Never has a housing boom ended with such a spectacular implosion. Fuelled by low interest rates, an absence of due diligence and zany mortgage products that in retrospect beggar belief, the bursting of the US and UK housing bubbles crippled the mortgage markets and destabilized the global economy. Now politicians and industry representatives are working together to rebuild these vital markets.

There is a lot to be done and the overarching theme emerging from early discussions is: back to basics. Gone are the days of 125% loans, tempting customers with free cars and accepting fake income documentation from unscrupulous websites such as fakepaystubs.com. At least it is hoped that this kind of excess and fraud will be curbed and the business of making housing loans to those truly able to afford them will return.

It will take time. The US and the UK take different approaches to mortgage financing. The most important difference is that the former used government-sponsored entities (GSEs) such as Fannie Mae and Freddie Mac to handle the prepayment risk long-term fixed-rate mortgage products generate. Thanks to the sub-prime crisis, both countries now face the same fundamental problems that have dramatically curtailed mortgage lending and damaged the wider economy.

The cores of the two countries’ financial systems are barely functioning and bank bail-outs have so far done little to unfreeze the credit markets. Investor confidence has been shattered, making the public sale of mortgage-backed bonds impossible. The outlook for primary market issuance, apart from those bonds structured and sold to central banks for repo, is also weighed down by the amount of paper sloshing around in the secondary market. Until this overhang is dealt with, the prospects for the primary market are bleak.

The postmortem on the sub-prime crisis is well under way. Although no firm plans have been established to reform the mortgage markets, experts are focused on a back-to-basics approach. Broadly it will include more transparency and a better alignment of risks throughout a mortgage’s lifecycle, from origination through to financing. A bolstering of the fundamentals of mortgage finance should gradually restore investor confidence to the point that a healthy and sustainable mortgage finance sector will function once again in the important US and UK markets.

The bigger they come...

At $12 trillion, the US mortgage market is far and away the world’s largest. Built on the GSE concept, as of 2008 half the market was either owned or guaranteed by such institutions as Fannie Mae, Freddie Mac or a Federal Home Loan Bank (FHLB). In 2003, a record $4 trillion in mortgages were originated, most of which were refinancings. That kind of volume wasn’t sustainable but demand from investment banks’ structured credit desks kept the party going until early 2007.

"The US housing boom would have petered out in 2004 without the substantial increase in sub-prime lending," says Michael Lea at Cardiff Consulting in San Diego, California, a former chief economist for Countrywide Financial. "It extended the bubble for three years and accelerated the pace. Most of the problems are in loans made in 2004 through 2007 where 100% loans were made to non-creditworthy borrowers on the assumption that prices would continue to go up. Now we are suffering the consequences."

It didn’t take long for sub-prime loans to come under pressure and the domino effect to kick in. By late 2008, Fannie and Freddie were both placed into conservatorship and many of the largest players in sub-prime mortgages such as Lehman Brothers, Countrywide and IndyMac were out of business. While the US government continues to prop up ailing Fannie and Freddie, policymakers and industry representatives such as the Mortgage Bankers Association (MBA) are studying ways of reinvigorating the barely functioning mortgage markets.

At the forefront of concern is what to do with the GSEs and how to go about jump-starting the private-label securitization market. In the immediate aftermath of Fannie and Freddie’s collapse in September MBA leapt into action and started to draft a framework for recovery.

"We wanted to expand the debate beyond just fixing Fannie and Freddie into a more global consideration of how the markets should look," says John Courson, president and chief executive of Washington, DC-based MBA.

MBA convened a secondary market summit, which included its membership, representatives from the Bush and incoming Obama administrations as well as Congress and think-tanks focused on the mortgage market. The outcome has been the establishment of a council of industry leaders and the publication of a white paper entitled Key Considerations for the Future of the Secondary Mortgage Market and the Government-Sponsored Entities (see mbaa.org). This paper is meant to be a foundation for discussion that will take place and lays out the ideas that should be considered. It includes the summaries of various funding options available as well as suggestions for dealing with GSEs.

The future of the GSEs is coming up for much discussion and the early thinking is that there will be a role for them but it probably won’t be as a bulk purchaser of mortgage loans.

"As long as we have these 30-year fixed-rate mortgages as a prominent feature of housing finance, we’re going to have a Fannie Mae or Freddie Mac in some form," says Cardiff’s Lea.

The new GSE or GSEs will likely play the role of a government guarantor or a risk insurer of securities rather than a buyer and holder of securities. It would also provide a liquidity backstop for the broader mortgage market.

"GSEs will still have an important role," says MBA’s Courson. "One is to provide funding and hold securities or loans for products that do not have a viable secondary market, like affordable housing products. Second will be as a liquidity backstop when the private market is not working properly."

"[The GSEs] will be either competing with or superseded by Ginnie Mae," says Lea. "You put a guarantee on a pool of mortgages and then sell it into the market. You won’t have the big portfolio build-ups that were the source of systemic risk for Fannie Mae and Freddie Mac. They’ll have this guarantee function and then the question is, do you need Fannie Mae and Freddie Mac if you have Ginnie?"