Jack M. Guttentag The Mortgage Professor

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.

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 At that time the prevailing assumption was that rising house prices would generate equity on loans that were originally made with no down payment.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.

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.