Follow the Money

So how do we attack this twin-tiered challenge of mounting inventories and falling prices?

First and foremost, we have to address the biggest thing that matters - money. Without the ability to finance home purchases, we're only going to sink deeper and deeper into the black hole.

There's no arguing the fact that bad financing - securitization - got us into this mess.

Forget all the arguments about how loan factories spun out no-doc "liar loans," or how buyers were equally complicit in perpetrating mass fraud. Forget about the argument that the Community Reinvestment Act (CRA) forced banks to make bad loans to subprime borrowers (the academically derived statistics don't support this assertion). Forget about how low interest rates were to blame (that's partially true). And forget about the fact that deregulation greased the whole slippery slope (that's definitely true).

At the end of the day, the truth that matters is that securitization financed the whole scheme.

Without the ability to offload the risks being packaged into mortgage-backed securities (MBS), very few of the millions of suspect mortgages made would have been originated in the first place.

And without such government-sponsored enterprises (GSEs) as Fannie Mae (OTC: FNMA) and Freddie Mac ultimately competing against private MBS syndicators, the doomed housing-market train would never have left the station - let alone achieved the long length and high velocity that exacerbated the crash damage.

That's where we start. Unless the government is providing direct-and-transparent tax incentives to bolster homeownership (more on that later), it has no business being in the mortgage business - especially when that "business" ultimately puts taxpayers at risk.

Fannie Mae was a Depression-era program, as was the Federal Housing Administration (FHA). Fannie was nothing more than a "bad bank" that U.S. President Franklin D. Roosevelt established to take on the defaulting mortgages that were building up on the balance sheets of U.S. banks. The idea was to free up bank capital so that the banks could make loans elsewhere.

It worked so well that Fannie eventually grew to behemoth proportions and President Lyndon B. Johnson, in order to get Fannie's debt portfolio off the government's balance sheet, privatized it in 1968. In fact, Fannie was such a success as a monopoly that the U.S. government, in its infinite wisdom, decided to create a duopoly by forming Freddie Mac and privatizing it in 1970.

Because of the widespread belief that these institutions were backed by the federal government (technically they are not), Fannie and Freddie were cheaply and easily able to raise the money they would use to purchase mortgages. When the securitization business began in the 1980s - and especially after that business soared - those two GSEs were at the forefront of packaging and selling MBS instruments, as well as buying back many of them for their own bloated accounts.

Fannie and Freddie are both now under government conservatorship, which is another way of saying they became insolvent and taxpayers bailed them out. When they collapsed so did the private securitization market.

Here's how to fix that market - and revive the U.S. housing market in the process.

Three Ways to Revive U.S. Housing Market Financing

To fix the securitization market, and resuscitate the American housing market in the bargain, the federal government must do three things.

First, the government must guarantee all of Fannie and Freddie's existing notes and mortgages (they're essentially doing that already), to make sure the market isn't panicked. Once that's done, announce a cutoff date - after which Fannie and Freddie will no longer be given a Treasury credit line and will be unwound.

Second, Washington must mandate that all the banks that got government help - on a pro-rata basis proportionate to their bailouts and their profits (calculate in bonuses and dividend increases) - will have to contribute to a private national pool of mortgage capital. That pool will replace Fannie and Freddie and will finance mortgage lending in competition with all banks and mortgage lenders. But it will have a single, 10-year lifespan. The government must decree that earnings and profits from this pooled capital are tax-free and must unwind the pool over the allotted 10 years. After all, Fannie and Freddie don't pay state or local taxes, and never did.

Third, Washington must reinvigorate the private-securitization market by making a new federal ratings agency responsible for assessing creditworthiness and assigning ratings on mortgage pools. It should tax interest and profits on the pools (those not created out of the national mortgage pool outlined above) at a flat 10% for 10 years.

These moves will bring the securitization market back to life and new investor cash will flow into the mortgage business.

To establish a guarantee on individual mortgages the government should follow the FHA business model by having mortgage borrowers pay an up-front guarantee fee equal to 1% of the borrowed amount (the fee can be rolled into the loan, if desired). The borrowers can then pay an additional ½ of 1% of outstanding principal each year into the guarantee pool - and those payments can be spread out over the 12 months of each year.

Mortgage pool s yndicators should have a 10% retention requirement (5% is being proposed and banks are already balking at that), meaning that MBS bankers should have to keep 10% of what they originate on their books. But new regulations can give bankers a break on the set-aside haircut by reducing the reserves they are required to hold against these balance-sheet assets.

A Defibrillating Shock

If we're to simultaneously arrest the U.S. housing market's mounting inventories and falling prices, we need to create tax incentives for buyers to stimulate demand.

Banks have supposedly set aside loan-loss reserves against bad mortgages (in fact, they are already reversing a lot of those reserves as they see credit metrics improve). So these institutions are technically carrying inventory and MBS assets that have been marked-to-market, meaning they should be valued at today's depressed prices.

Against that backdrop, any improvement in sales and prices from here would be good news.

To stimulate sales, and generate at least some tax revenue, Washington needs to start a tax credit program that begins on Jan. 1, 2012 and runs for the next five years. For the first full year the property is owned, the rules should allow 100% of capital appreciation on purchased residential property to be credited back to reduce the home's cost basis. That cost- basis- reduction program should be permitted to run for five years, with a 20% annual diminishment in each subsequent year from the first full year of the program.

After this coming Jan. 1, in addition to a credit against appreciation that reduces the cost basis and increases the home's potential profitability, the government should also allow homebuyers a tax credit equal to 50% of any depreciation in the value of their home for the next five years.

In addition to increasing homebuyer demand, these tax incentives will also stabilize the market. And that will help drive investor interest in mortgage-backed instruments, increasing available financing and lowering its cost.

These are not-so-modest proposals, but if we are going to do something about the depressed state of the U.S. housing market, there's no time to waste being modest. Without these actions, the financial ugliness we're experiencing right now could literally last for decades.


News and Related Story Links:

• The Money Map Report:
  Official Website.
• Money Morning News Archive:
  Columns by Shah Gilani.
• Hope Now:
  Official Web Site.
• U.S. Department of the Treasury:
  Official Web Site.
• U.S. Department of Housing and Urban Development:
  Official Web Site.
• RealtyTrac.com:
  Official Web Site.
• Wikipedia:
  Real Estate Owned (REO).
• Investopedia:
  Liar Loans.
• U.S. Federal Reserve:
  Community Reinvestment Act.
• Wikinvest:
  Residential Mortgage-Backed Securities.
• Wikinvest:
  Subprime Lending.
• Investopedia:
  Government Sponsored Enterprise.
• HUD.gov:
  Federal Housing Administration.
• WhiteHouse.gov:
  Franklin D. Roosevelt.
• WhiteHouse.gov:
  Lyndon B. Johnson.
• The Business Dictionary:
  Duopoly.