In his book The Ascent of Money ( also a PBS show ), Niall Ferguson reports that mortgages used to be short term affairs, for perhaps three to five years. The principal on the loan was not paid until the end of the term as opposed to now where each payment you make is part interest and part principal. During the Great Depression, foreclosures spiked and the housing industry was devastated.
As part of the New Deal, the Home Owners’ Loan Corporation refinanced mortgages for periods up to fifteen years to keep people in their homes. Next, the Federal Housing Administration was created in 1934 to provide federally backed insurance for mortgage lenders. Four years later, the Federal National Mortgage Association (Fannie Mae) was formed to purchase and securitize mortgages in order to provide additional funds to lenders and home buyers.
Ferguson notes that “by radically increasing the opportunity for Americans to own their own homes, the Roosevelt administration pioneered the idea of a property-owning democracy. It proved to be the perfect antidote to the red revolution.” You’ll recall that it was the Bolshevik Revolution in 1917 that lead to the creation of the Soviet Union in 1922.
Thus, as Ferguson states, “from the 1930s onwards, then, the US government was effectively underwriting the mortgage market, encouraging lenders and borrowers to get together. That was what caused property ownership – and mortgage debt – to soar after the Second World War…”
The process of securitization basically works like this – a bank lends you money to buy your home. The bank then puts your loan, along with a lot of others, into a package which it sells to investors. This provides the bank with more money that it can lend out, starting the whole process all over again. The residential mortgage market is now approximately $10 trillion, half of which has been securitized.
In another of the same series of white papers previously mentioned (What to Do About the Government Sponsored Enterprises?) the authors note that “the structure of the GSEs leads to the classic moral hazard problem in which the lack of capital market discipline and cheap credit provides an incentive for excessive risk taking.”
Fannie Mae is one such government sponsored enterprise. The white paper authors argue that the current GSE model is flawed, because it introduces systemic risk into the system. The question that is raised (“what is the appropriate reform to be followed?”) is indeed a poser.