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Key Industry Players Blamed for Mortgage Mess
Should feds hold mortgage brokers, loan officers accountable for bad loans?
By Jack Guttentag
March 24, 2008
You have heard the complaint: "In our current home loan system, nobody worries about the risk because they pass it on to the next player in the chain. If everyone in the chain had skin in the game -- something to lose if the loan goes bad -- we wouldn't be in the mess we are in now."
A long chain of risk transfers is certainly a feature of our housing finance system. In a typical scenario where loans end up as collateral for a mortgage security, a mortgage broker shifts the risk to a wholesale lender, who transfers it to an investment banker, who transfers it to multiple investors. The broker at the head of the chain usually knows the most about the risk, while the investor who ultimately bears the risk often knows the least.
Some knowledgeable observers have suggested that the government should enact the following rule: "Every player in the chain must have skin in the game." I think this is a bad idea.
Economists term situations where one party makes a decision for another, without having the same stake in the outcome of the decision, the "principal-agent problem." It is pervasive in our society. Principals protect themselves by establishing rules that their agents must follow and by control mechanisms designed to assure that the rules are being observed. Sometimes these mechanisms work, and sometimes they don't.
At the top of the mortgage chain, skin in the game is one of the control mechanisms used by principals. Investors purchasing a mortgage security may require that the investment bank issuing the security retain a piece of it. The investment bank, in turn, will require that the lenders from whom it purchases loans agree to repurchase those loans that don't meet the investment bank's standards.
The rules and their enforcement became lax during the boom years, but now they are extremely stringent -- wherever the market continues to function, that is. Even if government intrusion were warranted here, which I don't believe is, the timing is terrible.
At the bottom of the chain, lenders set underwriting rules -- conditions that loans must meet to be approved -- that agents (brokers and loan officers) must follow. A lender employee called an "underwriter," or an automated underwriting system, must sign off on a loan before it is approved. The control mechanisms for enforcing compliance, however, are weak.
Wholesale lenders can't require that mortgage brokers have skin in the game. The typical broker does not have the money to buy back loans that don't meet the lenders' standards. About the only thing a lender can do is take a miscreant broker off its approved list, but that won't prevent the broker from doing business elsewhere.
The inability of lenders to control brokers is one reason why some observers would not be unhappy to see brokers disappear, and some of their proposals seem to have that as an unstated objective. They appear to believe that eliminating brokers would eliminate the principal-agent problem at the point of sale.
But that is not the case. The alternative to mortgage brokers is loan officers, with whom lenders have a principal-agent relationship that is basically the same as the one that exists in their relationship to mortgage brokers. Loan officers are lender employees who are compensated on a commission basis, whose income depends entirely on the number and amount of loans they produce, and who have no stake in whether or not a loan turns out to be good or bad.
I remember vividly that soon after joining the board of a large savings and loan, the CEO gave the board a list of the most highly compensated employees of the association. To my surprise, the CEO's name was third on the list, and I did not recognize the two names at the top. They turned out to be loan officers.
I found that there was no way to cap the compensation of loan officers, or to force them to put their skin in the game, even though they legally are employees. Lenders who have tried to base commissions on loan performance have found that their best producers quit to join other lenders.
The only way to get skin in the game at the bottom of the financing chain where loans are originated is to revert to a primitive system, similar to those found in many less-developed countries. In such a system, lenders are either individuals or very small firms where the owner is CEO and makes all loan decisions. Every player in the chain has skin in this game, and the potential for boom and bust would be negligible. The trouble is, systems of this type typically offer one type of loan, high interest rates, short terms and large down payments.
Copyright 2008 Jack Guttentag
Builder Confidence Remains Unchanged In March
| March 17, 2008 - Builder confidence in the market for new single-family homes remained unchanged in March, according to the latest NAHB/Wells Fargo Housing Market Index (HMI), released today. The HMI held firm at 20, which is near its historic low of 18 set in December of 2007 (the series began in January of 1985).
“Our surveys confirm what I’ve been hearing personally from builders across the country, which is that interested buyers are out there, but they are either reluctant to go ahead with a home purchase or they are unable to find mortgage financing they can afford,” said NAHB President Sandy Dunn, a home builder from Point Pleasant, W. Va.
“NAHB applauds the Federal Reserve’s aggressive actions over the weekend in response to escalation of financial market pressures, and we strongly encourage the Fed to ease monetary policy substantially when the Federal Open Market Committee meets tomorrow,” said NAHB Chief Economist David Seiders.
“With the deepening problems in today’s economy and financial markets, Congress and the Administration should enact additional stimulative measures, and the next round should be directed squarely at the housing sector,” he added. “A temporary home buyer tax credit, FHA modernization and GSE oversight reform are the three most important things that Congress can accomplish right now to help ensure that housing does not drag the economy into a full-blown recession. Provided that the necessary actions are taken promptly, a housing market recovery most likely would take shape by the second half of this year.”
Derived from a monthly survey that NAHB has been conducting for more than 20 years, the NAHB/Wells Fargo HMI gauges builder perceptions of current single-family home sales and sales expectations for the next six months as “good,” “fair” or “poor.” The survey also asks builders to rate traffic of prospective buyers as either “high to very high,” “average” or “low to very low.” Scores for each component are then used to calculate a seasonally adjusted index where any number over 50 indicates that more builders view sales conditions as good than poor.
Two out of three of the HMI’s component indexes were unchanged in March from the previous month. The index gauging current sales conditions for newly built single-family homes held firm at 20 while the index gauging traffic of prospective buyers stayed at 19 following a significant gain in February. The index gauging sales expectations for the next six months edged downward by a single point to 26.
Regionally, the HMI was mixed, with the Northeast posting a two-point decline to 21, the Midwest holding even at 16, the South reporting a two-point gain to 26 and the West showing a one-point decline to 15. |
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