Saturday, November 24, 2007

The Mortgage Crisis, Part 2

Because all the mortgage lenders could easily sell the loans to other investors, often packaged up with many other loans, they had plenty of incentives to drum up more and more business. Any time you have this situation, people tend to abuse it. How do you offset that?

A savvy consumer should partly offset it; if it's too expensive he theoretically doesn't buy. That didn't happen, partly because the borrowers also had a strong desire to buy property they could not in reality afford. Home ownership is, after all, the American Dream.

The credit rating agencies should partly offset it. They're supposed to be the ones that protect the buyers, valuing the loans properly (i.e., more risky therefore less valuable). Lower value on the loans means less incentive for the lenders to cheat. They could have stopped this thing cold if they rated the loans properly.

Of course since at least some lenders were fabricating income numbers, the rating agencies may not have had the ability to catch all those problems.

All in all, a bunch of lawyers are probably salivating over the prospects. Some of the lenders are bankrupt, others are on thin ice, so the ratings services with deep pockets ought to be getting uncomfortable about now.

It's also interesting to note that surely the top executives of lenders knew interest rates were going up and would continue to do so for a long time -- but the borrowers didn't. As far as they knew, rates could go either up or down. Oops.

The solution? Complex and in dispute. Some say the borrowers were stupid and should pay the price, emphasizing personal responsibility. Others say the lenders misled the borrowers and they have responsibility. Still others say the ones buying the loans are rich and can pay the price, and so on. As usual in a situation with so many moving parts, the answer is probably a mix of the above.

As a part of the solution, I favor allowing the borrowers to renegotiate at a lower (fixed) rate. (The Federal Reserve has already made this course of action more reasonable by cutting overall rates.) Of course this means the value of those loans would drop, but surely it would be less than the loss due to nonpayment and foreclosure. And the amount of the loss would be predictable -- not like the panic we've see this year. There's a saying that Wall Street can price in anything but uncertainty.



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