath of the Great Fire of Copenhagen in 1795. It has not prevented housing bubbles, but it has never broken down. And it proved its worth again in 2008.
In the Danish system, homeowners do not borrow from either a mortgage originator or a GSE. They borrow from the bond market, through a mortgage credit intermediary. Every mortgage is balanced by an equivalent amount of an identical, and openly traded, bond. This is called the Principle of Balance....MORE
HT: the Financial Times' Money Supply blog.