A Modest Proposal
Lost in the glare of the health care reform conflagration: the House passed the Wall Street Reform and Consumer Protection Act of 2009. If you had told me one year ago that Washington’s massive proposed long-term response to the worst financial crisis since the Great Depression would gather relatively little notice, I wouldn’t have believed it. Or, at least, I wouldn’t have wanted to.
Believe it or not, even though mortgage lending sparked the crisis, the Act doesn’t provide much guidance on how the system should be reformed. In essence, it punts the question to regulators, telling them to enact regulations that provide mortgage loan orginators with the proper incentives to create a competitive market that provides both affordable, and sustainable, mortgage loans. Feel better?
I’ve spent a fair amount of time writing and talking about mortgage lending reform. It seems to me that the most effective way to improve mortgage loan origination in the United States is to adjust the risk faced by mortgage loan originators. Readers of Concurring Opinions probably already know that mortgage loan origination underwent a fundamental change in the latter half of the 20th century. Unknown to most borrowers, the banks from whom they obtained their mortgage loans did not keep them. They sold them, and the right to receive payments on them, to securitizers, who then bundled loans together and sold securities in the bundles to institutional investors. The system had the positive effect of creating a robust market in mortgage lending, making home buying more affordable, for individuals as well as businesses who may need physician mortgage loans. It also had the negative effect of creating a market in which loan originators received reward without risk, since the failure of the borrowers to repay the loan was no longer the originator’s problem. That, in turn, created an enormous incentive for loan originators to make loans — any loans, to anyone, regardless of their ability to repay them. Hello, subprime lending and the race to the bottom. Remember Lending Tree‘s ad slogan: “When Banks Compete, You Win“? Turns out, not so much, unless by “win” you mean “live in economically disastrous times.”
What to do then? For guidance, look north. The Great White North, specifically. Canada came through the mortgage crisis just aboot fine. There are lots of differences between the Canadian and U.S. banking systems [ironically, the Canadians based their system on Alexander Hamilton’s national bank model, which we discarded] but there are enough similarities to make a couple of simple reforms modeled on the Canadian system. In my opinion, they would go a long way to preventing a recurrence of the crisis.
First, a simple rule: mortgage originators must keep a certain percentage — say 10% — of the loans they originate in-house: no selling them on the secondary market allowed. But here’s the rub: the orignators don’t get to choose which 10% stay in-house. That’s done randomly, through a lottery system. Now we have both a robust secondary market, and a strong incentive for originators to make quality loans. A good balance of risk and reward. One reason Canadian banks originated solid mortgage loans is that a high percentage of those loans stay in-house. Consider the toxic asset metaphor: it’s one thing to produce toxic waste if you know you can dump it all someone else’s yard; quite another to produce it if you know you might have to keep it in your living room.
If — and only if — we enacted the first rule, I’d suggest another, also borrowed from the Canadians: no fixed-interest rate loans longer than five years. This redistributes some risk from the originating banks to the borrowers. If a bank is caught in an interest rate squeeze because of a long-term fixed rate, the external effects are potentially much worse than if you or I are. If banks have to hold some loans in-house, we want to make sure they don’t go under when interest rates increase.
Anyway, those are my ideas. What are yours?