Last month Barney Frank unveiled the House plans to fix the financial services industry. One of the provisions (section 1501) will require that any creditor who originates a loan to retain some of the ultimate risk of non-repayment of the loan. The provision is an apparently sensible response to the pathologies in the originate-to-distribute (OTD) model of mortgage lending that we saw at the height of the subprime boom. The basic idea is that originators were insufficiently incentivized to monitor the credit worthiness of applicants, and therefore manufactured a huge volume of ultimately toxic financial assets. The idea is to fix the problem of agency costs by aligning the incentives of loan originators with loan holders. Despite the plausibility of the proposal, I think that it is ultimately a bad idea.
First, it is a bad idea because it addresses a symptom rather than a cause of financial rot. The problem with the mortgage-brokers-as-villains narrative is that it fails to explain why the brokers could do a land office business selling toxic junk to a voracious secondary market. One explanation – the one implicit in section 1501 – is that brokers were taking advantage of purchasers, selling them supposedly sound financial assets that the purchasers were too unsophisticated or blinded by greed to realize were junk. To state this assumption explicitly is to see its limitations. The purchasers of mortgages were not unsophisticated consumers or little old ladies entrusting their savings to fast talking swindlers. These were a bunch of extremely wealthy, extremely sophisticated, extremely large financial institutions. It is rather unlikely that these guys were “fooled” by the mortgage brokers.
A more plausible story, in my opinion, looks at the underlying supply and demand for credit. First, why did the mortgage brokers go into the subprime market? At least in part the answer is that they could afford to do so. With the short term wholesale funding on which they relied to originate loans costing them essentially nothing, it was extremely inexpensive to originate loans. At the same time, the massive subsidization of the subprime market through implicit guarantees to the Fannie and Freddie, the so-called “Greenspan Put” on which Wall Street relied, and various (admittedly much smaller) direct subsidies created a massive demand for the assets churned out by the mortgage brokers. Add to this the impact of monetary and Chinese balance of payments factors on asset prices, and the notion that the subprime crisis was really the result of agency costs in the OTD model looks implausible. Absent macro-economic and regulatory distortions, I suspect that market competition and reputational sanctions are sufficient to keep the OTD brokers honest. Given those distortions, we have seen spectacular examples of those who did have skin in the game responding perversely to the perverse incentives with which they were presented. Read More