Representative Barney Frank (D MA), the chairman of the House Financial Services Committee, wrote a comment in this morning's Financial Times (subscription required).
Rep. Frank states that the answer to the subprime problem is more regulation. While I appreciate his position, I believe that he is wrong on that point.
I have no problem with his wish to allow Freddie Mac and Fannie Mae to purchase mortgages, so long as they are purchased at an appropriate market price. When a defaulted mortgage is owned by more than one institution, the workout process is extremely difficult and painful.
The reason that I am against regulation is that the rules would have to be written very specifically to prevent what happened - and, had those rules been in effect at the time, something similar would have happened by skirting those rules.
Existing regulations were primarily written to protect depositors. Unless Representative Frank wishes to write specifications for what the minimum requirements a borrower must meet in order to qualify for a mortgage, and then determine all of the other minimum factors (including who can appraise and what the official method of appraisal should be), regulation of this type can't work; and, given the differences in markets in the US - both in costs of living and income levels, such regulation would be impossible to manage.
We can be fairly certain that no institution will support the lax lending standards that prevailed recently any time in the near future. Without funding, the whole process is paralyzed.
I am not saying that there will not be another bubble. That idea is absurd given recent history, and the history of markets in general. I just don't believe that it will happen in the mortgage market (at least for quite some time).
Pursuing specific regulation to prevent the future occurrence of what just happened will be a waste of effort and will only benefit the legal profession.
The problem, ultimately, occurred because the people who purchased the ownership of the loans had no ability to understand what they owned. They primarily relied on the ratings agencies who, in turn relied on statistical experience (expected percentage of defaults, recovery percentage on defaults, early repayment risk, etc.) to judge the risk of the derivative securities that were secured by pools of mortgages.
While there may have been some fraud involved, there was a perfect storm of circumstances that led to the problems we are experiencing now.
All the parties believed that what they did was in their own best interest:
- The seller of the home wanted the highest price they could achieve, and it was a seller's market (more demand than supply).
- The borrower / home purchaser wanted to buy a home, even if it was just a bit of a stretch, with the expectation that the value of the home would either remain constant or, more likely, appreciate.
- The mortgage broker / issuer was incentivized to create assets. They became more creative as the demand for more loans was insatiable - and they were paid, effectively, for volume.
- The pooler of the mortgages had institutional investors and hedge funds looking to put assets to work for the greatest possible return. They constructed instruments that they could sell to most institutions (various levels of investment grades from the rating agencies). They were incentivized to create as many highly-rated tranches as possible.
- The ratings agencies, knowing their reputations were on the line, did what they could to ensure that the securities issued were properly rated.
- The funds were under intense pressure (for reasons that I will deal with in the future) to get the highest possible returns for their investors / beneficiaries.
The system, which had worked in past environments, was flawed. These flaws became evident in the marketplace when interest rates started to increase.
The potential risks were known; the belief, however, was that they were priced into the market. Clearly, now, that was not the case.
One MAJOR flaw was the assumption that the past would have any relation to the future. Data from the past reflected a normal buying patterns, with normal default and recovery rates. Of course, the mortgages issued over the last few years reflected nothing like a normal pattern. Instead there was a speculative bubble underlying the securities, making all past history suspect, if not totally irrelevant.
Representative Frank is absolutely correct that, in the past when a mortgage was issued by a local financial institution, the issuing institution would keep the loan and be extremely concerned with the ability of a borrower to meet the payments on the loan. Those days, however, are long past. There has been an active mortgage-backed security market in this country for over 20 years. Financial disintermediation has continued in the US (and, for the most part, that's a good thing).
Dr. Richard Bookstaber, in his recent book (A Demon of our Own Design) discusses a regulatory and risk management framework that would be, in my opinion, a better approach. Hopefully he will address this more on his blog.
There are two sides that were hurt by this: the home purchasers and the ultimate owners of those loans. Representative Frank invokes the hearings in the 1930s (leading to the Securities Act and the Securities Exchange Act) when suggesting that fears of regulation are overblown. In this case, however, the purchasers of the securities were sophisticated investors who are able to purchase securities that are not subject to the SEC. It's not the same thing.
As for the borrowers, perhaps the Fannie Mae/Freddie Mac idea would help.
As to future borrowers, unless Representative Frank believes that the Government should interfere in what citizens buy and how much they pay, we should rely on the existing laws against fraud. Any frauds that were committed (bait and switch, or some other means) are, presumably, already illegal.
I would be interested in what others think on this.Sphere: Related Content