What is hidden from Uncle Sam’s balance sheet is the implicit control in the largest bond market in the world, also known as the U.S. mortgage-backed securities (MBS). Established by the U.S. congress as a mechanism to make mortgages available to low-income families, government agencies such Fannie Mae and Freddie Mac market share is greater than two thirds of the total outstanding mortgage-related debt. And these government-sponsored entities have the peculiar responsibility to make loans affordable to the public on one hand, and to be shareholder-minded on the other.
Such a dichotomy would confuse anyone. And regulatory changes over the past two decades were muddling up the cards as well. Take subprime loan origination, notoriously known to have played a major role in the 2007 recession, as an illustration. The Alternative Mortgage Transaction Parity Act permitted variable-rate mortgages and balloon payments. The Tax Reform Act of 1986 prohibited the deduction of interest on consumer debt. And the combined effect made mortgages appealing to consumers.
The interest rate environment and financial engineering techniques such as securitization had pivotal roles as well. As interest rates rose prime originations fell and mortgage companies moved to subprime markets to maintain volume. And securitization started to gain popularity at about the same time alongside the advent of adjustable-rate mortgages (ARMs) that made borrowing easy. How the story unfolded is known but few companies took the time to study its lessons.