The always engaging and frequently brilliant economist, Arnold Kling, sat down last weekend and wrote a fantasy script for a Congressional hearing on the mortgage industry to which he has not been, and yet should be, invited.  It is clear, concise and easy to understand in the style that has made Kling so popular and widely read.

The secondary mortgage market began in 1968, when the United States formed the Government National Mortgage Association (GNMA). GNMA pooled loans originated under programs by the Federal Housing Administration (FHA) and the Veterans Administration (VA) and sold these pools to investors. The purpose of this, as with the quasi-privatization of the Federal National Mortgage Association (Fannie Mae) that took place that year, was to take Federally guaranteed mortgage loans off of the books. President Johnson, fighting an unpopular war in Vietnam, wanted to save himself the embarrassment of having to come to Congress to ask for larger and larger increases in the ceiling on the national debt.

Thus, the first steps toward mortgage securitization were taken in order to disguise financial reality using accounting gimmicks. It has been the same ever since.

Kling describes the shift from home loans offered by savings and loan associations managed by local residents offered to the neighbors they knew in areas they lived in and in which they held a vested interest.  Over a thirty year period this model of American home ownership transformed into a system where bundles of thousands of mortgages were marketed to investment groups and funds as far away as Singapore, Riyadh and Brussels.

There has been a flight to safety in credit markets in recent weeks. What is probably a necessary and significant consolidation in the financial sector has turned into a rout.

Under the circumstances, there are two policy imperatives. First, regulators must sort out the banks that are sound from those that are insolvent. The insolvent institutions need to be merged or closed as expeditiously as possible. Sound banks should be encouraged to make loans to qualified borrowers. Some forbearance of capital requirements may be appropriate in order to ensure that good borrowers do not get turned down. Finally, there may be some banks that are neither clearly insolvent nor clearly sound, in part because of questions concerning the values of their mortgage securities. These banks should be allowed to continue operating, under close supervision, perhaps with loans from the Federal Reserve.

Under no circumstances is it justified to attempt to revive the mortgage securities markets. Resumption of active trading in those markets is neither necessary nor sufficient to address tightness in credit markets caused by the flight to safety.

The author also notes the glaring breakdown of communication between the senior managers and analysts and mid-level executives of their own firms who have been warning of intrinsic problems in the market for years.  Kling refers to two excellent articles by Charles Duhigg of the New York Times detailing the internal problems in Fannie Mae and Freddie Mac.

To illustrate what he calls a suits vs geeks problem, Kling cites the compelling economic commentator, Megan McArdle, who has posted a fascinating parallel between the mortgage security debacle and the results of an investigative study of NASA’s Challenger space shuttle disaster.  The late Nobel Prize laureate and world-renowned physicist, Richard Feynman, served on the Challenger commission and wrote this in his remarks in the final report:

Finally, if we are to replace standard numerical probability usage with engineering judgment, why do we find such an enormous disparity between the management estimate and the judgment of the engineers? It would appear that, for whatever purpose, be it for internal or external consumption, the management of NASA exaggerates the reliability of its product, to the point of fantasy.

Arnold Kling concludes as follows:

Robert Merton, a Professor of finance at Harvard and a Nobel Laureate, suggests that the decisionmakers who I call “suits” need better training in modern mathematical finance. That is one solution. Another solution would be to try to limit the ways in which under-educated “suits” can expose their firms and our economy to risk. As I indicated earlier, I do not believe that the mortgage securities market would have emerged without regulatory favoritism. If such favoritism were taken away, and the mortgage securities market were to fade away as a result, then the communication gap between the suits and the geeks would cease to be a problem.

Read the whole thing here at the Library of Economics and Liberty.