by guest contributor, Peter Fugiel, Ph.D.

The recent $25 billion National Mortgage Settlement, an historic joint agreement between 49 states along with the federal government and the nation’s five largest loan servicers may seem insignificant in the context of the $10 trillion dollar U.S. mortgage market. But when you consider the astonishing political diversity of the 49 state attorneys general involved in these negotiations, in light of the awesome loan servicing might of the largest banks, the settlement hints at a much larger possible impact.

In fact, if the state governments were to stay focused on what it is they need from the mortgage industry in their various local markets, the National Mortgage Settlement has the potential to lead to a much bigger state/bank collaboration. If we assume that the Federal Reserve is still interested in using the U.S. banking system to finance the home mortgage market of the future, then the states themselves might be able to help devise an appropriate banking system that will recapitalize the sinking local home markets.

Home mortgages are a tough asset to finance Until Wall Street invented the mortgage securitization product, home mortgages were best known for wide variations in asset value and cash flow returns. As a result, home financing was a second-class citizen in the U.S. capital markets. The securitization of large pools of home loans broadened the investor universe by giving investors a wide choice of cash flow and credit options. Over the past twenty years, capital poured into the sector, as high credit ratings were offered to investors all along the yield curve.

Housing securitization stressed cash flow options  Even though real estate assets are valued based on local markets, most existing mortgage pools were offered with minimal portfolio information. Instead of asset analysis, a “too-big-to-fail” attitude slowly developed in the new mortgage market. The common sense of investors needing relevant secondary credit information was ignored in favor of the ubiquitous cash flow model. Mortgage pools were being structured to perform in good times only. Little thought was given to the devastating administrative and market risks of a home price deflation. Worst-case scenarios were embarrassingly positive. “U.S. home prices never go down” was the prevailing mantra.

Recent Trends in Financing Sources for U.S. Mortgages

Mortgage Total: $10,366,091,000,000* (as of 3rd qtr 2011)


Bank/Savings & Loan






Ginnie Mae



Private Label






 *Mortgage total has declined nearly $1 trillion since 2007.

Source: Federal Reserve Bank

As a result, the federal government took over the U.S. mortgage markets In the rush to market ever-larger mortgage pools, it was widely assumed that no entity could offer a better credit guarantee for all of this under-disclosed real estate than the U.S. national government. Even though most mortgage pools were guaranteed by marginal private entities, the capital markets assumed that with  the explosion of Agency debt, the national government would HAVE NO CHOICE but to stand by the federal agency  ’moral obligation’ guarantees.

…housing policy in the largest states must reflect local market differences such as growth and recession, out-migration and immigration change local markets over time.

Recent National Mortgage Settlement offers a new paradigm  The widely divergent policy perspectives of the fifty states, when combined with the awesome loan servicing reach of the biggest banks, have the potential to take U.S. mortgage finance back to a more decentralized, dare we say, a more “American”, template. This model would rely upon private capital market standards, but could also accommodate the needs of the fifty states as they strive to save local community tax bases. Going forward, housing policy in the largest states must reflect local market differences as growth and recession, out-migration and immigration change local markets over time. To preserve the integrity of the market value of properties, pricing should reflect the respective state’s distinctive characteristics and economic condition.

National Mortgage Settlement offers banks a chance to restructure   For the first time in this real estate downturn, there is some real capital available to allow banks not just to refinance loans, but to strategically restructure loans. Many distressed households want to stay in properties that currently have only marginal market value. In order to keep the asset intact, there should be a write down. Considering what the bank may have to pay to foreclose on the loan in a weak market, working with a household that is qualified at least to rent, is important to the bank’s bottom line. Just as important, keeping a marginal real estate asset occupied is crucial to the community where the unit is located.

States must provide distressed households state-based counseling  One crucial public sector element missing in the recent state/bank settlement is the timely counseling of distressed household. Mortgage lenders should not be expected to offer a household a fuller set of housing options. Renting may the best route, or rent-to-own may be a fallback position for many households. But we should not expect lenders or the federal government to have to “save” distressed households for ownership. The state governments themselves have to respond to their respective distressed inventory problems with their own unique take on what is needed in order to be fair to their state households and to be successful in preserving local market home values. Household counseling may be the most cost-effective housing program needed in the U.S. over the next five years. Local markets do not need any more empty units, especially in marginal and distressed areas.

In the middle of a real estate deflation, enabling distressed households to stay in their units is crucial   Most of the U.S. home markets are over-adjusting from the bubble. This is happening because there has been a contraction in the supply of capital to the home finance sector. Mortgage debt outstanding has declined by nearly one trillion dollars in the past four years. Widespread household credit problems should not preclude the successful conversion of many owner units to rentals. This policy would keep many households in units they already like.  Of course, that ultimately has to be a private capital decision. But in many slow growth urban markets, keeping the cash flow coming into the unit, and into the local tax base, will be unbelievably important over the next five years.

The Federal Reserve wants to bring the banks back into the mortgage industry In a very important white paper released by the Treasury Department and HUD a year ago, a new  template for the private financing of U.S. mortgages was contemplated. The Federal Reserve could supervise the recapitalization of many existing mortgage pools by encouraging the banking system to create new, high quality asset-backed bonds. These bonds would be rated according to the respective bank’s ratings, with strong underlying real estate assets backing the new debt.  It can be assumed that the banks would reflect regional and local market capital needs in their debt issuance. The U.S. would all get away from a centralized model of mortgage financing for what are essentially, place-based, market-sensitive assets.

Bank-issued bonds would be well-structured and should price well in the secondary market  If we are going to get away from the federal government dominating the home finance markets, then mortgage securities are going to have to meet the high standards of bank regulators and the private capital market. Transparent portfolio information, cash flow reporting, and efficient secondary market pricing are all private capital standards that should be established by investors in the open market.

State governments have already succeeded with financing home mortgage pools that are creditworthy  Most state governments have sizeable and viable housing agencies that have been financing affordable home loans in the municipal market for thirty years. Strict household income and purchase price requirements kept the state programs from straying too far from common-sense lending. And even though the state agencies have been affected by the bubble, no one would have dreamed it would be the state, and not federal housing agencies that were left standing.

State government/local bank collaboration has great promise   Just how the new mortgage pools are issued and secured is less important than the recognition that the U.S. home markets are too large and diverse to allow for prudent federal agency control. Certainly, as with the recent state/bank settlement, there will always be a dynamic role to be played by the national government. Guaranties may be needed at times. The full faith and credit of the Ginnie Mae pledge is rapidly increasing that agency’s market share. FHA loan insurance may be necessary, providing it is priced effectively for various kinds of credit risk. Bank oversight of institutional reporting and loan loss reserves will keep the industry creditable.

Demographic demand for affordable housing is very strong through 2050  Unlike most mature economies, the U.S. has astonishingly positive demographics. A continual supply of younger workers, a high birth rate, and good household formation potential all indicate strong housing demand. It is less important that starter households rent or own. It is more important in this deflationary cycle that starter household units be preserved in the communities where the units tend to be concentrated. Counseling for all distressed households and widespread rent-to-own household options could, together, reduce the shadow inventory in most local home markets over the next five years. By that time, the banks and the Federal Reserve System should be ready to recapitalize the existing GSE and private pool mortgages, hopefully at price levels that both the U.S. taxpayer and the local community tax collector would like to see.

About the Author:

Peter Fugiel, Ph.D., a housing and public finance consultant in Chicago, is a frequent contributor to  His firm, PMN Community Services, provides research services to Chicago-area communities based on a platform that combines real estate market analysis with municipal bond research.

Peter was a longtime municipal housing bond analyst with the lead investor in that sector. He pioneered the establishment of industry disclosure standards in his role with the National Federation of Municipal Analysts. Peter won the Federation’s Meritorious Service Award in 1991 for his espousal of voluntary disclosure information by the various sectors of the municipal market. Peter wrote his doctoral dissertation on the significance of the decentralized fiscal structures that should exist under American federalism.