If you put capital into a bad bank, it is still a bad bank unless you are certain that the capital is enough to absorb all prospective losses on mortgage-related securities.
The Fed and Treasury might, therefore, focus more on stabilizing these assets by making 10-year, interest-only, low-interest-rate (for example, 3%) mortgages to homeowners in amounts equal to, say, 85% of their existing mortgages, the proceeds of which would fully satisfy their existing mortgages.
The result would be a rise in mortgage-backed securities prices because many homeowners would be able to meet their lower monthly payments; foreclosures would slow substantially; home prices would stabilize, perhaps rise; bank capital would be replenished from higher MBS prices; and banks would be more comfortable lending to each other even without a government guaranty.
This program would also be politically popular with both parties, keeping Americans in their homes and averting the taint of a Wall Street "bailout."
The secondary mortgage market must be restored to generate enough low-cost mortgages to increase home sales, stabilize or increase home prices, and as a result give banks confidence that the MBS on the balance sheets of the financial institutions they lend to have bottomed. Banks would then be willing to lend, and rising home prices would increase consumer spending, and start us along the path to economic recovery.
An efficient secondary mortgage market requires current information on the performance of the loan pools underlying the MBS. Servicer tapes, which contain pool delinquencies, defaults, foreclosures, and recoveries, should be made broadly available as opposed to reserving them for those who can afford the high cost. Credit measures better than FICO (which turned out to be a terrible predictor of default) and loan-to-value ratios should be updated and published periodically.
This is likely to generate bids for MBS, which would increase their prices; replenish bank capital; increase lending; reduce mortgage rates; increase home sales; and, consequently, consumer spending.
A secondary mortgage market needs credible MBS ratings. To reestablish rating agency credibility, rating analysts' compensation must be better aligned with the performance of their ratings. In particular, rating analysts' bonuses should be paid over several years and the unpaid amount forfeited if the rating turned out wrong due to poor analysis.
Also, analysts responsible for challenging the accuracy and reliability of data and criteria should be paid as much as those who determine the ratings, even if their criticism threatens major revenue streams. And rating agency culture must encourage such challenges; such a culture was sorely missed in recent years.
Also, shopping for ratings — choosing the agency that gives the highest rating — must be stopped. The core theory behind the recent rating agency legislation — that opening up the market to more agencies will create competition and yield more accurate ratings — is flawed.
Rating agencies are more likely to compete by giving higher ratings. This not only misrepresents issuers' creditworthiness to investors but also abuses the many regulatory benefits that attend higher ratings, such as lower capital requirements for banks, insurance companies, and brokers, and investment eligibility for mutual funds, public retirement plans, and money market funds.
A better solution would be to recognize only a few rating agencies, require issuers to provide complete information to the agencies not selected to rate an issue, and require those agencies to rate the issue and publish their rating and rationale despite not being paid to do so.
Mortgage lenders must better align the compensation of their employees with the performance of the mortgages they originate. Commissions for arranging mortgages should be paid over three years — the period during which most mortgages defaults occur — and the unpaid balance forfeited if a mortgage defaults due to flawed underwriting.
Mortgage originators should be required to retain more risk on their balance sheets instead of securitizing substantially all of it. This would better align their profitability with the mortgages' performance. The mortgage business had adopted an originate-and-sell model (in which originators securitized even their future servicing) that required little retention of risk. The retention of more risk would cause management to adopt better underwriting standards and better internal controls over lending employees' behavior.
The same compensation approach should be taken with investment bankers, that is, bonuses should be paid over several years and the unpaid portion forfeited if MBS they create perform poorly.
Lower leverage limits should be imposed on mortgage lenders and investment banks (though the latter have ceased to exist in their traditional form). These institutions leveraged their MBS portfolios up to 35 times. Burgeoning defaults on subprime mortgages caused market-value declines and margin calls that forced the liquidation of these securities, pushing market values below intrinsic values, that is, the present value of their future cash flows.
These market-value declines triggered additional markdowns and liquidations of MBS into an already distressed market. This reduced capital levels and produced cliff-like share price declines, causing reduced access to capital, loss of customers and counterparties, rating downgrades, additional collateral-posting requirements, and so on. The overall effect: a financial meltdown.
Meanwhile until a private-sector secondary market can be restored, Fannie Mae and Freddie Mac must continue to provide our secondary mortgage market. Without their substantial involvement, mortgage credit would be constrained, home sales remain sloth-like, and home prices unstable. Then economic growth would slow even more and credit pipes would remain clogged. As a private-sector secondary mortgage market is restored, the roles of Fannie and Freddie could be reduced or even eliminated.