FAQ #23: (originally posted at http://www.SwapRent.com on July 20th, 2008) Why are you championing the idea of getting the local state, county and city governments involved in a new national housing finance system for our country going forward, given the failure and pending collapse of Fannie and Freddie? What does de-centralizing or localizing credit risk management of home mortgages mean? Why are the new SSEs (State Sponsored Enterprises) or LGSEs (Local Government Sponsored Enterprises) that you proposed better than the current GSEs?
Yes. This is something new and few have been convinced so far. Ruthless critics said the effort would prove to be as futile as teaching pigs how to fly. Many local governments officials themselves are not excited about the ideas either. Most of them are quite scared by the thought of having to do something new themselves, out of their 9 to 5 daily routine. Job security, not flying with innovative accomplishments, is usually what their priority is. They either try to push this to be a private sector business or even if government needs to get involved it should be the federal government’s job to do something about it. They failed to understand that these wrong ideologies and hands-off approach in the past contributed in a major way to our nation’s housing finance problems. Many of them bureaucratically viewed adopting an innovative approach to save their own government finances, their homeowners and their local economies is not worth granting a favor to a private business. Similar to the refusal of the parents of a cancer child to buy a cancer cure from a pharmaceutical company which has diligently invested heavily in the past to develop a viable solution, they seem to rather let the child die than taking up the offer to help, unless the pharmaceutical company turns to be a non-profit organization and practice socialist medicine. Wrong ideology or personal emotion like that is often what kills, not the lack of innovative solutions. Banks and mortgage lenders such as American Home Mortgage, Bear Stearns, Countrywide and IndyMac may have gone to their demise in a similar way, despite the tremendous efforts we had spent to visit and communicate the worked out SwapRent (SM) solutions with the executive management teams since mid 2006.
Fannie and Freddie will be gone for sure. Many still try to fool themselves and are not willing to face up the reality. We saw recently that the Treasury Secretary went to Congress to beg for a blank check to back them up. It looks like a gambling addictive son trying to ask daddy for his blank check book in order to bluff his fellow poker players. It may have bluffed some naive folks for a short while but many would see through it soon that daddy is more broke and full of debts than the son is. It won’t last.
I bumped into such an idea of getting the local governments involved by accident or by fate, depending on how you look at it. Let’s simply view it as a side effect derived from our tenacious efforts to promote the implementation of the SwapRent (SM) methodology. As we had come to the realization in early June, 2008 of the fact that many of the major banks and mortgage lenders we have had consulting/licensing discussions to for the last two years no longer have the credibility or ability to launch any new consumer financial products to save themselves (let alone our national economy), going through the financial institutions route to launch the SwapRent (SM) project will only be possible for a newly set up financial entity. That requires major capital investment and regulatory hassles which may further delay the offering of a timely help to the homeowners.
On the federal government and the congressional law makers side, they seem to have their own political agenda of doing things. For example, within the last two years we have approached the White House, the Fed, Treasury Department, HUD, all banking regulators, GSEs and the FHLB system with almost no stone unturned. Although many of the Republican administration officials loved the ideas of SwapRent (SM) and appreciated the fact that it could really help solve our current economic problems, some of them told us their positions may be too low at the totem pole to help put this proposed solution on a high political priority. We were advised to approach the congressional law makers and their staff members at the House Financial Services Committee and the Senate Banking Committee. We naturally made a lot of effort in that regard. Among all the numerous academic referrals and social introductions to approach the decision makers, our Boston-based business partner even went as far as attending a gay party event trying to hand-deliver a copy of our SwapRent (SM) proposal to an influential Congressman! I don’t have much detail on what exactly happened next later that night. My poor straight partner may have had to bend over backwards to please some Congressmen, literally … and so forth. My point is merely that those federal people who need to know were indeed all well informed about the availability of the viable SwapRent (SM) solution to effectively stem mortgage defaults and foreclosures during the last two years already.
Despite all these efforts, Congress only came up with a Housing Bill which was given to a few well connected bankers to draft to save themselves and their earlier bad investment in a major defunct mortgage lender. The only conclusion we could draw is that the Democrat-controlled Congress may not have the urgency or intention to really solve the current economic problems before the 2008 national election in November. The worse the state of our economy the better chances there may be for a Democrat president to be elected in November. Although a speculation, there is really no other reason that could explain why they would not adopt some worked out innovative solution, no matter where it comes from, as they should not have the same mental block of a wrong ideology as mentioned above. Perhaps they do too and I may be wrong on that assumption.
After more than two years of our relentless efforts to spread the gospel, the economic merits and the social value of the SwapRent (SM) methodology have indeed been understood and acknowledged by most of the people who may hold the power to make a difference, it remains a challenge for us to get them to stand out from the shadow to help form that critical political force to have it implemented in a timely manner for the benefits of our nation. It is politics at work as usual. A few more years in the future, we might be able to look back at these people for political accountability based on hindsight historical chain of events, but that might be too little too late to save our national economy from spinning downward into a deep recession and the many displaced once homeowners along the way.
To understand the significance of the future roles of the local governments and a de-centralized homeowners’ credit risk decision making mechanism in a new national housing finance system, first let’s look at a few technical aspects of what the conventional mortgage really is. From a business risk management perspective, a conventional mortgage has financial risks, legal risk and operational risk for its providers. Within the financial risks there are credit risk, interest rate risk, prepayment risk and real estate market or property value risk all combined and mingled into one single financial product. The key to solve the current default/foreclosure crisis and to establish a healthy new housing finance system is to quantify and single out each of the four types of financial risks out of the conventional mortgage and manage them separately in a new approach.
When each individual risk of the home mortgage is properly identified and addressed by this “divide and conquer” approach, the chance of a potential systemic risk in the housing finance system that could bring down our banking system again in the future could be minimized dramatically.The interest rate risk will no doubt continue to be managed at the national level by the Federal Reserve or a central bank equivalent. The prepayment risk may be able to continue to keep the securitization game going and many in the industry employed. Both of these two risks will also continue to provide the investors the guessing games either through the secondary whole loans market or the new incarnation of a “Covered Bonds” market borrowed from certain European countries. The real estate market or property value risk will be best managed by the new SwapRent (SM) methodology to extract them out of a conventional mortgage as explained above in details. It will not be repeated here again. Local governments at all levels, on the other hand, will be the best candidates to participate to assume an active role to manage the homeowner credit risk since they have the vested interests and the geographical convenience to perform the due diligence required to ensure a sound new housing finance system.
The emphasis here is to create a new role or to expand some existing practices for the local governments to assume a stronger economic function of policing the granting of credit to homeowners and get compensated for it either as a non-profit agency or as a for profit entity similar to Fannie and Freddie.There are many ways this new role could be accomplished. The simplest way may be to assume the modified but similar mortgage insurance function of the FHA without the capital providing function rather than underwriting the entire mortgages directly that the Fannie and Freddie have been doing. They could set up new local state agencies to perform those similar roles of Fannie and Freddie at the local level and they could be called SSEs (State Sponsored Enterprises) or LGSEs (Local Government Sponsored Enterprises). The modified state version of a new Fannie or Freddie so to speak, with the homeowner credit decisions made at state or even county and city levels. Critical mass and scale of the operations could be accomplished through re-insurance at a national level or to private sector entities. In fact, at most states the state housing finance agencies may not be new but we should let them take on more active new roles. Extra care should be taken for the local governments not to repeat Fannie and Freddie’s many mistakes and abuses.
This new involvement by the local governments will not crowd out the existing private sector business by the financial institutions and will only perform the complementary functions that the original intentions of Fannie and Freddie were set out to deliver.
The main benefits of this approach will speak for themselves. Real estate business will go back to a be a regional or localized business as they used to be and where they belong. The unscrupulous behaviors of a few individuals in the mortgage system will no longer affect us as a nation. This could easily be understood if you look back at what had happened within the last few years. The disconnect of credit risk monitoring brought about by the securitization business and the personal abuse of the system by some mortgage brokers and underwriters had quickly brought the whole country down. Moral hazards were created by these centralized housing finance agencies. National monetary policies were held hostage by these inter-linked nation-wide epidemics. Forced low interest rate policies then brought about the sinking US dollar and the ensuing run away inflation led by high commodity prices … etc.
By having the credit risk management function performed at the local levels with different regional decisions being made independently we could have a much more diversified, resilient and stronger national economy. Economic problems such as what had happened recently could be compartmentalized at a regional level and will not trigger the ominous collapse of the entire empire that many wise guys having been predicting. National monetary policies and fiscal policies will no longer be held hostage by their failures since incompetent or abusive local housing finance agencies or these new SSEs could be punished and left hung dry without batting an eyelid by the politicians. “Too big to fail” will also no longer be a common phrase for the lobbyists or a convenient excuse for the special interest groups. Taxpayer bailout may be reduced to a regional or state issue. Pensioners in Norway, small bank depositors in Germany or central banks in China and around the world may also finally get to be spared by the consequences of local American’s credit indulgence.
To further use an analogy to compare practices in other countries, it may make sense to have one single interest rate policy for the entire Euro zone, but try to imagine how ridiculous that could be to set up one Europe-wide agency to offer mortgage insurance and make homeowners credit granting decisions based on one single standard to all European homeowners from Southern Italy to northern Lapland in Sweden and from remote Romanian villages to metropolitan London area in the UK? That would really be a paradise for the opportunistic local mortgage brokers and underwriters if they could simply sell the mortgage loan credit risks away to a centralized European version of Fannie and Freddie the same way they have been doing in the US all along. Pent up problems would similarly be waiting to explode if this were real. That is how ridiculously these GSEs in the US have been run in the past and grew to become such humongous monsters.
The recent discussions of borrowing the Covered Bonds market concepts as practiced in certain European countries may offer some cosmetic technical changes to the mortgage securitzation practices in the US. If these fundamental credit risk management issues are not properly addressed, letting local underwriters continue to sell homeowners default risks away to a centralized agency, developing a new Covered Bonds market will not be able to help change the situation. Changes in the technicality of the securitization process and methodologies may be helpful but the real evil is the idea of a centralized GSE itself to let the local underwriters off the hook so easily. Credit risk underwriting and monitoring will have to be kept locally, either with the original underwriters or with somebody who may have assumed these homeowner credit default risks subsequently but could continue to make decisions on monitoring and taking rescuing measures when necessary.
Put simply, accountability and responsibility of underwriting these credit risks should not be sold away or securitized away to people who do not have the ability to perform ongoing management. The responsibility of granting credit risks to homeowners and performing ongoing monitoring, in whole or in part, has to stay local with either the financial institutions or the local governments. Equipped with the flexible new housing affordability tools such as SwapRent (SM) and its embedded new mortgage products (HELM), they could also further provide timely assistance to financially distressed homeowners on an on-going basis. All this will happen naturally because they are made and remain the risk holders and will have the natural motivation to perform the required due diligence of risk underwriting and subsequent risk monitoring.
There seems to be many further research opportunities of the details in this de-centralizing or localizing of homeowner credit risk decision making process could be pursued. There also appears to be many options on how this could be best executed, both through the way how the mortgage credit risk insurance practice by financial institutions are structured and a much more active participation by the local governments in the housing finance process in order to set up a stronger and healthier new national housing finance system. Creating new State Sponsored Enterprises (SSEs) or Local Government Sponsored Enterprises (LGSEs) is just one of such ideas meant to be seeds for further discussions and debates.
