The bipartisan Johnson-Crapo bill in the U.S. Senate calls for the creation of a new hybrid mortgage finance system to replace Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC). Regardless of the bill’s chance for passage in the Senate or even to become law, the creation of an untested, new mortgage finance system begs the question, “will it actually work?”

Fannie Mae Freddie Mac FHFA Federal National Mortgage Assctn Fnni Me (FNMA)

According to Wharton emeritus finance professor Jack Guttentag, the answer is maybe, but we really don’t know. Guttentag goes on to suggest that from what we do know about the new system, it is unlikely to be much better than the old system, and extremely unlikely to lead to what we really need — the revival of a robust private secondary mortgage market.

Guttentag argues we would be much better off if we would simply adopt the Danish mortgage finance model which combines originators, aggregators and guarantors into one entity, essentially an all-in-one mortgage bank. He offers a brief explanation of how the mortgage bank model works: “The mortgage-backed securities issued by the bank would be guaranteed by the government, but as liabilities of the bank, they would also be protected by the total capital of the bank.”

Johnson-Crapo Fannie Mae, Freddie Mac reform proposal

Guttentag offers an overview of the proposed new mortgage finance structure created by the Johnson-Crapo bill to replace Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC). “The Federal Mortgage Insurance Corporation (FMIC) that would replace Fannie Mae and Freddie Mac would be wholly owned by the Federal Government, with insurance functions similar to those of FHA, and regulatory functions similar to those of FDIC. Its weaknesses would be those of Government corporations, which are much better understood than those of private/public hybrids.”

It should also be noted the Johnson-Crapo bill gets rid of federal affordable housing targets, but levies a 10bp fee on guaranteed mortgages to support the future purchase or construction of affordable housing through a new Mortgage Access Fund.

Fannie Mae, Freddie Mac: Danish mortgage bank system

The first point Guttentag makes is that there has never been a default on a mortgage security issued by a Danish mortgage bank. The Danish mortgage market remained rock solid even at the height of the 2008-2009 financial crisis.

Guttentag also highlights that the mortgage bank model should appeal to both sides of the political spectrum. “The Danish model should appeal to the right side of the political aisle because the risk exposure of the government is buffered by 100% of mortgage bank capital, and over time the government’s exposure will disappear altogether. The Danish model should appeal to the left side of the political aisle because it drastically simplifies the mortgage lending process for borrowers.”

In a mortgage bank system, a borrower is funded directly by the secondary market. A mortgage bank can securitize the loan by just adding it to an open bond issue for the same type of mortgage. This is ideal for consumers as borrowers can search secondary market prices online to find the lowest price loan.

With this kind of mortgage bank system, disadvantaged social groups could also be given a boost by creating special mortgage securities backed by the government.