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.

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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.

There are a couple of different broad ways housing finance reform can be achieved. Most would address the problems recently encountered during the housing bubble.

The mortgage business is complicated. It is no longer as easy as a bank wanting to make a loan and a borrower wanting a loan. These days, banks don't create mortgages based on the deposits they've got: most mortgages are funded through a secondary market. That means lenders will sell the mortgages they originate to somebody else. Sometimes this is an investor. Other times the government buys them up. Lenders will even sometimes sell their loans to another bank.

At this time, the secondary market is almost entirely controlled by the U.S. government. Since the market froze in 2007, private investors haven't been interested in mortgages without a government guarantee. But this could change if the government forced certain reforms on the market. Here are three potential reforms that have been proposed and could help.

Better Information for Investors

For the private secondary market to take on mortgage risk again, securitization must return. Although it got a bad name during the financial crisis, it's a perfectly legitimate funding mechanism. The problems during the financial crisis were two-fold: ratings relied on ridiculous assumptions and not enough information was provided to investors to assess the mortgages themselves. This situation, however, could be remedied fairly easily. A new infrastructure could be created where investors could obtain mortgage data quickly when deciding whether or not to buy a mortgage-backed security. This might slow down issuance slightly, but the delay would be worth the reward of less government in the market.

Standardized Mortgages

Investors would also have an easier time taking on real estate risk if mortgages were more standardized. During the housing bubble, credit criteria became so muddled that some mortgages didn't rely on any documentation of borrower characteristics. Such sloppily originated mortgages should be forbidden. Investors can become comfortable with standardized mortgages that are underwritten with specific criteria satisfied.

Covered Bonds

If some pending legislation is passed in Congress, another helpful reform will be in place for the secondary market: covered bonds will become easier to issue in the U.S. Although Europe has relied on these mortgage funding tools for a century, current law makes issuing covered bonds difficult in the U.S. Briefly, these bonds are sort of a hybrid between mortgage-backed securities and unsecured bank debt. Basically, they're bank debt secured directly by mortgages, but technically paid by banks. That makes them safer than either and more appealing to nervous investors. For a better explanation, check out this post.

New Mortgage Products

Developing innovative new mortgage products could also help investors to find mortgage financing more attractive. Here are a couple of possibilities.

The "DJI Mortgage"

Last year, I suggested that banks think about creating a mortgage where the interest rate declines over time. I called it the "Declining Jackhammer Interest Mortgage." The purpose here is twofold. First, a higher interest rate will compensate the lender for the higher risk associated with the mortgage when the borrower's equity is smaller. Over time, however, as the interest rate declines, the borrower will benefit from lower payments and also have less incentive to refinance the loan. So the lender's interest rate risk is also reduced.

The Mana Loan

Another proposal I learned about recently is called the "Mana Loan." This innovative idea would allow a borrower to have no down payment or to put down as much as they like. The lender would then overfund the mortgage by lending the borrower an additional 20% on top of the normal mortgage. That overfunding would be used to pay for an annuity as well as a high cash-value designed life insurance policy, providing the homeowner a quicker buildup of equity over time and giving both the lender and the homeowner a financial safety net, in case they need it. This will appeal to lenders because it will quickly develop a thick cushion for losses if default occurs.

Borrowers also benefit from the additional savings component provided by the cash value in the life insurance policy. The homeowner now has the beginnings of a tax-advantaged retirement plan, building college funds, and/or rainy day savings. A number of banks are interested in the product, but investors remain hesitant to consider mortgages, especially new products, not guaranteed by the government.

The Adjustable-Rate Mortgage

Okay, so you've heard of this one before. Adjustable-rate mortgages got a bad name after the housing bubble. But research shows that they actually performed better than fixed rate mortgages when the bubble popped. This might be partially because interest rates were cut very low when the crisis hit, which made paying adjustable-rate mortgages easier. But in general, if these loans are well-structured and intelligently originated, then they should be appealing to borrowers as well. The trick is for a borrower to obtain a mortgage of a size they can afford, no matter how sharply interest rates rise. In other words, the mindset for obtaining an ARM needs to be the opposite of what it was during the bubble.

Only the Government Can Allow Housing Finance Innovation to Flourish

So really, innovation is possible in housing finance. Investors can eventually become comfortable with mortgage risk again. But as long as the government is taking that risk on instead, investors and bankers have no reason to change the status quo: they're obtaining a healthy return and letting taxpayers shoulder most of the risk. The government must force the financial industry to innovate.

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