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Jack M. Guttentag The Mortgage Professor

Jack M. Guttentag, The Mortgage Professor

Should 'Skin in the Game' Be a Requirement to Play?

by Jack M. Guttentag

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Posted on Wednesday, March 19, 2008, 12:00AM

You have probably heard a variation of this complaint: "In our current home-loan system, nobody worries about the risk because they pass it on to the next player in the chain. If everyone in the chain had skin in the game -- something to lose if the loan goes bad -- we wouldn't be in the mess we are in now."

A long chain of risk transfers is certainly a feature of our housing finance system. In a typical scenario, where loans end up as collateral for a mortgage security, a mortgage broker shifts the risk to a wholesale lender, who transfers it to an investment banker, who transfers it to multiple investors. The broker at the head of the chain usually knows the most about the risk, while, often, the investor who ultimately bears the risk knows the least.

Some knowledgeable observers have suggested that the government should enact the following rule: Every player in the chain must have skin in the game. I think this is a bad idea.

The Principal-Agent Problem

Economists term situations where one party makes a decision for another, without having the same stake in the outcome of the decision, the "principal-agent problem." It is pervasive in our society. Principals protect themselves by establishing rules that their agents must follow, and control mechanisms designed to assure that the rules are being observed. Sometimes these mechanisms work, sometimes they don't.

At the top of the mortgage chain, skin in the game is one of the control mechanisms used by principals. Investors purchasing a mortgage security may require that the investment bank issuing the security retain a piece of it. The investment bank, in turn, will require that the lenders from whom it purchases loans agree to repurchase those loans that don't meet the investment bank's standards.

The rules -- and enforcement of them -- became lax during the boom years, but now they are extremely stringent (wherever the market continues to function, that is). Even if government intrusion were warranted here, which I don't believe it is, the timing is terrible.

The Bottom of the Chain

At the bottom of the chain, lenders set underwriting rules -- conditions that loans must meet to be approved -- that agents (brokers and loan officers) must follow. A lender employee called an underwriter, or an automated underwriting system, must sign off on a loan before it is approved. The control mechanisms for enforcing compliance, however, are weak.

Wholesale lenders can't require that mortgage brokers have skin in the game. The typical broker does not have the money to buy back loans that don't meet the lender's standards. About the only thing a lender can do is take a miscreant broker off its approved list, but that won't prevent the broker from doing business elsewhere.

The inability of lenders to control brokers is one reason why some observers would not be unhappy to see brokers disappear, and some of their proposals seem to have that as an unstated objective. They appear to believe that eliminating brokers would eliminate the principal-agent problem at the point-of-sale.

Alternative to Mortgage Brokers

But that is not the case. The alternative to mortgage brokers is loan officers, with whom lenders have a principal-agent relationship that is basically the same as the one that exists in their relationship to mortgage brokers. Loan officers are lender employees who are compensated on a commission basis, whose income depends entirely on the number and amount of loans they produce, and who have no stake in whether or not a loan turns out to be good or bad.

I remember vividly that, soon after I joined the board of a large savings and loan, the CEO gave the board a list of the most highly compensated employees of the association. To my surprise, the CEO's name was third on the list, and I did not recognize the two names at the top. They turned out to be loan officers.

I found that there was no way to cap the compensation of loan officers, or to force them to put their skin in the game, even though they legally are employees. Lenders who have tried to base commissions on loan performance have found that their best producers quit to join other lenders.

The only way to get skin in the game at the bottom of the financing chain where loans are originated is to revert to a primitive system, similar to those found in many less-developed countries. In such a system, lenders are either individuals or very small firms where the owner is CEO and makes all loan decisions. Every player in the chain has skin in this game, and the potential for boom and bust would be negligible. The trouble is, systems of this type typically offer only one type of loan, as well as high interest rates, short terms, and large down payments.

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122 Comments

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  • notashakermaker - Tuesday, March 25, 2008, 2:05PM ET  Report Abuse

    • Overall: 1/5

    Gee - so you can't manage your business unless the sharks are in control. What a bunch of hooey. Lots of industries are faced with the challenge of giving sales people the right incentives. Don't kid yourself. CEO's love out of control sales people, because it drives their bonus/compensation through the roof. So don't shed any tears for these bozos. Yes, sales people will leave for greener pastures, but the real question is do you want bad sales to bring in bad customers or do you want good sales to bring in good sales? Loan officers are just sales people. It is not their capital they are putting on the line or the reputation of the firm. Managers who care about their entity and the future growth of their organization always seem to be able to attract and keep the right people. Wonder how that happens.

  • joe581863 - Tuesday, March 25, 2008, 1:04PM ET  Report Abuse

    • Overall: 1/5

    The author does not seem to grasp the problem at its core. This is the very loose underwritting guidelines that originally started with the community reinvestment act. The borrowers need to be the ones with the skin in the game. Joe

  • Jeckle - Tuesday, March 25, 2008, 12:36PM ET  Report Abuse

    • Overall: 1/5

    This useless article describes a problem and offers no solution. I don't get this at all. He starts off by saying that he thinks the government forcing every player have 'skin in the game' is a bad idea. But his explanation of how the problem evolved contradicts this statement. The problem evolved because those making the loans don't carry the risk. The misplacement of risk combined with very low interest rates created the bubble, which we're finding out is harmful to the entire economy. But he offers no solution; he only says that having the local lender take on the risk for the loans they make would be 'primitive.' What's wrong with making a large down payment? Back in the 90's when I purchased a house I put down 20%. What's wrong with that. It ensured I could afford the purchase and would be able to make the payments. What's wrong with a mortgage system that forces people NOT to buy things they can't afford?

  • kadiddle_bw - Tuesday, March 25, 2008, 10:27AM ET  Report Abuse

    • Overall: 1/5

    As a genral rule, I usually agree with Mr Guttenburg. In this case, however, he is showing his lack of understanding on how the industry works. Mortgage brokers are the no risk, no investment sales leg of banks and mortgage entities, period. Shoud the lending institution's employees have the incompetancy to approve a bad loan, it is on thier shoulders. Want to write a good article, do some exploration on builder mortgage companies (mostly classified as brokers) and see how much fraud you can find. You won't do it because no writer has the cahonies to stand up to DR horton, Centex and the like.

  • bobtarantino - Monday, March 24, 2008, 4:07PM ET  Report Abuse

    • Overall: 3/5

    Now that most of you knuckleheads have chimed in about spreading the loss when a loan defaults, let me ask you this important question: Who gets to make the call to approve or decline the loan?----------Here's an even more intriguing question for all of you: If I am the Broker/Loan Originator and I run the applicant thru either Fannie or Freddie's loan underwriting software and it gets approved, did you know that I can not legally turn down the loan? In fact, neither can the bank that has agreed to purchase it. Once again it all goes back to redlining. The whole principle of it is to avoid discrimination. Whether the Broker feels they deserve the money or not, he can not turn down the loan application. Please read my comment from Wednesday, March 19, 2008, 9:08AM ET. The reason we get into a mess like this is becasue nobody wants to spend the time to find the root of the problem. Please educate yourselves and think thru the logistics as well as the consequesnces of what you are proposing. If you vote in the coming elections with your heart instead of your mind, much the same as many of you react to a problem like this, we are finished as a nation.

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