Be Careful What you Wish For

I'm hearing more and more industry commentaries, wishing for the days of old when mortgages were written by the local bank. The friendly banker knew the customer, gave the customer a mortgage and collected the mortgage payments until the mortgage was paid off. The concept being that in the event the borrower ran into financial trouble, the banker would be in a position to work something out with the borrower so the borrower didn't lose his home.

Most mortgages today are written by lenders that will then sell the mortgage into the secondary market. The job of the secondary market is to pool large numbers of mortgages together to create a diverse group of credit grades, geographical regions, interest rates and loan-to-values. This pool in then securitized. That is, bonds are then issued at various interest rates that represent the level of risk the buyer is taking on. A simple example would look like this. A pool of mortgages having an average interest rate of 8.0% is assembled. The servicer of the pool collects the interest payments from each borrower. Bonds, called Mortgage Backed Securities (MBS), are issued yielding 3 different interest rates; 6.0%, 8.0% & 10.0%. As the mortgage payments come in, the buyer of the 6.0% MBS gets paid first. Once that obligation is satisfied then the holder of the 8.0% security is paid. Only then is the holder of the 10% note receiving any money. The investor willing to take the highest risk (the last in line to get paid) is entitled to get the highest return on his money (in this example 10.0%).

The problem in the mortgage market right now is because the actual default rate of mortgages is higher than expected, so not only is the investor who bought the highest yielding securities not getting paid, the more conservative investors are not getting paid what they expected. This is the basis of all the turmoil we are now seeing in the mortgage market.
There is no direct contact with the investor who purchased the MBS and the borrower. To make matters worse, pooling by its very nature makes it impossible to create a link from any one borrower to any one investor. This makes any form of a workout with a borrower that's in trouble, impossible. It's from here that the desire to go back to the "good old days" of lending seems appealing.

Securitization of mortgages was not only encouraged by the federal government, they created the first organization to implement it, Fannie Mae. The reason for the creation of securitization is being overlooked in these recent media commentaries. To begin with, securitization allows consumers to borrow money at a lower rate. A banker who expects to hold a mortgage for 30 years, at a fixed interest rate, will need to charge a rate high enough to cover his long term cost of money as well as the long term effects of inflation. A banker today can close on a mortgage and keep it on his books only for as long as he wants to. He can sell the mortgage into the secondary market any time he feels it make good business sense for the bank.

The other big advantage of securitization is that it allows for more liquidity in the marketplace. A banker holding every mortgage he closes is limited in the actual number of mortgages he can write. His total amount of outstanding mortgages can't exceed the total amount of money that has been deposited in his bank. By selling closed mortgages into the secondary market he is able to continue to write mortgages well in excess of his depository base. This gives him the tools he needs to continue writing loans into the community he is serving, supporting all levels of the local economy.

Nothing in life is perfect. For every positive there is a negative and the mortgage market is no different. The mortgage model of the "good old days" had the advantage of personal interaction between the borrower and the banker, yet was limited in the number of people it could serve. Securitization enables the industry to service a greater percentage of the population and at a lower cost. Its drawback is that when trouble arises it doesn't have the flexibility to address the problems facing each individual borrower.

So be careful what you wish for. You will regret having your wish for the "good old day" granted if you find yourself seeking a mortgage and can't get one. Being turned down because you've harmed your credit or don't earn enough money is one thing. Being turned down because the bank has no money to lend is a totally different problem, one this country hasn't had to face for many decades. Hopefully we'll never go back to the "good old days."