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10/15/2015 11:28 am ET Updated Oct 15, 2016

Review: Why Can't Something Be Done About Our Broken Home Mortgage System?

This review first appeared in The National Book Review. By Jim Kaplan

Shaky Ground: The Strange Saga of the U.S. Mortgage Giants

By Bethany McLean

Columbia Global Reports 154 pp. $12.99

Consumer spending is the bulwark of the U.S. economy, and housing is easily the largest part of what most American consumers spend. But housing is more than that: it is also the linchpin of most Americans' retirement and long-term economic security, because home equity is by far the biggest part of most households' net worth - much more than stocks, bonds, and other investments.

The emotional connection of most Americans to their home is also unmatched. Since the early 1900's, immigrants to the United States have known they really made it, and become real Americans, when they scraped together a down payment and qualified for a mortgage on their first house.

Given how important home loans are, why is it that in the world's most aggressively capitalist country, their origins are oddly . . . socialistic? So much so that Merwyn King, the former governor of the Bank of England, told Bethany McLean, "Most countries have socialized health care and a free market for mortgages. You in the United States do exactly the opposite."

Why on earth is that the case? That is the critical -- and frustrating -- question at the heart of Shaky Ground, the latest very smart finance book by McLean, who first made a name for herself with her way-ahead-of-the pack reporting for Fortune magazine on the troubles at Enron. Her latest book is part of Columbia Global Reports, a welcome new publishing imprint from Columbia University that signs up top journalists to delve into important but under-reported stories.

McClean found a very good one in our deeply flawed home mortgage system. Its problems start with a simple but incontrovertible fact: home mortgages are normally a great deal for the homeowner, but a terrible deal for the party who actually makes the loan. Homeowners, who in America typically lock in a fixed interest rate and level payments for 30 years, merely run a risk that at some point they will experience a major income decline during the mortgage period, putting their home and investment at risk.

Until about 2008, this looked like almost no risk at all, since even if middle-class Americans lost jobs, the pre-'08 economy normally meant they could find new ones at similar pay and replace the lost income and pay their mortgage. That is often no longer the case, and this is one of many factors that leads to the central quandary in McLean's book: Is widespread home ownership dead in post-Great Recession America?

In any case, McLean notes, the investor side of the 30-year mortgage became untenable decades ago. The interest rate risk is the killer for (mainly) banks who make and then hold the loans. As rates move upward, the income stream represented by the fixed rate mortgage becomes less and less valuable. And the odds of a period of sustained "high interest rates" in any 30-year period is enormous.

This was the biggest reason for the thrift collapse of the 1980's and early '90's: when banks held long-term debt paying say 6%, and they needed to pay deposit rates well over 10% to get money, they went bankrupt in droves. They never had a chance to play the "long game" and wait for their 30-year loans to pay off and to re-invest at market rates. Mortgage lending banks failed before that could ever happen, and they took depositors' money (in excess of the FDIC insurance amount) down with them.

The 1980's thrift crisis led in part to the securitization phenomenon, pioneered by the legendary Lewis Ranieri of Salomon Brothers, described brilliantly by Michael Lewis in his first book, Liar's Poker. Indeed, a huge secondary market developed for those 30-year mortgages. Banks no longer had to hold them and risk failure; they could sell them to investors who could better deal with the rate risk and longevity risk through proper diversification and other standard risk management techniques.

But there was one problem with this scenario, which is that although securitization effectively took care of the mortgage originator's (mostly banks') rate risks, it did not take care of the credit risk, i.e., the risk that the mortgage borrower - usually American households - would default on the loan at some point in 30 years, a very long time in credit terms, even if the credit risk was perceived as low.

In stepped the U.S. Government, as McLean relates. Or rather, in stepped the Government-Sponsored Enterprises (GSE), Fannie Mae and Freddie Mac, which enjoyed an "implicit" government guarantee, or backing, and thus could finance their own operations with very low cost money.

More important, the fact that Fannie and Freddie put their guarantee on so much U.S. mortgage debt in the two decades before the 2007-'09 recession (usually by bundling the debt into mortgage-backed securities, guaranteeing repayment of the mortgages, and then selling those securities to the investing public), made it easy and desirable for banks and other lenders to make loans to riskier and riskier credits. They could easily get these loans off their books immediately (for "conforming" mortgages, which were the vast majority for the middle and working classes), transferring (some might say unloading) both rate and credit risk to investors and the government, respectively.

Fannie and Freddie took greater and greater market share until a few years before the financial crisis, guaranteeing increasing number of loans throughout the '90's and early 2000's. They relied on the historically very low default rates on home mortgages that had existed since the 1930s, which was really as far back as reliable statistics could be found.

For most of two decades, Fannie and Freddie got rich taking fees up front to guarantee and securitize mortgages, and took relatively few defaults until the Great Recession, when the roof caved in and defaults skyrocketed in the perfect storm of weak borrower credit, poorly structured loans, and terrible permanent job losses for borrowers that caused them to lose their incomes and default.

What went wrong? McLean hits the nail on the head, both in this book and her 2010 book about the crisis, All the Devils Are Here (co-authored with Joseph Nocera). When the originators of loans were separated from ongoing credit risk, these originators (mainly banks and thrifts, but increasingly "shadow banks," largely unregulated mortgage providers) were unwittingly incentivized to increase profits by making riskier and riskier loans.

And in the America of the 1990s and especially the 2000s, there were lots of riskier loans to be made. First, the increasing casualness of a lot of American employment had made typical homeowners much bigger credit risks than in earlier eras, something the financial industry as a whole failed to appreciate. Compared to homeowners in other countries, American workers in the Great Recession lost their jobs in greater numbers and with greater swiftness and often could not find new jobs at similar pay.

Making matters worse, the "loss given default" during the Great Recession on loans was much greater than anticipated, because of the recession-induced collapse of housing values, which caused the loss on any given defaulted mortgage to be far larger than forecast.

On top of all this, in the 2000's the mortgage industry increasingly structured loans with variable rates instead of fixed rates, and with low "teaser rates." These teaser rates adjusted upwards after one, two, or three years to a much higher fixed rate, causing many borrowers in 2008 and 2009 to have significantly increased mortgage payments at the same time as they lost their jobs or experienced a decline in income.

As McLean explains, Fannie and Freddie, which had effectively guaranteed those loans, were all but wiped out by these developments. They were placed into government receivership in 2008 and have never come out of it.

At this point, years later, the GSEs still exist, still guarantee, package, and securitize home loans, and once again (after a period of horrendous losses), are making big money. Instead of going to their shareholders, however, all profits still go directly to the U.S. Treasury, presumably to pay back the extensive costs of receivership and "bail out." Indeed, McLean says, the GSEs have actually paid back about $40 billion more than they ever received from taxpayers.

But what happens to the housing market now? McLean accurately reports that the Obama Administration would like to formally do away with Fannie and Freddie, and the leading bipartisan solution (the Corker-Warner bill) would as well, although with a government guarantee that backstops private insurers after 10% of losses have been absorbed. The private insurers would pay a fee for the government guarantee.

In short, the proposal brings back Fannie and Freddie with the names changed, because acting as a government guarantor for other people's mortgage originations (for a fee) is what Fannie and Freddie have more or less been doing for decades.

The reason Fannie and Freddie can't really die is clear. As McLean succinctly explains, in discussing Republican Senator Bob Corker's proposal:

It might seem shocking that any Republicans would sign on to a system that kept any kind of government guarantee. But there is widespread agreement among policy makers on at least this element of investors' argument, which is that you cannot keep a cheap, long-term, fixed-rate mortgage available to the wide swath of Americans through big economic ups and downs without some sort of government backstop. There is a reason no other country has such a product. For all the supposed ideological purity in today's Washington, no politician wants to be responsible for the loss of something Americans have come to see as a right.

And they do see it as a right. As McLean notes, although Alan Greenspan said years ago that many Americans would be better off with adjustable rate mortgages, in November 2014 a stunning 87% of Americans who took out mortgages to buy a house chose a 30-year fixed-rate mortgage.

So here we are, back where we started pre-crisis: the government remaining the guarantor of the American housing market because Americans really can't fulfill their goals of home ownership and long-term secure mortgage financing any other way.

McLean makes the point that it is possible that a younger generation, hardened by their negative experience with home ownership during the Great Recession, and burdened by much more casual employment in the Age of Uber, will turn away from the owned home as the centerpiece of household finance and life in the U.S. The idea is that we as a people would become more mature, cynical, and less enamored of the bonds (positive and negative) of homeownership.

That would lessen, or even eliminate, the need for government to stand behind the housing market. But McLean expresses real doubt about whether that sweeping societal transformation will take place anytime soon.

She seems right about this, which means the inherently risky contradiction she describes, that of a massive, government-backed, socialistic housing sector inside an increasingly competitive, largely deregulated capitalistic, individualist economy, will continue to beset us for a good while longer.

Jim Kaplan is a Chicago lawyer with more than 30 years of experience, specializing in banking and financial regulatory issues.