The 2008 Mortgage Meltdown Occurred By Design

A major factor in the 2007-2009 recession was the sharp downturn in the real estate sector. Housing prices and real estate values in general rose tremendously from the 1980s until 2006 when a significant correction left many homeowners and real estate investors with enormous losses from their investments in real estate. As the correction unfolded, the damage was increased by the discovery of many flaws in the mortgage market.

In the heat of the real estate boom credit standards became so slack or nonexistent that many people with poor credit histories were allowed to borrow more money than they could ever hope to repay. Some were even allowed to borrow under so-called no-doc or liar's loan programs in which the borrower provided no verifiable proof of income or repayment ability. In exchange for a higher interest rate, lenders approved loans to people whose repayment ability was unknown.

This happened for two reasons and all the regulation and recriminations that have followed in hopes of preventing a replay of this financial disaster have only addressed one of the two. The second still hangs over us all.

The first flaw in the mortgage market was a significant calculation error in the risk of real estate loans. One part of this mistake was that lenders assumed repayment ability did not matter because if the borrower did not pay they would simply foreclose on the property. Foolishly assuming that real estate values would never go down (or at least go down by much), the collateral of these loans was considered so safe as to obviate the need to worry about repayment. After all, if the lender had to foreclose on the property, most lenders assumed they would actually turn a profit by selling the property for more than the loan balance. This turned out to be far from true once real estate values dropped.

A second part of the poor estimate of the risk in these loans was a mistake made by financial market participants and the rating agencies that served them. Supposed experts believed that bundling sets of mortgages together and selling shares of these bundles would make the investments safe because only a few of the mortgages in any bundle could be expected to go bad. Even subsets of these bundles, called tranches, that held the riskiest mortgages in the bundles were thought to be safer because of the aggregation of multiple mortgages. After all, what would cause large numbers of people in different geographic markets to all stop paying their mortgages at once?

Perhaps these financial experts should have seen a recession coming or realized that real estate values were rising too far, too fast, but they did not. The thirst for high-yield investments that were deemed safe enough by the ratings agencies to allow pension funds to invest in them was too strong for reality to intrude into this market.

Now as the market for these mortgage backed securities is returning, people should have learned lessons from the above. Surely many investors are now more wary of these financial instruments and have learned how to more accurately assess their risk. Certainly regulators have stepped in to try to make this market safer in hopes of protecting the economy from another financial crisis. However, nobody has addressed the second reason for the recent mortgage market meltdown: flawed incentives.

Incentives matter. When economists work on what we call market design, much thought goes into incentives and how they will encourage people to act. Many public policies are based on the power of incentives. Charitable donations earn you a tax deduction because government assumes that the incentive of lowering your tax bill will encourage you to make larger charitable donations. Cigarette and liquor taxes are designed to be disincentives, discouraging people from smoking or drinking.

Unfortunately, the incentives in the mortgage market are designed in such a way as to create exactly the type of mortgage market meltdown we recently experienced.

When you apply for a mortgage you deal with a mortgage broker. Even at most banks, the person you deal with has multiple sources of funds. Each source has provided the mortgage broker with an amount of money to lend, a set of rules to qualify for a mortgage, and interest rates to charge based on credit worthiness. The mortgage broker hopefully pairs you with the best mortgage deal given your circumstances. When the loan is approved and closes, the mortgage broker gets paid a commission.

That means the broker's incentive is to close the deal and collect the commission. Whether the borrower makes payments on the mortgage is irrelevant to the mortgage broker. This was not lost on the mortgage brokers who stretched and bent rules in some cases in order to get deals done.

The firm that made funds available to the mortgage broker is really just a mortgage market middleman. These firms usually start with $100 million and parcel it out among brokers along with a set of credit standards. These wholesalers own the mortgages while the deals trickle in, so they collect the first few payments on a number of the mortgages. Once all $100 million has been lent out, the mortgages are bundled into the famous mortgage-backed securities and sold to investors, hopefully for a profit.

Thus, the wholesaler's incentive is to put together an attractive looking bundle of mortgages quickly so it can turn a profit, recoup its working capital, and start the process again. The wholesaler only cares if the borrowers make the first couple of payments; after that it is the investors' problem.

Investors in mortgage-backed securities would seem to have an incentive to carefully check the credit worthiness of the borrowers behind the securities they are purchasing, but that is not as easy as it sounds. Any single security will represent pieces of 200-1,000 different mortgages. In most cases, investors are given little information beyond some summary statistics on the credit scores of the borrowers.

How might we change the incentives to improve the mortgage market's functioning? Some hints can be found in the workings of another market for long-term products: life insurance.

If you go to an insurance agent to buy a term life insurance policy, that agent gets paid a commission on your purchase. That commission is paid out each year after you pay the annual premium. The agent, therefore, has an incentive to sell policies to people in good health who will make premium payments for many years. If the life insurance company makes money, so does the agent who sold the policy.

Mortgage brokers and wholesalers face a very different set of incentives. They make money by completing mortgage loans as quickly as possible with very little regard for the long-term profitability of those mortgages. The brokers and wholesalers do not care if the mortgages end up being profitable to investors or not; they get paid all their money up front.

If we want to avoid a repeat of the recent mortgage market meltdown, we would be wise to reform the incentive structure in the mortgage industry. No government regulation is needed to accomplish this. Wholesalers can change the way they pay brokers and investors can require wholesalers to keep some skin in the game by taking at least some of their profits over time along with the investors. Spreading payments over even as little as three to five years would significantly change the incentives.

If wholesalers and brokers got paid only if the mortgage borrowers made their payments, I suspect that we would have fewer mortgages with repayment problems. Incentives matter and, for now, mortgage brokers and wholesalers still have incentives to make loans with no regard for the likelihood the borrower will make the payments. More good could be accomplished by changing these incentives than will be done with all the new banking regulations being proposed.