Wednesday, October 24, 2007

Kroszner's Testimony before Congress: Just Jawbone Exercise

Federal Reserve Board Governor Kroszner always manages to say something annoying. In his congressional testimony in support of the Mortgage Reform and Anti-Predatory Lending Act of 2007 (Congress's idea of "doing something" about the subprime mortgage mess), Kroszner says a few things that cry out for my commentary. Here are a few examples:

"As I have discussed, the [Federal Reserve] Board supports the goal of ensuring that consumers do not receive unaffordable and abusive loans." Well, isn't that a relief? That's all we need, a Federal Reserve in favor of foreclosing all of America.

"The Board firmly believes that lenders should give due consideration to a borrower's ability to repay a loan, before the loan is extended." Oh, I hadn't thought of that. Shouldn't every Tom, Dick and Harriet be able to own a home, no matter what their financial circumstances? (For those of you who would answer yes to that question, I'm being facetious.)

"A nationwide registration and licensing system for all mortgage loan brokers would help limit the ability of bad actors to move to a new state after having run afoul of regulators in other states." I doubt that. Milton Friedman makes a better case than I can here against licensing arrangements. See his Capitalism & Freedom, Chapter IX. Kroszner should read it.

"The Mortgage Reform and Anti-Predatory Lending Act of 2007 would require originators to present borrowers with loans that are appropriate to the borrower's circumstances." Is Kroszner saying that we need legislation for this? He must be joking.... No, he's not. That's the scary part.

"The Mortgage Reform and Anti-Predatory Lending Act of 2007 would hold securitizers and loan purchasers ('assignees') liable for the actions of mortgage originators." Aha. But here we have the crux of the matter. Who's responsible? Who should be left holding the bag?

ferret button
[Thanks to for the image.]

Securitization [the bundling of loans into bond-like assets that can be sold on the open market] is the best thing since sliced bread, there's no doubt about it--with maybe one hitch. I have always questioned whether it doesn't introduce too much distance between loan originator and ultimate investor. Securitization unlinks the creator of the loan from the responsibility for the loan's reimbursement, thereby removing all incentive to do the job correctly. It puts too many intermediaries into the equation.

It used to be that a family would approach a local bank, present their work documents and credit history, go through an interview, and fill out an application to receive a loan from that same bank for the purchase of a house in the neighborhood. The future income of that bank used to depend upon the family's timely reimbursement of this loan with interest. Therefore, the bank had every incentive to see that the family could indeed afford the home based on a solid job, good credit, and sufficient income relative to the price of the house.

With securitization, you take away the loan originator's incentive to limit lending to good risks. In fact, today anyone can sell loans to anybody, and the loan seller can resell this loan to investors through complicated legal instruments that obfuscate responsibility. Banks and mortgage brokers' loan repurchasing customers don't sell the loans themselves; they have set up intermediaries that dilute responsibility for the repayment of the original loans, plus the securitized loans are then resold, and perhaps resold again to the derivative markets, a highly speculative environment where risk is the name of the game.

The end investors have no idea what precise amount of risk is involved with the mortgages they are purchasing. The naive ones accept the loan originator's assurance that the risk is minimal, and the speculators don't really care because they believe that they can sell the instruments before anything bad happens.

By removing the consequences from the actions of the loan originators through the securitization process, the loan salesman has no incentive whatsoever to do his homework. Once he has sold the loan to the intermediary who will sell to an investor, his work is done, his commission is paid, and he can go on vacation in Hawaii.

This is the fundamental problem with securitization. Congress would now like to legislate this problem away; but they cannot defy market rules. Too much distance between the ultimate holder of the mortgage and the mortgagor prevents normal market incentives from doing their job and now will require great government expense to police and adjudicate. The sad part is that the market would do all this for free, if the liaison between mortgagor and ultimate mortgagee were tighter.

And why did securitization of loans begin in the first place? Because banks are so regulated by the federal government that they can't function anymore. There is little competition in the industry at present, and banks can't offer sufficient interest to attract much investment. The open market, however, can, and so securitization looked like a neat way for banks to get back into the lending business. (But that's another topic for another day.)

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