by Tanta on 8/03/2007 08:19:00 AM
Friday, August 03, 2007
Andrew Davidson & Co. generally produces thoughtful stuff; they are a well-known provider of pricing and risk analytics models to the mortgage and securitization industry. This essay attempts to get at the problem of "degrees of separation" of risk in the current industry model, and it arrives at the conclusion that having larger capital stakes at the origination points--skin in the game--would probably help.
In aid of which argument the following graphical illustration is provided:
Every time I look at something like this, I confess, I am less struck by the question "Where's the capital stake?" than I am by the question "How many mouths can a homeowner feed?" Davidson, just as a for instance, provides high-quality software and consulting services. They aren't free. And this chart doesn't even show you the points were the mortgage insurers enter, where due-diligence firms get paid to look at loans, where banks with a trust department serve as document custodians for these securities (for a fee), or all of the other for-profit businesses that have grown up around not just mortgage lending as such, but secondary-market mortgage lending. Tax service contracts, for instance: in a thrift-style lend-and-hold model, you don't need to pay a vendor to track property tax bills for you; you need that if the servicing rights to the loan are going to change hands six times prior to maturity. Every loan needs a "flood hazard determination" to assure that the home isn't in a flood plain, but now you pay incrementally more to get a "transferrable" one. A company called MERS, Inc. exists solely to replace the old-fashioned assignment of mortgages in the old-fashioned county land records with an "electronic registration," the entire demand for which is a function of secondary market sales of loans.
Somebody is paying for all this, and it would be you, the homeowner. You pay part of it in your interest rate; you pay a lot of it in fees and closing costs and prepayment penalties. There's an argument that increasing technological innovation (like MERS, or those transferrable tax service contracts) does make it cheaper for all this to go on, and that you benefit by having "access" to secondary market lenders, who can now afford to take your risk. I'm not interested in arguing that today.
I simply want to point out that "due diligence" is not missing from the chart above, at certain points, because no one thought it necessary. It was missing because subprime borrowers cannot buy overpriced homes and still pay a high enough interest rate that we can afford to have Clayton look at every loan in the deal. Well, not if some fund manager is going to take 2 and 20 we can't.
I've listened to more investor conference calls than I should have, life being as short as it is, and I can tell you that I rarely hear anyone ask if enough money is being spent on "inefficiency" to assure that operational risk is being priced correctly. The usual political response by industry lobbyists to increased regulations is always that the costs of it will be passed on to you, the consumer. It is worth you, the consumer, asking what costs you're already covering.