Philadelphia Reflections

Mortgages From the Bank's Viewpoint

The Federal Reserve Bank of Philadelphia

There has been much talk of the "moral hazard" for banks in acting as mere salesmen for mortgages they plan not to keep, ending up with "no skin in the game". But when a bank sells a mortgage to a mortgage packager, the bank gets rid of a lot of problems which the new owners of the loan didn't understand well enough when they got into the deal. After all, the securitization of loans is a new and complicated business in itself, and the investment bankers may have been a little bedazzled by the obvious efficiencies of the new system. Securitization provides an excellent way to transfer money from cash-rich foreign nations to local homeowners in cash-hungry regions, at a better price than either party would have been able to obtain locally. And mortgage prices are further reduced by largely ignoring the financial prospects of the anxious borrower on the other side of the desk in favor of lumping his risks and advantages with those of fifty others. The price is then no longer set by hiring a shrewd and experienced banker to ponder the speech patterns, family background, and demeanor of each applicant; such bankers tend to set the price too high just to protect themselves. The idea of bundling and securitizing is a brilliant and useful innovation which must not be destroyed in a national convulsion of revenge. Yes, prices must be adjusted upward somewhat to account for careless salesmanship; but once that risk has been priced, it's likely ample savings will still emerge, compared with the old one-by-one underwriting system.

Unfortunately, that's far from a complete description of the risks involved in holding a loan for five to thirty years. The risk of default and foreclosure is quite small at first, rising to a peak after the mortgage is about five years old, after which the rate of default steadily falls. During the first year, however, the banker anxiously watches the national delinquency rate -- missed payments -- and compares it with his own, or that of the locality, and compares those rates with earlier years. If all these delinquencies seem to occur at historic rates, the banker can normally breathe easy when a loan gets to be five years old. In the meantime, he has to agonize over whether local or national economic conditions are somehow going wrong, and whether some particular cohort is going to create unexpected losses which must be recovered by raising prices on new loans. The contract has been signed; while tempestuous re-negotiation of terms is possible along the way, it is expensive and often fruitless. Each year's delinquency and the default rate is compared with other years, attempting to discern whether a trend is starting, or reversing. If home prices are steadily rising, it is one thing, if they are falling it is quite another. Reading these tea leaves are combined with trade gossip, at conventions and the like. Out of this, the market establishes prevailing prices; the more things are lumped together, the fewer the issues which matter.

It is now clear the designers of this elegant system underestimated the degree to which the system itself would change its own environment. If loans get cheaper, weaker borrowers are able to risk them. One of the beauties of the new system is to permit international traffic in funds surpluses; the deterioration of the dollar was unexpectedly large for an issue which had been irrelevant to real estate under the old Jimmy Stewart system. Home prices rose faster than normal, and then they fell more than normal. That created a risk that more people would abandon their mortgages out of the calculation of costs, rather than an inability to pay. As matters now stand, thirty percent of mortgages issued in 2005 is showing delinquencies; no one is sure whether that will revert to a more normal rate, and when. Or whether the dumping of property on the market will depress prices, leading to a spiral of more mortgages being abandoned. As these warning signs of rising delinquencies appeared, they were noticed. It is not necessary to postulate some particular blunder or conspiracy which started a rush out the door.

In other words, no one knows what these loans will be worth in five years, so no one knows what to charge for one today. The result is a freeze; nominal prices may remain the same for a while, but no one will pay such prices until things stabilize. No one knows how long this uncertainty will last, but it could be a number of years. Meanwhile, a calamitous amount of debt and securities sit on the market, unable to move. Bad deal.

Originally published: Sunday, May 04, 2008; most-recently modified: Sunday, July 21, 2019