Members of the U.S. Senate are wrangling over what could eventually become one of the most consequential pieces of legislation to emerge from the financial crisis. Proposed by South Dakota Democrat Tim Johnson and Idaho Republican Mike Crapo, it would aim to replace Fannie Mae and Freddie Mac, the government behemoths that now dominate mortgage lending, with a system much more reliant on private investment.
Legislators looking to find common ground should keep one thing in mind: It's hard to know whether the private sector is ready to take on the responsibility that they intend to thrust upon it. A couple of tweaks would help increase the odds of success.
Most mortgage loans in the U.S. get financed in one of three ways: They stay on lenders' balance sheets; they're guaranteed by Fannie or Freddie and sold to investors as securities; or they're packaged into "private label" securities and sold to investors with no guarantee. Lending now depends almost entirely on the government-guaranteed channel, thanks largely to the spectacular failure of private-label securitization, which produced an abundance of toxic assets in part because intermediaries -- including the brokers and lenders who originated loans and the Wall Street investment banks that packaged and sold them -- had little incentive to care about the fates of borrowers or investors.
The Johnson-Crapo bill, introduced last month, intends to lure private capital into a new market with trimmed-down government guarantees. It also aims to revive the fully private market, where much has changed since the bust. New rules requiring verification of a borrower's ability to pay are pretty strict: They would have forbidden an estimated 84 percent of all the loans packaged into private-label securities during the boom. A proposed "risk retention" rule might further require the creators of mortgage securities to keep a 5 percent portion of the riskier loans they sell. Issuers are making their own fixes, such as hiring independent entities to vet and monitor loans that go into mortgage-backed securities.
Still, the private mortgage market remains practically nonexistent, accounting for only about 2 percent of new mortgage bonds issued. Apparently, investors remember all too well how the various entities involved in securitizations -- the trustees who administered the assets, the servicers who handled transactions with borrowers -- often failed to hold lenders responsible for faulty loans or take obvious steps to prevent costly foreclosures. Perhaps they also recognize that measures such as 5 percent risk retention won’t solve incentive problems: If a bank manages to sell 95 percent of a bad loan to investors for a good price, that's still better than keeping the whole thing.
This is where the Johnson-Crapo bill comes in. If legislators want to help make the mortgage market attractive to private investors and beneficial to borrowers, a couple of changes would help. Both are included in amendments already proposed by two other senators, Ohio Democrat Sherrod Brown and Louisiana Republican David Vitter.
First, the bill should impose fiduciary duty on trustees, exposing them to litigation if they fail to monitor servicers and act in the best interests of investors. This would alter the incentives in cases in which a servicer, for example, stands to make more money by foreclosing than by modifying a loan in a way that would be advantageous for both the borrower and the investor.
Second, it should prevent single institutions from combining the role of insuring mortgage securities with those of originating and packaging loans. If one part of a big bank makes loans and another part decides whether those loans qualify for government-backed insurance, there's a greater chance that investors and taxpayers will get stuck with the poorer-quality stuff. Also, such vertical integration could lead to a market dominated by a few giant, systemically important institutions that would originate, own, package and insure mortgages -- and that the government would be compelled to rescue in a crisis. This is precisely the kind of too-big-to-fail situation that reforming Fannie Mae and Freddie Mac is supposed to avert.
Johnson-Crapo probably won’t become law in this election year. That said, it sends a clear signal of the direction in which legislators intend to take the mortgage market. Given the potential impact on millions of families and the broader economy, they should do what's needed to give their plan the best possible chance of working.
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