Why the New Mortgage Risk Rules May Fail

Mortgage
CNBC.com
Mortgage

Yesterday financial regulators proposed a set of rules intended to lower mortgage defaults by requiring banks to retain five percent of the risk when they package home loans as securities. Unfortunately, the plan relies on banks to adequately self-regulate their lending practices—something they’ve shown time and again they are not very good at.

The Dodd-Frank financial reform law enacted last summer required risk retention for home loans. But banks had hoped that they would succeed in getting regulators to water-down the requirements by creating broad loopholes. We learned on Tuesday that bank regulators had largely rejected this approach, allowing only the most conservative mortgages to be exempt from the requirements.

The idea behind the risk-retention requirement seems rather straight-forward. Lawmakers believe that the development of the securitization market allowed banks to off-load risky mortgages on less-informed investors. This “originate to distribute” practice allegedly led to sloppy underwriting and unsafe lending. Requiring banks to retain part of the risk on mortgages they securitize should result in less risky lending.

The available historical data, however, doesn’t support this idea.

The financial crisis was not caused by the fact that banks had too little exposure to mortgage risk—it was caused by the fact that they too much. Investment banks and commercial banks had gorged on mortgage-backed securities during the housing boom. When the housing bubble burst and borrowers began to default in record numbers, the entire financial system came under unprecedented distress due to this over-exposure.

If anything, the “originate to distribute” model failed because it did not actually move mortgage risk out of our most important financial institutions onto a broader class of investors. Too much of the risk remained on the balance sheets of the banks.

Why did banks take on so much exposure to the housing market? The most popular theory is that executives decided to ramp up the risks they were taking in order to increase temporary profits—and their own bonuses. What’s more, the biggest financial institutions knew that they were “too big to fail” so they weren’t worried about risk—if things fell apart, the government would bail them out.

This theory is undermined by the facts. Ninety-three percent of all the mortgage-backed securities held by banks prior to the financial crisis were either rated triple-A or backed by Fannie Mae or Freddie Mac. In other words, bankers were not acquiring the riskier mortgage backed securities that had much higher yields, they were buying up what they—and the ratings agencies and the regulators—believed were the safest mortgage backed securities.

This belief persisted even when the housing downturn because apparent. Many top bankers believed that the drop in mark-to-market prices of top-rated mortgage-backed securities was a “temporary dislocation” or “market misbehavior.” As a result of this mistaken belief, they held onto the securities even as the market for them fell apart.

As it turns out, bankers were wrong about the riskiness of the highly rated securities. So were the ratings agencies, and so were the bankers. The problem was that the losses on these securities were far more extreme than historical precedent suggested they would be. As delinquency rates broke all records, the income streams for the securities dried up. The securities just were not as good investments as the bankers had thought.

So what caused the financial crisis wasn’t irresponsible risk-taking, it was the ignorance of bankers about the risks they were taking. It was error—rather than greed or imprudence.

This is a serious problem for banking regulation. The regulations seek to incentivize bankers to be more cautious and make safer loans. But if bankers lack the ability to accurately detect risk, all the incentivization in the world won’t help.

Ironically, the new risk retention rules may fail because they themselves are based on a mistake—the idea that bankers know what they are doing and can be made to behave more prudently if given the right incentive structure.

________________________________________

Questions? Comments? Email us atNetNet@cnbc.com

Follow John on Twitter @ twitter.com/Carney

Follow NetNet on Twitter @ twitter.com/CNBCnetnet

Facebook us @ www.facebook.com/NetNetCNBC