It has finally happened: the federal takeover of Fannie Mae and Freddie Mac, which together own or guarantee almost half of the $12 trillion home mortgage debt. The takeover came after inspectors poring over the books of the two companies concluded that the accounting methods used by Freddie Mac had overstated the capital cushion of the company. The methods used to bolster the capital cushion have caused serious concerns among regulators. Freddie Mac’s portfolio has many securities backed by subprime loans, but the company has not written down the value of these loans to reflect the current market price. The two companies have also inflated their financial positions by relying on deferred tax assets – Fannie Mae’s worth increased by $36 billion and Freddie Mac’s by $28 billion. Without tax deferred assets, the value of both companies would fall below the regulatory requirements.
The takeover is being seen as necessary to help stabilize the mortgage industry in the short term. But it does not answer the all-important question of how best to finance home mortgages in the United States.
The lender’s retention of credit risk and maturity matched finding are two key characteristics of safe, efficient, fixed rate mortgage lending. In the mortgage market, these two characteristics are missing to a great extent. Lenders have used the securitization process to pass the risk to others. The transaction cost of securitization is high, particularly if the mortgages are refinanced at a lower interest rate. Maturity mismatching has been prevailing at most lenders, including Fannie Mae and Freddie Mac, since the early 1980s.
One answer to the question is to introduce covered bond financing for mortgages. These bonds are on balance sheet borrowings and secured by mortgages owned by the issuer of the bonds. The lender can safely hold on its balance sheet the fixed rate mortgage it has made.
Covered bonds are new to the United States. Only two lenders – Bank of America and Washington Mutual – issue them. But in Europe, they have been issued for over two centuries. Today there are approximately $3 trillion of these outstanding in Europe. Since these bonds are on balance sheet borrowings, it acts as an incentive for good lending decisions: the lender would be stuck with lending errors.
The authorities are now taking steps making covered bonds more popular. The United States Treasury has already issued a set of best practices for issuing covered bonds. New Jersey Rep. Scott Garrett introduced a legislation for providing statutory protection for investors of covered bonds similar to the protection enjoyed by investors of covered bonds in Europe.
Covered bonds have the potential to fund a significant portion of the $10 trillion outstanding in home mortgages today. With covered bonds, the lenders need not sell their fixed rate mortgages into a secondary mortgage market. Instead, they can safely keep their mortgages.
The federal takeover of Fannie Mae and Freddie Mac has only demonstrated that the present mortgage infrastructure is inefficient and extremely risky. The introduction of covered bonds in such a scenario is a welcome step in the right direction.
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