Wall Street's Fatal Defect

The fate of Freddie Mac and Fannie Mae will be center stage in January when the Obama administration makes its required Congressional recommendations about what to do about the two companies. The stakes for homeowners and the economy couldn't be higher as the next Congressional session will determine if the U.S. has a private mortgage market or if, by controlling housing finance, government bureaucrats will be able to direct where Americans live and how much they pay for housing.

While the administration is trying to figure out how much is too much government intervention in the housing finance markets, it doesn't seem to be concerned with the underlying problems that shut down virtually all new issue volume in the private mortgage securities markets. As a result, administration proposals are doomed to fail until it acknowledges that radical mortgage finance reform is a prerequisite for the U.S. to break its dependency on Freddie Mac and Fannie Mae. Reform is needed to induce investors to buy newly issued non-government guaranteed mortgage backed securities.

According to the Securities Industry and Financial Markets Association, since 2006 new issue volume of private mortgage backed securities has dropped by more than 98% and in November came to an almost complete halt. In its place, Freddie Mac, Fannie Mae and the FHA are providing liquidity for most mortgages originated in the United States. When banks and other government insured depositories are included in calculations, the market share of mortgages that are directly or indirectly financed by the Federal government is virtually 100%.

The reason the private mortgage finance market died is that investors no longer trust Wall Street to originate, underwrite, package or service mortgages. Instead, investors are staging a buyer's strike and fleeing to the relative safety of government guaranteed mortgage securities. It doesn't matter what the underlying credit quality of mortgage pools are, investors just aren't buying.

It shouldn't be surprising to anyone that investors don't want to buy what Wall Street is peddling. Over the last four years losses in mortgage backed bonds almost took down the global economy.

But even with what has been reported since 2007, the news from the mortgage backed bond industry keeps on getting worse.

According to many industry experts, including the Congressional Oversight Panel, many private label mortgage backed bonds have a fatal defect. Of course, Wall Street disagrees and claims that the problem is a mere technicality and not very important. The "insignificant" defect that Wall Street is downplaying is that many mortgage backed bonds may not be backed by mortgages.

The last sentence was not a typo or a mistake of fact.

There is a serious chance that the issuers of many mortgage backed bonds lack ownership of the mortgages that are supposed to back their bonds. This dirty little defect has paralyzed the private mortgage finance markets and is a primary reason that new issuance of even private mortgage securities made up of loans to "A" quality borrowers and low loan to values has ceased. And, the problem seems to be ignored by the administration and regulators.

The defect occurred because it was too much of a paper work burden for Wall Street mortgage professionals to make 100% certain that they actually legally transferred mortgages to trusts that issued mortgage backed bonds. Instead of doing what generations of mortgage professionals had done before, the current generation of Wall Street geniuses decided to cut a few corners in the spirit of cost saving innovation.
Cutting corners when transferring mortgages to bond issuers isn't a good idea. If mortgages aren't transferred as expected, then mortgage backed bonds are close to worthless because they aren't actually backed by anything.

But it gets worse; flawed bonds are worth less than $0 to investors. Because of Wall Street's paper work errors, investors took what they thought were legitimate Federal and state tax deductions and paid taxes based upon the expected attributes of their investments. But, it turns out that they may not have been entitled to their tax benefits and as a result may face costly retroactive tax bills including interest and penalties.

The paper work problems in the mortgage finance and securities in industry are well known and well documented. The Congressional Oversight Panel's November 16, 2010 report titled Examining the Consequences of Mortgage Irregularities for Financial Stability and Foreclosure Mitigation provides an authoritative summary of the problem even though it reads like a cheap pulp fiction novel.

The Congressional Oversight Panel raises questions about the financial integrity of hundreds of billions of dollars of mortgage backed bonds and identifies a spillover effect on ordinary people who may be "unable to know with any certainty whether they can safely buy or sell a home." Even this week's report of continued falling home prices was predictable given fundamental title issues raised by the Congressional panel.

The Congressional Oversight Panel report concludes that "[t]he American financial system is in a precarious place" because of the private label mortgage securities issue.

While few experts believe that the economic nuclear winter profiled in the Congressional Oversight Panel report will actually happen, most experts agree that it is a more than remote possibility that "shoddy executed paperwork" will be a costly problem for investors and homeowners.

For its January Congressional recommendations to have any meaning, the administration needs to fix the private label mortgage backed securities problem and recognize that investors will continue to stay away from the market unless they are 100% certain that Wall Street abuses and errors won't reoccur.

The American public has a big stake in the administration's policy initiatives. Home price stability requires a vibrant and sound mortgage finance industry. Investors need to feel confident in the basic integrity of the bonds that they purchase. And, Wall Street decision makers that either made bad decisions or failed to supervise their subordinates need to be held accountable.

Without reform, protection and accountability, the administration's proposals will be stillborn and the U.S. will continue to be almost totally dependent upon the Federal government for housing finance. Maybe this time around Congress and the Administration will use common sense in their policy initiatives but I just don't plan on holding my breath waiting.