Revitalizing the Private Mortgage Market: 'Skin in the Game' and the Consequences for Future HomebuyersPublished: May 11, 2011 in Knowledge@Wharton
By mid-May, the spring home-selling season is usually in full swing. Homes look their best, and buyers rush to lock in deals so they can relocate in the summer. But this year, things are not so good. Despite low home prices, sales are sluggish as the market struggles to recover from the burst bubble of the past decade.
Many potential buyers are scared off by worries that a home bought this spring could be worth less a few months later, given that prices have fallen by more than 8% over the past 12 months, according to Zillow.com. Others are eager to buy at today's low prices, but cannot get a mortgage because lenders have tightened standards to avoid a repeat of the default and foreclosure crisis.
Amid all the uncertainty, a number of regulators, lawmakers and market experts continue to wonder: What will the mortgage market, so essential to a healthy housing sector, look like in the future? Key to that is a rekindling of the private market for securitizations -- the process of converting mortgages into bonds for sale to investors. Securitization provides the money lent to homeowners. In March, the Federal Reserve, Federal Deposit Insurance Corp. and four other agencies issued proposed new rules for the private securitization market -- requirements likely to toughen standards for both borrowers and lenders. But many experts feel the proposals -- still subject to comment before final implementation, possibly this summer -- would not correct the mortgage market's problems.
"I think it's a missed opportunity," says Susan M. Wachter, professor of real estate at Wharton and co-editor of a new book, The American Mortgage System: Crisis and Reform. "I think that we need obviously to envision a restructured housing finance system to replace the failed system that we have had, and this does not get us there. Quite the contrary, it raises more questions."
Currently, more than 90% of new U.S. mortgages are backed by the government entities Fannie Mae, Freddie Mac and the Federal Housing Administration, but almost no one wants the government to continue to be the prime source of mortgage securitization. After suffering huge losses from homeowners who failed to make payments, Fannie and Freddie were taken over by the federal government in 2008 and have so far required a taxpayer bailout exceeding $130 billion. The Obama administration has proposed phasing out the two firms over an unspecified number of years, but that cannot happen without a resurgence of the private securitization market.
The "private-label market," which was all but nonexistent before the 1990s, skyrocketed from 2004 to 2008, when it accounted for more than $2 trillion in outstanding mortgages. Now it is barely breathing. Enormous losses have scared off the investors who buy private mortgage bonds, which do not carry the guarantees that make Fannie and Freddie bonds attractive.
The federal proposals issued in March, required under the 2010 Dodd-Frank financial reform law, are designed to discourage the issuance of risky mortgages and securities based on them. They would require that firms that issue mortgage-backed securities retain 5% of the investment risk contained in the bonds sold to investors. Having "skin in the game," or a stake in the bonds' investment prospects, should make the participants careful in approving mortgages and putting the bond packages together, the agencies say.
Quibbles with QRM
The proposal would allow participants to avoid the 5% requirement when they securitize "qualified residential mortgages (QRM)," deemed relatively safe from default by borrowers. To fit this category, a mortgage would require a borrower with a solid credit rating who will make a down payment of at least 20%. Studies have shown that borrowers are less likely to default if they have made large down payments, which represent equity that would be lost in a foreclosure. Many of the bad loans issued a few years ago required little or no down payment.
The 5% rule is meant to "reduce adverse selection," or to get "loan originators to stop dumping just the bad stuff" into mortgage securities, says Kent Smetters, professor of insurance and risk management at Wharton. "A lot of originators didn't like this approach since it would require them to raise capital, which is not part of their business model." The QRM alternative effectively shifts risk, or the consequences of default, from the lenders to the homeowners, he notes.
"That approach might be reasonable because [borrowers] probably have the most information about their ability to pay," he says. But a 20% down payment requirement would probably reduce the level of home ownership in the U.S., he adds, noting that "many homeowners should not buy anyway until they can afford a reasonable down payment." A high down payment requirement, Smetters says, would probably have the biggest impact on first-time home buyers, who must draw on savings to put money down. People who trade up often have enough equity in the home they sell to make the down payment on the one they buy.
In announcing the proposals, FDIC Chairman Sheila C. Bair said she expected QRMs to be "a small slice" of the mortgage market, with the bulk of the market composed of a variety of mortgage types issued under the 5% risk-retention rule. But critics think lenders will be so averse to keeping money at risk that the QRM loans would become the industry standard. According to Wachter, a 20% requirement could bar 30% of borrowers from the market.
Jack M. Guttentag, an emeritus professor of finance at Wharton who runs a website called The Mortgage Professor, argues that a 20% down payment and strict credit requirements would unfairly make future borrowers pay for the mortgage industry's excesses in 2005, 2006 and 2007. "This is a subject that makes me somewhat irate," Guttentag says. The rules, he notes, "turn on its head the longstanding policy of the government for favoring disadvantaged borrowers. Now our system is going to put disadvantaged borrowers at a further disadvantage."
The mortgage market has moved in this direction already, he adds, with most lenders requiring high-quality credit and 20% down payments. The risk-retention and QRM rules would effectively make this permanent, while requirements might otherwise ease as the economy improves, according to Guttentag.
"What's so terrible is that it knocks a segment of the population out of the market," he says, noting that prior to the recent crisis, default rates were not bad on loans with down payments of only 5% to 10%. The crisis was largely brought on by a series of bad practices that were not common previously: a collapse in lending standards, the introduction of loans that would reset to higher interest rates and a bubble in home prices from borrowers' easy access to money. All of those conditions have been addressed by the marketplace, he notes.
"In the normal state of the world, there's nothing wrong with a 5% and 10% down payment, so long as the risk premium is written in a way that's appropriate to the risk that's embedded in the loans," he says. The risk premium involves measures like charging higher rates for riskier loans and borrowers, and requiring that borrowers carry mortgage insurance. Guttentag also questions whether the 5% skin-in-the-game rule would really change lenders' practices or just become an additional cost lenders would pass on to borrowers.
'An Information Failure'
Wachter doubts that the 5% rule would deter reckless lending when players think big profits are in the offing. She notes that in the mid-2000s, players like Fannie, Freddie and Countrywide Financial took on massive risks despite having enormous amounts of skin in the game, ultimately suffering devastating losses.
Dodd-Frank and the proposed regulations it produced involve a fundamental misunderstanding of what caused the mortgage and housing crisis, Wachter argues. The problem was not that lenders, securitizers and investors were taking on too much risk; it was that they didn't understand what the risks were. "The fundamental problem was an information failure," she says.
Fannie and Freddie have been in the securitization business for decades, dominating the market before the rise of private securitizations just prior to the crisis. When investors buy mortgage securities packaged by Fannie and Freddie, they take on interest-rate risk -- the risk that bond prices will fall if prevailing rates rise, and make older bonds less desirable than new ones.
But investors did not take on default risk, or the risk that a bond would lose value if homeowners stopped making payments. Fannie and Freddie shouldered that risk, promising to make up for defaults. Because default risk had not been a major concern, investors and other players in the mortgage securities market were not good at assessing this risk, according to Wachter. In the middle years of the last decade, lenders got into a "race to the bottom," relaxing standards to make more loans, she says. As these loans were packaged into unregulated private-label securities that did not have default protection, much of the information on risk was wrong or incomplete, leading the markets to believe the securities were safer than they were, Wachter adds.
Each mortgage bond represented a share in a pool of hundreds or thousands of mortgages, and one pool could be radically different from another, making it extremely difficult to compare bonds from different pools. As homeowner defaults began to grow, it was unclear which bonds would be affected, so panic spread and prices of all mortgage bonds collapsed, Wachter notes.
Although lenders and other market participants are risk averse today, Wachter predicts that competitive pressures may well encourage them to "under-price risk" in the future, causing a new round of problems. She believes the best way to discourage this is not to require skin in the game or high down payments, but to provide better transparency so investors see risks more clearly.
That could be accomplished, she says, by standardizing mortgage bonds, much the way stock options and futures contracts are standardized. An investor would then know, for instance, that a bond contained 30-year, fixed rate loans from borrowers with credit ratings exceeding a certain threshold, and who had made down payments of a minimum size. The Securities and Exchange Commission has the authority to demand standardization for bonds traded in the U.S., Wachter notes.
Down in the Tranches
William Frey, president of Greenwich Financial Services, a Connecticut firm that specializes in mortgage securities, says the U.S. system needs a comprehensive redesign to resolve conflicts that prevent various participants from working together to resolve problems.
In a typical deal, a bundle of mortgages is sold by the lender that made them to a trust called a Real Estate Mortgage Investment Conduit, or REMIC, overseen by a trustee, which receives a fee. The REMIC sells bonds based on the mortgage pool. The lender, typically a bank or other "originator," no longer owns the loans but is required to repurchase any loans that are later found to have failed to meet the underwriting standards promised. The originator, or some other firm, functions as a "servicer," collecting monthly payments from homeowners and passing them on to the bond owners. The REMIC has a "pooling and servicing agreement," or PSA, that defines rights and obligations of all parties involved.
According to Frey, this system is prone to conflicts. The PSA, for example, may require that a substantial portion of investors band together before they can sue, and originators may resist pressure to repurchase mortgages. In addition, mortgage pools are typically sliced into a variety of "tranches." Investors in some tranches stand at the front of the line for receiving homeowner's payments and therefore don't care if some borrowers default. Other investors are at the back of the line and are the first to lose money if there are any defaults at all. Finally, trustees and servicers want to keep fees flowing as long as possible.
Frey says this securitization process did not envision the widespread borrower defaults experienced in the past few years. One way to encourage various participants to work together better in the future, he notes, would be to postpone some portion of payments to all participants -- investors, servicers, originators and so forth -- until the "the deal is finished." That means some payment would be withheld until the mortgage bonds mature. The loan originator, for example, could not just sell a bundle of mortgages and be done with the deal, unconcerned about whether the homeowners actually made the payments they promised.
"There should be a requirement that part of [the loan originator's] compensation be deferred so that we have time to find out if they have lied" about the borrower's credit worthiness, Frey says.
Given the severe problems that continue in the housing and mortgage sectors, Wachter and Guttentag think it could be several years before a private securitization market begins to take over from Fannie and Freddie. Although lending standards are strict today, lenders, securitizers and investors have to be concerned about what would happen if too many lenders loosen standards too much in the future, Wachter notes. That could shake confidence in all mortgage securities, even those based on loans with sound underwriting standards.
Home prices are also key to rebuilding the private securitization market, she adds. Homeowners are less likely to default when prices are rising, because they don't want to lose their equity in foreclosure. If prices continue to fall, defaults will be a persistent worry, discouraging private securitizations by scaring off investors.
"The only thing that is going to rekindle the ... market is the passage of time," according to Guttentag, who adds that the overhang of foreclosures will depress prices for several years. "So long as there is the possibility of a further decline in real estate markets, you're not going to have a [private securitization] market."
Wachter, who has testified on securitization before Congress, believes the risk-retention and QRM rules currently under consideration may well be reviewed. The proposals have been criticized by a wide range of groups, from home builders and real estate agents to consumer advocates.
"I think we are back to the drawing board," she says.