The Future Of Residential Mortgages-Maybe

Fools rush in should have been the title of this post. Everything I put down is probably not going to happen but let’s go ahead and speculate about the future of the U.S. mortgage industry. It’s kind of connect the dots and see where things might lead.

The premise I’m starting with is that we really don’t have a private mortgage industry anymore. Sure, semi-private institutions like banks originate the loans and essentially collect a fee for doing so but they only do so in order to sell the loans to either Fannie, Freddie or FHA. There is no meaningful intent to make a loan and hold it in portfolio or hold, pool and sell a mortgage backed security on the private market.

FHA, Fannie and Freddie are all owned and supported via guarantees and other mechanisms by the federal government. Yes, Fannie and Freddie are nominally private corporations, but they remain so in order for the government not to have to consolidate them on its balance sheet. Whatever accounting fiction is employed, the existence of the three is wholly dependent upon the support of the federal government. So, the extension of residential mortgage credit is currently controlled by the government of the U.S.

The incoming Obama administration and members of the new Congress have made it manifestly clear that they intend to “solve” the current foreclosure crisis. Their preferred methods are loan modifications and a rewrite of the federal bankruptcy code to empower judges to modify residential mortgages. In both cases, massive write-downs of principal balances will be necessary to achieve the desired solution.

A consequence of the methods employed to avoid further foreclosures is going to be a significant reappraisal on the part of private investors as to the risk premium that should attach to American mortgages. In all likelihood, that risk premium is going to be substantially increased assuming that private purchasers can be induced to buy at all. 

Coincident to their plan to rework the framework of the current mortgage finance system, the new political order is committing to two additional housing initiatives.  One is the continuing promise of a house for just about everyone-the American Dream as they like to say. And two is a promise of incredibly low mortgage interest rates. Voices from Washington continue to talk about mortgage rates of 4.5% or lower.

To deliver on all of this, the government has only two choices. One is to become a mortgage bank. In other words buy the loans originated by the private sector and hold them or two to buy them, package them as mortgage backed securities and sell them off. The second alternative can only succeed if the government attaches its guarantee to the securities as the return demanded by the private sector would surely far exceed the rates that have been promised to the individual borrowers. There may be a smoke and mirrors way in which to keep the liability off of the federal balance sheet but in reality, the obligation to make good on losses will rest with the taxpayer.

Assuming that things developed in this manner, what might be the ramifications? In the short-term probably not much. Fiscal discipline is not even subject to lip service right now so that support for the mortgage market will simply disappear into the “stimulus package”. The long-term may hold some different outcomes.

Once low mortgage rates take their place as an entitlement any reversion to a private market in which the risk is market priced will be impossible. A stream will have been crossed and there will be no turning back.

It will take some time but eventually the role of banks as originators of mortgages will come to be questioned. Constraints on the profitability of mortgage origination will likely be imposed and it is probably not a stretch to imagine that the federal government might take over the business. After all, Fannie Mae has always lusted after the retail side of the business.

Once things do return to whatever normal might be then mortgages are going to become just one more line item on the federal budget. It may be hard to believe now, but eventually the country will have to pay attention to its expenditures. At that time the residential mortgage business will find itself competing with defense, health, education and whatever other initiatives that the federal government may elect to assume. One of the immutable laws of budgeting is that any program’s share of the pie tends to be relatively static and expenditures on that program only increase in line with overall budget increases. In other words, the availability of residential mortgages will not be flexible and could well fall short of the demand at some future point. In that case, rationing based on political calculus would probably be the order of the day.

As I said at the beginning, all of this probably won’t happen. But just in case, I’m going to be sure and save this post.

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