Wednesday, December 23, 2009, 1:29AM ET - U.S. Markets open in 8 hours and 1 minute.

Jack M. Guttentag The Mortgage Professor

Jack M. Guttentag, The Mortgage Professor

Fixing the Housing Crisis by Fixing the System, Part 1

by Jack M. Guttentag

Email this Page IM this StoryBookmark this StoryAdd to your Del.icio.us accountDigg this StoryPrint this Story
Good (317 Ratings)
2.605676/5
Posted on Tuesday, April 29, 2008, 12:00AM

The housing finance system, while still functioning, is in a crisis state. Interest rate risk premiums -- the rate increment on mortgages classified as riskier -- are two to four times as large as they were two years ago. Day-to-day rate volatility, which can cause havoc in the relationships between borrowers and loan providers, is larger than I have ever seen it.

Underwriting requirements -- the conditions that lenders require to approve a loan -- have tightened across the board. Loans without a down payment, and loans allowing borrowers to "state" what their income is rather than document it, are pretty much gone. Loans are taking longer to get approved, and sometimes lenders change the rules in midstream.

Recently I heard from a borrower who was scheduled to close on a home purchase in four days, with a mortgage approved by one of the largest lenders in the country. She had just been notified by the lender that her down payment had to be increased from 5 percent to 10 percent.

The reason for the bank's action is instructive. The area in which the property is located was reclassified as one with high potential for property-value decline. And the reclassification was based on a high and rising level of foreclosures in the area. Foreclosures lead to distress sales and downward pressure on prices.

A 180-Degree Change

This is a 180-degree change from two years ago. At that time the prevailing assumption was that rising house prices would generate equity on loans that were originally made with no down payment. Now the concern is that falling prices will wipe out the equity on loans made with down payments that are too small.

For example, if a $200,000 house is purchased with a $200,000 loan and the house appreciates at 5 percent a year, after two years it would be worth $220,500. The borrower in this case begins with zero equity, but the passage of time generates equity of $20,500. (I am ignoring the small change in the loan balance that occurs over the first two years.) If the same house is purchased for $200,000 with 5 percent down and the house value declines 5 percent a year, the borrower begins with $10,000 of equity, but the passage of time reduces it to negative $9,500.

A swing from a prevailing expectation that house prices will rise to an expectation that they will fall causes a major tightening of underwriting requirements. Indeed, the only reason the tightening has not been even larger is that the house price declines expected are temporary. The prevailing view is that they will last only until we get out from under the foreclosure crunch.

This places the foreclosure problem front and center as the critical policy issue. Most of the emphasis has been on the human toll from having families forced out of their homes, which is understandable. But reducing the number of foreclosures also is the key to reestablishing a well-functioning mortgage market going forward.

Finding a Solution

The Bush administration and Congress are trying to find a solution, but none of the proposals swirling around Washington have identified the source of the problem. The core problem is the way the mortgage industry manages default risk.

There are two systems for managing default risk. The first and, unfortunately, the larger of the two is to charge borrowers a risk premium in the interest rate. The risk premium is a rate increment above that charged on a "prime" transaction, which carries the lowest risk. The weakness of the risk premium system is that, with a few exceptions, risk premium dollars not needed to cover current losses are realized as income by investors. They are not available to meet future losses. So risk premiums collected in 2002 that were not needed to cover losses in 2002 became investor income and are not available to cover losses in 2008.

The other system is mortgage insurance, and it has worked well. Borrowers are required to purchase mortgage insurance if their down payment on a home purchase, or their equity in a refinance, is less than 20 percent. The mortgage insurance companies place more than half of every premium dollar they collect from borrowers in reserve accounts. The reserves that accumulate during long periods when losses are small are available when a foreclosure crunch comes -- such as now.

If a significant part of all charges for default risk were placed in reserves, then the system would be much less vulnerable to a major default episode. Future articles will explain how to do this, as well as why, among other benefits, it would provide a way to reduce foreclosures now.

Email this Page IM this StoryBookmark this StoryAdd to your Del.icio.us accountDigg this StoryPrint this Story

Rate This story

Good (317 Ratings)
2.5/5
Sign-in to rate!

144 Comments

Showing comments 1-5 of 144Next >>
Sort: first to last

  • Chris - Monday, February 16, 2009, 12:38PM ET  Report Abuse

    • Overall: 1/5

    It is always the Borrower that has to take it in the rear.

  • TJude - Thursday, February 12, 2009, 6:40PM ET  Report Abuse

    • Overall: 4/5

    A good article, but reserves won't do much good today form this crisis. That would have been well considered a year or more ago.

  • Teri - Monday, November 17, 2008, 9:04PM ET  Report Abuse

    • Overall: 3/5

    I really do not see what is so wrong with this story Part 1. At least he makes sense. He is 100% right that the goverment has yet to find a solution for what the lenders have done to our economy. I personally feel they should all go to jail or be fined for what they have done.

  • kelly d - Sunday, October 26, 2008, 3:35PM ET  Report Abuse

    • Overall: 1/5

    very bad man

  • Michael - Wednesday, September 10, 2008, 12:21AM ET  Report Abuse

    • Overall: 1/5

    Poorly written poor analogies and flawed logic with only a minimal statement of the process or understanding. I was a former underwriter as well as dealt directly with FNMA and FHLMC. First, a "risk based premium" is what in finance is known as beta (CAPM formula). The idea of FNMA/FHLMC was to be a conduit to standardize loans and make housing capital easier to in capital poor areas and to move and make investment grade securities available at a reasonable costs to capital rich areas, or entities. If a “risk premium” were assed on an individual basis it would be impossible to pool. Now if a loan is NOT salable say to a certain standard, and many lenders use standards tighter then FNMA/FHLMC and even vary internally based on the department or underwriters understanding of the rules, often incomplete, which is charged if a loan is classified not to be saleable to a certain standard. Without standardization the housing market would not exist as we know it. Certain areas would be controlled by an oligarchy of lenders, look at Hawaii circa 1960’s were there was a small group of lenders and often an incestuous set of cooperation. The intent of FNMA/ FHLMC was to make housing capital available to capital poor from capital rich areas or entities. By standardization the loans could be sold as pools without the massive due diligence by every buyer therefore lowering the cost of capital. Look at the cost for a corporation, state or city to do a bond issue. Just because FNMA/FHLMC has certain underwriting standards lenders can, and do, impose additional standards, as many are doing now out of fear. Also this is not the first time that there have been different standards or costs for high risk areas, just look to the housing bubble burst from, and because of, savings and loan crises, this is larger and more complex version, but many similarities. Then, as now, lenders loosened standards on the idea that increasing housing prices would bail them out, also the S&Ls were freed, just as Wall Street freed conduits to slice pools into Trenchs, to make or do deals before they were restricted from, leading them to need a constant stream of new fees to stay afloat. Well Wall street has done the same, a pool of loans can be sliced into so many categories or trenchs that a buyer can if they want just buy the default risk, or the interest, like stripping the coupons from a bond, first if the prepaid loan portions, or so many other trenchs the general public, and most mortgage lenders, the typical loan officer has no idea how the system works even, as lenders do not want them or the public to know too much. Overall, the crisis is because lenders and Wall Street again relied on of this time the housing market will not go down again AND we know what we are doing so we are protected from the risk, borrowers also got greedy and over leveraged themselves by buying and borrowing more the they could afford, often speculating that they could sale at a profit before the payments caught up to them knowingly, and I might add lenders needed to apply common sense, an example I once was ask to look at a loan by another underwriter, she wanted to a lawn person could really make $8,300 a month as an employee. I said that sounded unlikely but she had the power to pick up the phone and call the employer and ask the person who sent in the verification of income. Turned out the verification had been altered by the loan officer form the broker. When No Income verification loans started I called them “Liar loans” in the early 1990’s and they continued to get worse and more unqualified Loan officers, real estate agents, etc. rushed into what they saw as a boom market. And lenders, again needed the constant stream of fee income as loans did not stay on the servicing books as anticipated for 7-12 years, typically were repaid in 1-3 with a sale or refi. The idea of “risk premium” to offset future loses is based on the insurance idea but BAASSEL

Showing comments 1-5 of 144Next >>

More from Jack M. Guttentag

The Mortgage Encyclopedia

An authoritative yet concise guide to the mysteries of mortgage finance, arranged alphabetically from "A-Credit" to "Zero Balance." Includes information that will help you decide whether to use a mortgage broker, learn if you can avoid mortgage insurance, and much more. Reach for this indispensable guide and get the fast, accurate information you need!

Order your copy now!

Find out more about The Mortgage Professor.

More from Yahoo! Sources

  • CNN Money
  • Consumer Reports
  • Kiplinger
  • The Motley Fool
  • Business Week
  • Wall Street Journal

Historical chart data and daily updates provided by Commodity Systems, Inc. (CSI). International historical chart data and daily updates provided by Morningstar, Inc. Fundamental company data provided by Capital IQ. Quotes and other information supplied by independent providers identified on the Yahoo! Finance partner page. Quotes are updated automatically, but will be turned off after 25 minutes of inactivity. Quotes are delayed at least 15 minutes. Real-Time continuous streaming quotes are available through our premium service. You may turn streaming quotes on or off. All information provided "as is" for informational purposes only, not intended for trading purposes or advice. Neither Yahoo! nor any of independent providers is liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein. By accessing the Yahoo! site, you agree not to redistribute the information found therein.

Yahoo! Answers is provided for informational purposes only, and no Q&A is intended for trading or investing purposes. Yahoo! shall not be responsible or liable for the accuracy, usefulness or availability of any Q&A information, and shall not be responsible or liable for any trading or investment decisions based on such information. View Complete Answers Disclaimer.