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How would tighter regulation affect mortgage origination?
Here's one paper suggesting that regulation doesn't necessarily solve current problems:
We find that most aspects of mortgage broker licensing systems, such as mandatory professional education, do not have a significant and consistent statistical association with market outcomes. However, one component -- the requirement in many states that mortgage brokers maintain a surety bond or minimum net worth -- does have a significant and fairly consistent statistical relationship with both labor and consumer market outcomes. In particular, we find that tighter bonding/net worth requirements are associated with fewer brokers, fewer subprime mortgages, higher foreclosure rates, and a greater percentage of high-interest-rate mortgages. Although we do not provide a full causal interpretation of these results, we take seriously the possibility that restrictive bonding requirements for mortgage brokers have unintended negative consequences for many consumers. On balance, our results also seem to support theories of occupational licensing that stress the importance of pure entry and exit barriers over those that focus more on the human capital effects of licensing.
Get that? Tighter regulation does mean fewer subprime mortgages, but also higher foreclosure rates and higher interest rates on the mortgages. This paper is hardly the final word, if only because broker licensing is not the only possible means of regulation. But in the meantime caution is in order; don't be attracted to the idea of tighter regulation simply because you feel we haven't had good enough regulation so far. Regulators are famous for fighting the last war, not preventing the crisis to come.
So far I'm not finding an ungated copy of this paper.
Posted by Tyler Cowen on January 18, 2008 at 11:29 AM in Economics | Permalink
Comments
How about this solution:
1) Define some kind of "safe mortgage" that has characteristics likely to make it avoid foreclosure
(20% down, fixed, less than 30 years, less than 35% of initial gross income, no prepayment penalty).
2) If the mortgage offered to a client differs from the safe mortgage, require him to fill out a pointless
form and get (guaranteed) approval from a pointless bureacracy a week later. This creates a psychological
barrier to taking a non-safe mortgage, while still allowing people really intent on getting them for a good
reason, to get them.
3) Since non-safe mortgages will appear to have a lot more "hassle", people are more likely to avoid them
but they are still legal.
Thoughts?
Posted by: Person at Jan 18, 2008 11:53:38 AM
That's not too different from what we had during the last 10 years, with safe=conforming mortgage and non-safe=subprime. The problem was there was a bubble in sub-prime after someone figured out that you could split the cash flows to make AAA and junk paper with pension funds and GSEs buying the AAA and hedge funds buying the junk (and more funds writing credit puts on the junk.
The real problem was that lenders were lulled to offer ridiculous risk premiums because they were relying on faulty assumptions about defaults (set during the 10 years house prices were rising). So borrowers took advantage of the tiny spreads (and low adjustable base rates) and took them much further than many observers realized.
How do you regulate lenders (made up of the most sophisticated investors out there) to correctly price their loans?
About the only government change that would be wise to make would be returning capital gains tax parity on homes and other investments (at least that would get owners more focused on rental payment levels).
Posted by: nelsonal at Jan 18, 2008 12:03:29 PM
The paper makes sense. Fewer brokers mean they don't have to scamper as much, and so they are less likely to be desperate enough for volume to have done a lot of subprime.
But if there's less competition for customers, interest rates are likely to be higher.
I'm not sure why foreclosure rates would be higher; this might depend on the measurement used. I will note the WSJ earlier this week noted many home equity loan issuers (2nd mortgage) are NOT foreclosing on mortagees because foreclosing doesn't pay for them. [first mortagee gets paid first, of course]
Posted by: ZBicyclist at Jan 18, 2008 12:06:18 PM
I think the man in the street is going to confabulate regulation with lending standards. They are obviously not necessarily the same thing.
Posted by: odograph at Jan 18, 2008 12:20:57 PM
Get that? Tighter regulation does mean fewer subprime mortgages, but also higher foreclosure rates and higher interest rates on the mortgages.
Well, I haven't read the paper, but that's a pretty misleading summary of the section you quoted. It doesn't draw any conclusions about tighter regulation in general, just bonding requirements, and it specifically says, "we do not provide a full causal interpretation of these results."
Posted by: bob at Jan 18, 2008 12:26:40 PM
There's a december 2007 draft at this link: http://www.nber.org/books_in_progress/labmktinter/kleiner-todd12-11-07.pdf
Still a draft, but better than nothing.
Posted by: Lamiadestra at Jan 18, 2008 12:27:48 PM
Answer: But if there's less competition for customers, interest rates are likely to be higher.
Question: I'm not sure why foreclosure rates would be higher;
Posted by: ou_steve_o at Jan 18, 2008 1:06:12 PM
I doubt that "fewer" anything would have fixed the recent problems our industry is facing.
"More" would be better.
More due diligence (by none commissioned / incentive people) pre-funding to make sure the borrower and the property fit the guideline.
More weight place on the borrowers real ability to pay instead of relying on their historical credit score to ignore lack of assets and income.
More self policing by originators when they get a borrower who obviously cannot really afford the loan.
A more even playing field between the regulations that a broker must follow and the ones the bank originator must follow.
Posted by: Lee at Jan 18, 2008 1:17:42 PM
Sorry I haven't read the paper, but this sounds like a huge con. Why do we assume regulation is the independent variable? This might just explain the ebb and flow of policy reactions: Subprime mortgages and deliquincies rise, creating demands for more accountability in the regulatory regime. Or not. Regardless I would prefer a natural experiment, not a pure explanation of variation.
Posted by: Alex at Jan 18, 2008 2:06:08 PM
Sorry I haven't read the paper, but this sounds like a huge con. Why do we assume regulation is the independent variable? This might just explain the ebb and flow of policy reactions: Subprime mortgages and deliquincies rise, creating demands for more accountability in the regulatory regime. Or not. Regardless I would prefer a natural experiment, not a pure explanation of variation.
Posted by: Alex at Jan 18, 2008 2:07:05 PM
Why not "do nothing"? The major problem was that investment houses were mispricing the default risk for subprime borrowers, as mentioned above. The solution to this problem has already been seen - investment houses want a higher interest rate to take on these riskier loans. The result: less mortgage availability and higher rates for risky borrowers, which is entirely sensible given that we now know these borrowers are in fact higher risks when house prices are not increasing quickly.
I see some role at the margin for (for instance) documentation requirements, and securitizer liability rules, but the basic system has already self-corrected itself, has it not?
Posted by: cure at Jan 18, 2008 2:32:29 PM
The problem with this whole mess is that the lenders were able to lay off the risk of loans. (More exactly, they -- and investors -- thought they could lay off the risk; the troubles today are centered on interpreting the contracts to find who is actually liable.)
They took the logical next step and relaxed their standards. The system will work again when incentives are aligned, i.e., lenders suffer when loans go bad.
Posted by: David Zetland at Jan 18, 2008 3:57:40 PM
Usually I would agree with the idea that the market would eventually align the incentives (as stated in the last post), and that risky brokers would be weeded out naturally. The only issue is that in the banking system, it isn't just the "lenders" who get hurt.
Banks are just more or less like a consignment shop, paying you a low rate for your deposit and lending it out for a higher rate. They are, in general, more highly leveraged than most other entities in the economy. To be considered "well-capitalized, they only have to have a 10% ratio of equity to assets. That means that any major or widespread losses (like are feared from the sub-prime mess), could mean that depositors suffer losses.
For many reasons, depositor losses are bad, so some fix would theoretically be needed. The other option would be to require higher capital levels for banks so that they could absorb more losses, but that may have an ever greater impact than tightening broker requirements in reducing the availibility of credit in the market. So I would think regulation of brokers might be a good way to start, but as the original article mentions, is not without its drawbacks.
Posted by: Will at Jan 18, 2008 9:25:24 PM
"I see some role at the margin for (for instance) documentation requirements, and securitizer liability rules, but the basic system has already self-corrected itself, has it not?"
And also "self-correcting" our entire economy, I might add. Here is another instance where Tyler in a few months or so will be asking those of us with superior foresight, "What can we do now that we are @#$#@?", much like he did with the Iraq war. I am sorry, but some problems can't be fixed as easily as they could have been prevented.
We should most likely institute much of the regulations that are discussed in the paper, along with a significant regulations on credit derivatives. Credit Derivatives are "financial weapons of mass destruction" if un-regulated. Why? Because they privatize gains and socialize losses.
How many banking different banking crisises have we had in my 40 year lifetime that required significant federal intervention and/or public funds? And yet we have people claiming that the markets are self-correcting and are better unregulated. We watch the banking system blow up like every 10 years or so, with something that requires 100's of billions of cash money or artificially induced inflation dollars (think Asian Crisis), but still they claim the banking system is somehow better unregulated. Well, just let the banks fail then, truly allow them to face the market forces they create. SIVs wont save them.
I am tired of bailing these clowns out while others argue "well if we regulated, it would be even worse!" Well, we are about to go into a period that is going to change the way the world looks and not for the better. We will see what capitalism looks like on the other side of the decade from 2007-2017.
Posted by: mickslam at Jan 19, 2008 10:22:21 AM
Easy credit means easy bankruptcy. But the current scam in subprime mortgages is only a variation on the HUD scam of the 60s and 70s. However, in the earlier period, the taxpayers were left holding the bag. This time investors got burned. But basically the same thing happened. The real estate brokers and people who packaged the loans got their fees up front, then dumped the load on the suckers, I mean investors. The brokers have gone, the mortgage companies who packaged the loans are gone, only investors and those who lent to them are left. The same thing happened a few hundred years ago in tulips. However, the consequences are nobody wants to lend and credit dries up. People with legitimate needs can't credit. In this case, the housing market is dead. People who should have known better were asleep at the switch.
Posted by: jorod at Jan 19, 2008 5:20:58 PM
The whole subprime mortgage mess is a case clear cut case of regulatory malpractice…I mean, how can you be so naïve and give some few credit rating agencies so much power and not think that with thus you’d be creating the mother of all the systemic risks creation machine.
The credit rating agencies, acting as the regulatory agent’s subcontractors, analyzed the securities that were collateralized by some more than subprime subprime mortgages, without looking into, not even by sampling, any individual securities; and then proceeded to rate the security as prime risk free investment.
In the blame name game do not forget that whether there were predatory lenders or predatory borrowers didn’t really matter as none of them would have gone anywhere had it no been for the credit rating agencies… empowered by the regulators.
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