The Misaligned Incentives of the Mortgage Markets and The Case for Regulation
While many commentators (ourselves included) have noticed the current mortgage feeding frenzy, what makes these articles most interesting is that they point to a systemic misalignment of incentives between market participants - misalignments that lead to sub-optimal social outcomes. In other words, the very structure of the mortgage market is partially the cause of the current mortgage bubble. It’s the very definition of a market failure and a powerful argument for regulation.
According to Business Week, mortgage lenders currently have serious overcapacity. This is unsurprising given the volatility of mortgage originations and the record volumes of only 18 months ago. Mortgage lenders are now “desperate for business” and in an intense battle for market share - willing to “run the risk that many of their marginal customers will go into default.” In an industry that “simply doesn’t have enough customers to support its current size,” exotic and risky mortgage products are the weapons in a turf war to see who will survive the big shakeout.
Mortgage lenders have long-term market share goals that make higher short-term levels of default palatable; however, as with any war, there is unfortunately a significant amount of collateral damage that greatly harms innocent bystanders. Many borrowers who take on these ultra-risky loans not knowing the full ramifications of the risk they are assuming are left deep in debt and without a house. The tax-paying public is forced to bear the costs of a litany of externalities (shelter and bankruptcy for displaced former homeowners, deposit insurance if lending proves too profligate, etc.). And in numerous communities throughout the country, middle class families have been completely priced out of overheated housing markets.
Thankfully, Business Week reports that state regulators are finally starting to get the picture: “In Illinois, legislators passed a bill that would give a state agency the power to review mortgage applications in lower-income areas to determine whether borrowers should be required to attend loan counseling -- paid for by the loan originator -- before receiving the loan. That, lawmakers figure, will discourage brokers from extending loans to high-risk borrowers who have a high probability of ending up in foreclosure.” This program makes an incredible amount of sense - it ensures that people using exotic mortgages to reach beyond their means are aware of the risk they are undertaking, while preserving the availability of the product for those using it for reasonable financial reasons. But Illinois is only one state. These measures must be extended elsewhere. If they are not, then “a whole lot of homeowners could be caught in a painful trap,” once housing prices and interest rates step off of their current primrose path.
Instead of passing a bill to send lower-income mortgage applicants to detention for some obligatory financial instruction, Illinois legislators could have passed a bill denying mortgagees the right to go after defaulting mortgagors for deficiency judgments. That's the thing that puts these folks in debt.
A mortgagee who has acted responsibly in making the mortgage shouldn't ever need to sue, personally.
Let's not cheer the Illinois legislators who've only kicked the problem over to understaffed and underfunded regulators.
July 10, 2005 7:19 PM | Reply | Permalink
This is a problem that extends to the equity loan industry not just first mortgages. I am curious to see how many people have mortgaged their only asset, the equity in their home, to pay off credit card debt with shady equity loans.
I fear that many lenders are doing dreadfully sloppy work to push through borrowers and book loans to meet profit projections. In the long run once again, this greed will cost the middle class and the American taxpayer in the form of a bailout, similar to the S& L fiasco.
When the bubble pops, not only will the real estate market get a big kick in the pants, but the mortgage banking business with ramifcation to FNMA will be staggering.
The lending factories, the centralized loan servicing centers, fail to do the simplest procedures properly, for example, many equity line loans do not carry Title Insurance or escrow companies, so many lenders fail to record the equity loans, ( a simple task of sending someone to record at the county) some have stacks sitting unrecorded. No one is regulating and everyone is pushing the envelope of accepted lending practices. It's the same mentality that brought us the Enron accounting techniques.
Business Week is right, it's a train wreck.
July 10, 2005 9:46 PM | Reply | Permalink
As Ellen put it, above, proper uderwriting standards and procedures should limit the moral hazard risk to mortgagees.
Of course, if everything blows up the folks who lied on their mortgage applications will be in serious trouble. I would like to think that the lenders who put the mortgages together, approved them, and sold questionable mortgage-backed securities to investors would also face scrutiny.
Maybe that is asking too much of federal regulators.
July 11, 2005 12:14 PM | Reply | Permalink
You write:
"You know it has gotten bad when no less consistent a tout of aggressive capitalism as Business Week is ready to talk regulation."
While the larger argument you make is on the mark, the above remark isn't really fair to Business Week's editorial stance. BW is widely regarded as far more centrist than other major business publications. It's the only business magazine that still acknowledges a legitimate role for unions in the economy, for instance, and is quite willing to recommend regulation where it sees it in the larger public interest.
July 14, 2005 4:36 AM | Reply | Permalink