If Wall Street Is So Smart, Why Hasn't It Fixed the U.S. Mortgage Market?

Financial innovation is hot. Too hot perhaps, as some people think it helped sink the global economy in 2008. But bankers are stumped when it comes to getting government out of housing.

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Here's something you'll rarely see cited as a problem: The U.S. has too little financial innovation. The creativity of bankers and traders is one thing that enables them to make so much money. They think up fancy solutions to financial problems. Sometimes these involve complicated new securities designed by a couple of math Ph.Ds and may be well-understood by only a handful of people.

Financial innovation was a big factor in the international credit meltdown in 2008. We thought we had eliminated risk with clever financial instruments. We were wrong.

But today, the U.S. economy suffers from another failure of Wall Street innovation. The U.S. financial industry can't seem to figure out how to limit the government's role in the mortgage market.

Wall Street: The Silicon Valley of Financial Innovation

For starters, it isn't hard to understand why the U.S. has seen so much financial innovation over the past decade: it has paid very, very well. Few jobs out there can offer big six- and seven-figure paychecks to people who are very good at math and don't want to take the risk associated with entrepreneurship. The incentives for financial innovation are clear enough, so it's no wonder that some of the best mathematical minds made their way to Wall Street.

Where great ideas really come from. A special report

Some prime examples of innovation can be found in the asset-backed securities market. Back when mortgage-backed securities were invented a couple of decades ago, they were a pretty slick idea. They provided banks with more funding for mortgages and investors with bonds structured to their liking. Similar securities were developed for other consumer products like auto loans and credit cards. Even some interesting esoteric asset-backed securities were created, which were backed by weird assets like lottery winning payment streams or periodic lawsuit settlement payments.

The derivatives market has also been fertile ground for financial innovation. Credit-default swaps make it easy for investors to hedge against the risk of the bonds they own. Their price also provides a good indication of how risky the market considers a bond's risk to be. Lots of custom derivatives have also been created, which are tailored to a client's particular risk exposure. One of the more infamous derivatives is the synthetic collateralized debt obligation, which is a bond that can reference bonds that are created out of other bonds or loans.

And of course, innovative mortgage products played a part in the U.S. housing bubble. Option-adjustable rate mortgages allowed for very low initial payments that reset to subsequent higher payments in time. Some of those options included an interest-only period. Another option was negative amortization, where mortgages actually grew in size at first and required much bigger payments in future years.

Of course, some of these innovations turned out to be more dangerous than anticipated. Some of those derivatives, for example, didn't diversify risk as well as their creators had believed they would. Some securities actually managed to disguise risk. And some wacky mortgage products led to foreclosures when borrowers couldn't afford them after payments reset.

So if anything, the U.S. could be accused of too much financial innovation. Almost no one ever argues that it doesn't have enough.

Is Housing Finance Just Too Hard?

And oddly, this innovation breaks down as soon as it comes to housing finance. If you ask Wall Street how to get the government out of the mortgage market, it collectively throws up its hands and asserts it impossible. The government's guarantee is totally necessary -- the market can't function without it, assert bankers, traders, and investors. Without the government, down payments would have to climb to 30% of a home's value, some say. The beloved 30-year, fixed-rate mortgage could disappear, others warn.

Why can't Wall Street innovate its way out of this problem? This is a trick question: investors have no desire to innovate their way out of this problem. After all, they don't need to. Right now, the government stands behind more than 90% of new mortgage originations. For investors, this creates a great situation. This way, they don't have to worry about any default risk. Why fix something that isn't broken?

Well obviously, something is broken. This week, Fannie Mae announced that it needed another $7.8 billion from taxpayers. It and its brother Freddie Mac have amassed a bailout of more than $150 billion since the housing bubble burst. As long as the government casually stands behind the entire mortgage market, the moral hazard to create risky loans can return. The only sure way to control this risk is for someone to directly lose money if bad loans are made. During the housing bubble, investors were lulled into believing that the mortgage risk they took on was low thanks to the AAA-ratings that mortgage bonds were provided by the credit rating agencies. Only the government has deep enough pockets to protect them.

Innovation Can Provide Solutions

But surely these brilliant financial innovators could think up new solutions if the government refused to take on mortgage risk. The market wouldn't simply shrug and stop providing mortgages. There will always be a demand for home ownership and the loans that make it possible. There will also always be a supply of investors who are interested in taking on a modest amount of risk for a return slightly better than they would get from government securities. Thus, private housing finance should be possible.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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