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This Old House

There once were some bankers from Gaff
Whose products were layered with math.
With assets worth billions
Now stated in millions,
Those chaps were too clever by half!

With the U.S. mortgage finance industry in a serious state of disrepair, now is the time to draw up the blueprints, acquire some new tools, roll up our sleeves, and get to work building a sounder structure.

Houses have foundations and support elements, plumbing and electrical, heating and cooling systems, insulation, and, of course, décor. So too, the mortgage finance industry is made up of a set of components such as property appraisers, and loan brokers, originators, servicers; and holders. And just as houses cannot be built without the consent of local officials who determine zoning and building codes, the mortgage finance industry operates under the jurisdiction of various federal and state regulators.

Back in the day, mortgage holders were most likely the originating banks and thrift institutions (as they were fondly called), but the residents of that staid "buy and hold" bungalow have been displaced by occupants of glamorous "originate and sell" mansions. These occupants include independent brokers selling loans on behalf of mortgage banks, which themselves raise funds in capital markets instead of relying on insured deposits. And now the family of mortgage holders include not only the familiar secondary market entities Fannie Mae, Freddie Mac, Ginnie Mae, and FHA/VA, but also and importantly, global investors who hold claims to portions of mortgage pools that have been aggregated by investment banks, layered with private insurance, and graded by private rating agencies.

Explanations of the mortgage debacle range from lenders' greed and borrowers' naiveté on the one hand, to all actors in the drama merely responding to the incentives in front of them. The greed-cum-naiveté story leads us in the direction of sturdier consumer protection, such as the Federal Reserve's proposed revisions to its Truth in Lending regulation (adopted under the Home Ownership and Equity Protection Act), higher standards for state banking supervisors, who license mortgage brokers, and stronger financial literacy programs.

The incentives story reminds us that human nature is susceptible to the lure of the fast buck, such as the chance to earn excessive returns from mortgage-backed securities or buying a house with no money down. In recent years, mortgage lures became so powerful that investors happily filled the entire structure - from wholesale investment bankers to retail mortgage brokers - with cash, all fees and commissions paid up front. And many borrowers, it is said, tried to live beyond their means either by borrowing heavily to acquire a home or maintaining their living standards by cashing out equity built up in better times. Not having to put much equity into the deal, and having low monthly payments, created strong incentives for home buyers hoping to live the American Dream.

So how can we build a stronger structure for financing mortgages? Several ideas are being advanced, including more borrower equity in the deals; more disclosure to borrowers about the terms and conditions of the loan; better education for borrowers before they shop for loans; greater investor liability for any illegal, unfair, or abusive practices committed earlier in the ownership chain.

Lawmakers and regulators are finding some holes in the mortgage finance industry that merit repair, but they should realize that the industry participants - brokers, originators, investment bankers, rating agencies, and consumers - are also likely to change their behavior in response to the market forces unleashed by the current fiasco. There is every reason to believe that the rehabbed industry will be sturdier than the one it replaces and able to protect everyone it serves from losing the roofs over their heads.

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