This post is Part 1 of a series of 3. Part 1 gives an overview of the problems in the mortgage market, casting them in terms I think technology can go a long way toward helping to solve. Part 2 explains how and why the change I suggest — switching form a market in mortgage-backed securities to one in actual mortgages — would actually work. Part 3 addresses the security and privacy concerns associated with such a transition.
All the problems of the mortgage crisis flow through two related facts:
- The financial markets badly mispriced Mortgage-Backed Securities (MBS).
- Even going forward, nobody can think of a good management and incentive structure to keep that problem from recurring.
Somebody holding a huge amount of long-term debt generally has to rely on the kindness of their own creditors — such as bank depositors — to finance them in holding it. (The only truly natural long-term debt holders are pension/retirement funds.) If lenders hadn’t been able to sell off existing mortgages in the form of MBS, they wouldn’t have been able to issue so many new ones. And thus the market and regulatory mechanisms in place would have reined in additional bad lending much, much sooner. Or, if the MBS market had valued the mortgages accurately, lenders wouldn’t have been able to make profits (real or apparent) by issuing bad mortgages and then flipping them to another holder.
Some of the resulting problems have no good solutions, only bad ones and worse. A whole lot of money was borrowed by people and organizations who can’t pay it back. The borrowers want to get paid by somebody. Unhappiness ensued. Trillions of dollars are irrevocably lost, and the politicians are working on how to distribute the pain.
What I’m writing about, however, is a different problem — how to get the mortgage market working again. The old model, in which banks took deposits and lent the money in the form of mortgages, no longer works. Money flows too freely to sustainably support a business model in which you just borrow short-term and lend long-term. Oh, it could work for a while, but another crisis would be inevitable — more like the 1980s collapse* than the current one, but costly and destructive even so.
*The United States Savings & Loan industry collapsed in the 1980s, largely as a result of a deregulatory increase in consumer bank deposit interest rates.
Thus, it is necessary to have an aftermarket, in which mortgages wind up being owned by long-term investors. That’s where MBS come in. Mortgage-Backed Securities are, in essence, bonds that pass through streams of payments from a large pool of mortgages. Investors have access to some statistics about the mortgages that make up the pool, but transparency is far from ideal. And things get more complicated after that. Portions of the payment stream often go into different bonds in a dizzy chain of machinations, the main objective of which seems to be hoping that somebody will incorrectly price something, thereby allowing everybody else in the chain to simultaneously make money.
The essence of the oversight problem — and I’m talking about oversight by financial services entities, private third parties, and regulators alike — is that financial services professionals and their managers get paid in real money for making imaginary profits. Thus the incentives for both self-delusion and deliberate deception are immense — and the disastrous results of same now dominate the news.
I don’t think these problems can realistically be solved for MBS, as MBS are currently constructed. The twin problems of insufficient transparency and overly short-term incentives are inescapable. So I have a radical proposal: Stop issuing new mortgage-backed bonds, and instead trade individual mortgages themselves.
This idea doesn’t do anything special for the short-term incentives problem, which I think is generally unsolvable in an economy where you can’t rely on an experienced decision maker to keep the same job for the next 30 or so years. But the idea does greatly increase transparency. Its core benefit is radical simplification, which would serve to make prudent management, safe(r) investment, and effective regulation all more realistic.
Bottom line: In order for the economy to be repaired, mortgage-backed securities need to be replaced by an individual mortgage aftermarket.
