FT Alphaville has been reporting recently on the latest contrarian thinking on mortgage markets in general and securitisation in particular. In the spirit of thoroughness, here’s a contra-contrarian view on mortage securitization, in the form of an essay by economist Arnold Kling.
Kling, who blogs over at EconLog, has some hands-on experience of the mortgage market – he was an economist with Freddie Mac from 1986-1994.
Kling lays out his mission thus:
Like Humpty-Dumpty, mortgage securitization has taken a big fall. There is a widespread presumption that government policy, if not all the king’s horses and all the king’s men, should be aimed at putting securitization together again. The purpose of this essay is to question that presumption.
He devotes 3,397 words (not including footnotes or the introduction to the essay) to a considered take-down of the traditional arguments in favour of slicing and dicing home loans.
Not surprisingly, he also argues against any attempt to revive the market for these loans. For instance:
A basic problem in private-label securitization is that the functions for managing idiosyncratic risk (procedures for qualifying sellers, establishing and enforcing guidelines, and so forth) are no one’s responsibility. Some party must take on those functions in order to address idiosyncratic risk.
Another problem with all forms of mortgage securitization is that of systemic risk. At this point, there is no private-sector firm that can credibly insulate security holders from systemic risk. If Freddie Mac, Fannie Mae, and AIG all are unable to proceed without government backing, then there is no way that securitization can come back without the government acting as a guarantor of last resort.
One suggestion that I have heard is that government should provide support along the lines of “the GNMA model.” This strikes me as nonsense. GNMA packages loans that are guaranteed by FHA and VA. GNMA is not taking any credit risk. Instead, losses are absorbed by the agencies from which it obtains the loans.
The only way that the “GNMA model” could be used for the entire mortgage market would be if the FHA were to guarantee every mortgage. However, the FHA is not even capable of properly pricing the credit risk within its own niche. The FHA currently is suffering significant losses, creating large liabilities for taxpayers.
The essay is also worth reading for the light it sheds upon the way Freddie Mac and Fannie Mae dealt with interest rate, duration and credit risk in the late eighties, and with the ‘principal-agent problem’ in the mortgage market.
Related links:
IMF defends securitisation markets – FT
Securitisation and subprime mortgages – a contrarian view – FT Alphaville
The Danish mortgage model – Marginal Revolution