We Have Learned Nothing From The Mortgage Market Meltdown
In the decade before the 2008 financial crisis household debt increased greatly while the quality of the borrowers declined. Mortgage originators reduced required down payments, required less proof of credit worthiness, and approved less qualified borrowers. This worked because they made money on the volume, not quality or loans, and suffered no losses because all the loans were bundled and resold before any could go into delinquency or default.
In the aftermath, hindsight made clear that the incentives in the mortgage market were almost designed to create such a crisis. Regulators and Congress set out to prevent a recurrence of the subsequent mortgage market meltdown. Yet government completely failed to enact any meaningful reforms and the mortgage market certainly hasn’t reformed itself. It appears we are intent on repeating our recent history, costing borrowers and investors billions of dollars and a lot of anguish. The sad thing is we know the problems and the solutions.
We know down payments matter, but low down payment loans are back with a vengeance. The old, traditional, 20% down payment is amazingly effective at preventing mortgage default and any financial crisis emanating from residential mortgages. People work hard to avoid defaulting because they have considerable equity and are unlikely to end up underwater even if home prices drop. In the rare cases when lenders do have to foreclose, they either won’t lose money or will lose little because of that cushion of equity. Yet, even though we know requiring large down payments protects both borrowers and lenders, 3% down loans are rapidly returning to the mortgage market and zero down loans are likely to reappear soon.
While no documentation loans don’t officially exist anymore, the difference between the no-doc loans of 2007 and today’s alt-doc loans is pretty small. Sure, lenders must do a little more than collect a signature to demonstrate that the borrower can afford the mortgage, but it’s still a channel for people to get into trouble. While such loans have a legitimate place for truly high-income home buyers, for most people they only serve as a way to get in over their head.
One of the biggest contributors to the financial crisis was the fact that mortgage lenders did not own the mortgage loans they were making for more than a couple of months. Thus, they had little incentive to ensure borrowers could pay. The road to profits in the mortgage origination game was and remains volume and speed. The more loans you can make and the faster you can bundle them into mortgage-backed securities, the more money you make. Borrowers making their payments isn’t necessary for originators to profit.
Dodd-Frank was supposed to reform the mortgage market and require lenders to have skin in the game, by forcing them to retain an ownership share (some of the mortgage-backed securities they created) in all but the safest of mortgages. This would have changed the incentive structure so that originators did care (at least a little) about borrowers making their payments, but the final rules that implemented Dodd-Frank made almost all mortgages exempt from this requirement. That means lenders still don’t care about the ability of borrowers to repay their loans.
Contributing to this mal-incentive, mortgage brokers, the people borrowers actually interact with, still operate under a commission system that incentivizes them to make lots of loans, not good loans. Mortgage brokers get paid upon the loan closing, with no financial interest in whether the borrowers ever make even a single payment. This means they want volume, not safety in the mortgage pipeline.
This incentive flaw is not an unknown issue. Life insurance brokers get paid a commission when you buy a life insurance policy and then additional commissions each time you pay a premium (which implies you are still alive). That means they have an incentive to sell life insurance to healthy people, aligning their interests with the life insurers. Mortgage brokers and originators, in contrast, just want to close as many mortgages as possible, with no regard to the quality of those loans.
Finally, mortgage quality is declining. Recent reports show that the average credit score in mortgage backed securities is declining while the share of average borrower’s debt payments as a share of income has risen from below 32% up to 36%, a figure considered quite high by those who want consumers to borrow responsibly.
All the features of the mortgage market that contributed to the mortgage crisis still exist. No new regulations put in place since the recent recession have done anything to prevent a recurrence of a financial crisis. The incentives for mortgage originators still favor volume over systemic risk management. Borrowers are getting deeper into debt again after paring back following the recession.
This is not a case of those who don’t know history being doomed to repeat it. Virtually everyone in the financial industry remembers what happened and understands at least many of the causes. Yet, we still may repeat the last housing crisis because we are currently busy duplicating all the conditions necessary for another mortgage market meltdown. If we don’t change paths soon, we will pay a price for failing to learn the lessons of the recent financial crisis.
Jeffrey Dorfman is a professor of economics at The University of Georgia. His last popular press book is an e-book, Ending the Era of the Free Lunch. You can follow him on Twitter @DorfmanJeffrey