We Need Fundamental Mortgage Reform

By BERT ELY
September 8, 2008

Yesterday's federal takeover of Fannie Mae and Freddie Mac was necessary and should help in the short term to stabilize U.S. home-mortgage lending.

But this event must spark fundamental rethinking about how best to finance American home mortgages. As we've seen numerous times in recent years, narrowly based or "monoline" financial entities fail when problems arise in their particular line of business.

Municipal bond insurers exemplify the failure of that business model. Mortgage insurers have experienced difficulty, too, while the monoline credit-card issuers have been acquired or diversified. Banks that have failed recently were too heavily concentrated in construction lending. S&Ls in the early 1980s were too heavily concentrated in home lending. Arguably, Bear Stearns was too narrowly focused on an institutional customer base.

Two characteristics are key to safe, efficient, fixed-rate mortgage lending: the lender's retention of credit risk and maturity-matched funding, i.e., funding fixed-rate mortgages with debt of comparable maturities. To a great extent, those characteristics have been missing in home-mortgage lending. Instead, lenders often have passed mortgage credit risk to others through the securitization process. Securitization also incurs high transaction costs, particularly when home mortgages are merely refinanced at a lower interest rate.

Maturity mismatching (funding long-term assets with short-term debt), the initial cause of the S&L crisis in the early 1980s, has continued to today, notably at Fannie and Freddie. While they tried to hedge that mismatching through derivatives, their recent problems stem in part from difficulties in rolling over their short-term debt.

We need rule changes to help diversified lenders to safely make and hold on-balance-sheet, long-term, fixed-rate home mortgages alongside a broad range of other types of loans and investments.

Regulatory impediments must be removed to permit the growth of "covered bond" financing for home mortgages. Covered bonds are on-balance-sheet borrowings secured by mortgages owned by the issuer of the bonds.

For example, a bank might issue $2 billion of covered bonds with five-year and 10-year maturities that are secured at all times by at least $2.1 billion of performing home mortgages. Because of that security, covered bonds are highly rated, usually AAA.

Covered bonds have been issued in Europe for over two centuries; approximately $3 trillion of these bonds are outstanding today. They are a well-tested innovation, yet only two U.S. lenders have issued them: Bank of America and Washington Mutual.

By issuing long-term covered bonds, a mortgage lender can safely hold on its balance sheet the fixed-rate mortgages it has made. This gives the lender a powerful incentive to make good lending decisions because it will be stuck with its lending errors.

Treasury Secretary Henry Paulson has strongly endorsed covered-bond financing. On July 28, Treasury issued a set of "best practices" for covered-bond issuance. Unfortunately, those best practices have been unnecessarily constrained by an excessively narrow and parochial Covered Bond Policy Statement from the Federal Deposit Insurance Corporation.

Rep. Scott Garrett (R., N.J.) has introduced legislation to provide important statutory protections for covered-bond investors, along the lines of European protections.

Investors need to gain comfort with covered bonds and a secondary market for them will take time to develop. But they have the potential to fund a significant portion of the $10 trillion outstanding today in home mortgages. No longer would lenders feel compelled to sell the fixed-rate mortgages they make into a secondary mortgage market dominated by Fannie and Freddie. Instead, they could safely keep those mortgages.

Funding mortgages with covered bonds also will permit banks and other lenders to experiment with mortgage innovations that are difficult to implement today because of how the secondary market deals with refinances. Even though the essence of a mortgage refinance is simply to reduce the mortgage interest rate, that can be accomplished today only by paying off the old mortgage and replacing it with a new mortgage that has to be sold and then securitized. That is expensive, as anyone who has refinanced knows.

If banks used covered bonds to fund and keep the fixed-rate mortgages they originated, they could experiment with ways to lower the rate on those mortgages without incurring all the transaction costs now triggered by a mortgage refinance. Such innovations could save homeowners billions of dollars annually when reducing the interest rate on their mortgages.

Covered bonds and mortgage innovations are not the entire answer to improving the safety and efficiency of the U.S. mortgage marketplace. However, they are representative of the types of innovations which are needed to move the United States away from a mortgage-finance infrastructure which is both inefficient and extremely risky to taxpayers, as the government takeover of Fannie and Freddie has demonstrated.

Mr. Ely is principal of Ely & Company, Inc.

Detroit's Blackmail Attempt
Is Beyond Shameless

By PAUL INGRASSIA
September 8, 2008

It was only a matter of time, unfortunately. And now that Michigan is an election-year swing state and Detroit's auto makers are posting sales declines topping 20% each month, the time has arrived. The issue of a government bailout for General Motors, Ford and Chrysler is moving to center stage.

Barack Obama has said yes to this proposal early on, and last week John McCain climbed on board. So much for change and fighting pork-barrel spending. We're moving beyond moral hazard here, folks, and into a moral quagmire. At least the Chrysler bailout of 1980 was structured so that taxpayers could reap a reward for taking a financial risk on the company's future. That's not what's happening now.

David Gothard

Late last year, in its energy bill, Congress authorized $25 billion of low-interest loans to high-risk borrowers -- a strategy perfected by home-mortgage lenders in recent years. In this case the high-risk borrowers are the loss-plagued Detroit car companies. The loans are supposed to help them develop new, fuel-efficient cars, and retool their factories to produce them. Detroit, not being satisfied with this taxpayer largess, wants $50 billion.

This is bad public policy for reasons of philosophy, practicality and precedent. And by the way, this is a dumb idea for the car companies too, simply in terms of their own self-interest.

Philosophically, if the Freddie Mac and Fannie Mae debacles teach us any lesson, it is that subsidizing private profits with public risk is a terrible idea. Implicit government backing has led the managements of these two companies to make reckless investments that have backfired badly. Now government backing has become explicit, and under the plan announced by Treasury Secretary Henry Paulson yesterday, taxpayers likely will pay billions to keep Fannie and Freddie solvent -- with the exact amount uncertain.

The Detroit Three got into their current quandary by making decades of bad decisions, with some help from the United Auto Workers union. Yet despite the current crisis, General Motors is still paying dividends to shareholders, the car companies are paying bonuses to executives, and the private-equity billionaires at Cerberus who bought Chrysler are trying to reap enormous rewards from their risky investment. Meanwhile the UAW's Jobs Bank -- which pays laid-off workers for doing nothing -- remains in place.

Of course, we can all hope that shareholders do well, that executives reap handsome rewards for work well done, that the Cerberus billionaires make more billions on Chrysler, and that workers get paid on whatever terms the car companies agree. But we taxpayers shouldn't subsidize any of this.

The only reason we should bail out any private company is the risk that its demise would wreak havoc on the entire economy. Bear Stearns conceivably passed the test; its collapse could have threatened the U.S. financial system, and the government didn't make the mistake of bailing out shareholders or management.

But just what calamity are we trying to avoid by subsidizing loans to Detroit? That we'll all be sentenced to the indignities of driving Hondas, Mazdas or BMWs? Toyota and Honda, the current leaders in hybrids and alternative-fuel technology, did their research and development on their own dimes.

Even if Ford, GM and Chrysler were to go out of business -- and it's highly unlikely that all three will simply cease to exist -- there will be plenty of good cars for Americans to buy. And many will be made in America, even if they carry foreign nameplates. Toyota, Nissan, Honda, Hyundai and other foreign car companies have expanded greatly their U.S. manufacturing operations in recent years. They're doing so because Americans are buying their cars.

As a practical matter, Americans could choose to buy more Detroit cars. Frankly, they should -- considering such outstanding products as the Ford Focus, a fuel-efficient and comfortable compact, and the Chevrolet Malibu, a terrific new mid-sized sedan. But they're not. Americans are voting with their dollars, which is their right.

And what about the precedent the government would set? If we bail out Detroit, where do we stop? The newspaper industry is in financial trouble because more readers and advertisers are turning to the Internet. Newspapers are good for democracy -- Thomas Jefferson said he would choose newspapers over government, after all -- so shouldn't they get low-interest government loans to help them adjust to the Internet? Of course not, and ditto for Detroit.

If Detroit's auto makers would apply more than knee-jerk analysis to what's being proposed, they would reject it quickly. No matter what their spin, including the patently absurd claim that government-guaranteed, below-market loans aren't a bailout, loan subsidies will paint them in the public mind as corporate welfare recipients that can't compete on their own. That can't be good for sales.

More fundamentally, the last thing these companies need just now is more debt. They are leveraged to the hilt, and risk climbing into a financial hole from which they'll never recover. Better to raise money by selling more assets (e.g., Ford's recent sale of Jaguar and Land Rover) or raising more equity -- even if new investors would require management changes or other measures.

All this said, if Detroit's short-sightedness and political expediency make a bailout inevitable, let's make sure taxpayers stand to get rewarded for their risk. In 1980, the government didn't lend any money directly to Chrysler, instead guaranteeing loans to the company made by private lenders, mostly banks, in the amount of $1.2 billion (bailouts, like everything else, were cheaper back then). But in return, the government got warrants to buy Chrysler stock at a very low price. When Chrysler staged its spectacular recovery and paid off the bank loans seven years early, the warrants soared in value and the government earned some $400 million.

Then CEO Lee Iacocca tried to get the government to forego its profits -- he even got into a telephone shouting match with Treasury Secretary Donald Regan. But Regan, backed by President Reagan, stuck to his guns.

One other stipulation: any low-interest loans to develop fuel-efficient cars should be made available to all car companies, not just the Detroit Three. The law passed by Congress last year is framed to make this highly unlikely. But if developing fuel-efficient and alternative-energy cars is deemed worthy of taxpayer subsidies for public-policy purposes, it's just common sense not to put all our eggs in Detroit's basket.

Mr. Ingrassia, a former Detroit bureau chief for this newspaper, won a Pulitzer Prize in 1993 for his automotive coverage. He writes on automotive issues for The Journal, Condé Nast Portfolio and other publications.

Latin America Wants Free Trade

Of the two U.S. presidential candidates, one promises to expand international trading opportunities for American producers and consumers. The other pledges to raise the barriers that Americans already face in global commerce.

For Latin America, this is the single most important policy issue in the campaign. If Republican candidate John McCain wins, he says he will lead the Western Hemisphere toward freer trade. Conversely, Democratic candidate Barack Obama has promised that he will craft a U.S. trade policy of greater protectionism against our Latin neighbors. The former agenda will advance regional economic integration, the latter will further Latin American isolation.

Getty Images

John McCain and Colombian President Alvaro Uribe, July 1.

Anyone who has read 20th-century history knows the seriousness of this policy divide. The last time Washington adopted a protectionist stance toward our southern neighbors was in 1930, when Congress passed the Smoot-Hawley tariffs. It took more than 50 years to even begin to climb out of that hole.

Many economists blame Smoot-Hawley for the depths of the U.S. depression. But Latin Americans have suffered even more over a longer period. Their leaders chose to retaliate at the time with their own protectionist tariffs, but the damage didn't end there.

In his 1995 book "Crisis and Reform in Latin America," UCLA professor Sebastian Edwards writes that though there was a brief period of liberalization in Argentina, Brazil and Chile in the late 1930s, it didn't last long. Adverse conditions brought about by World War II prompted the region's policy makers to restore tariffs, in the hope that protectionism would stimulate economic development.

Latins need a McCain victory over Obama, The Americas columnist Mary O'Grady tells James Freeman. (Sept. 8)

"By the late 1940s and early 1950s," writes Mr. Edwards, "protectionist policies based on import substitution were well entrenched and constituted, by far, the dominant perspective." The U.N.'s Economic Commission on Latin American and the Caribbean, he adds, provided the "intellectual underpinning for the protectionist position."

Protectionism made a mess out of the region, and not only because spiraling tariffs and nontariff barriers blocked imports and destroyed the export sector. They also provoked an intellectual isolation as the information and new ideas that flow with trade dried up, along with consumer choice and competition. This had a deleterious effect on politics too, as closed economies spawned powerful interests which seized not only economic but political control and grew entrenched.

According to Mr. Edwards, it was only in the late 1980s and early 1990s that U.S. and Latin leadership (not counting Chile, which liberalized earlier) began to recognize the twin unintended consequences of this model -- poverty and instability -- and decided to act. "Tariffs were drastically slashed, many countries completely eliminated import licenses and prohibitions and several countries began negotiating free trade agreements with the United States."

THE AMERICAS IN THE NEWS

Get the latest information in Spanish from The Wall Street Journal's Americas page.

Mexico and Canada signed the North American Free Trade Agreement with the U.S. in 1993, but the regional opening process continued well into this decade. A U.S.-Chile bilateral agreement kicked off in 2004. Five Central American countries and the Dominican Republic signed their own FTA (Cafta) with the U.S. in 2006. Peru's FTA with the U.S. was finalized in 2007. Colombia and Panama have signed agreements with the U.S. that are awaiting ratification by the U.S. Congress.

It is true that unilateral opening would have been a superior path. Yet for a variety of reasons -- not the least the political attraction of reciprocity -- FTAs have become fashionable. And there is no doubt that the agreements, warts and all, have aided in the process of dismantling trade barriers, strengthening the rule of law, and moving the region in the direction of democratic capitalism.

Mr. McCain wants the U.S. to continue its leadership role in opening markets in the region. He favors ratification of the Colombia and Panama FTAs, which the Democratic-controlled Congress is blocking. He also wants to lift the U.S.'s 54-cent tariff on Brazilian ethanol, and he wants to preserve Nafta.

Mr. Obama would reverse regional trade progress. He supports House Speaker Nancy Pelosi's opposition to the Colombia FTA, even though it will open new markets for U.S. exporters. He promises to "stand firm" against pacts like Cafta and proposes to force a renegotiation of Nafta, which is likely to disrupt North American supply chains and damage the U.S. economy. By heaping new labor and environmental regulations on our trading partners, his "fair trade" proposal will raise costs for our trading partners and reduce their competitiveness.

Perhaps worst of all, his antitrade bias will signal the region that protectionism is back in style in the U.S., and encourage new trade wars. No good can come from that, for the U.S. or for Latin America.

The Truth about Fannie Mae and Freddie Mac

USA MORE SOCIALIST THAN CHINA

Russians 'agree Georgia deadline'

Russia has pledged to remove its forces from Georgian land - excluding Abkhazia and South Ossetia - within a month, French President Nicolas Sarkozy says.

Following talks with Russian President Dmitry Medvedev in Moscow, Mr Sarkozy announced 200 monitors from the EU will be deployed in South Ossetia.

And Russia also agreed to remove a key checkpoint within Georgian territory.

In the same briefing, Mr Medvedev said there would be international talks on the area's security on 15 October.