This week was a mite unpleasant for mortgage servicers. Senior Democrats suggested the business is so vital and so flawed that the heavy hand of systemic regulation should befall it. One Member went even farther. Channeling Eliot Ness, he suggested that servicers be busted on racketeering charges. We doubt that will happen, but we do think mortgage servicing is in for a brutal, strategic makeover. Some might say, “Good riddance,” but the fate of the U.S. housing-finance system hangs in the balance.
Servicing isn’t looking its best of late, leading to suggestions that residential finance go back to the good old days. Then, “servicing” was done, but principally by the S&Ls that originated mortgages and then held the loan until the borrower – yes, this happened – paid the whole darn thing off over its thirty-year term, owning the house free and clear for a gentle transition to retirement and the great beyond. Now, of course, the mortgage market doesn’t resemble this and not just because of the excesses of recent years. The problems with this business model are evident in its result: the S&L debacle of the 1980s that cost taxpayers record hundreds of billions until the current crisis topped that tab.
Why did the good old days of mortgage lending go bad? Certainly, it wasn’t the impact of affordable-housing requirements or the Community Reinvestment Act – two oft -cited causes of the recent mess. The affordable-housing goals weren’t mandated for the GSEs until 1992 and CRA didn’t kick in until 1978 and, even then, had almost no teeth until the mid-1990s. These laws could be blamed for the current crisis – although we think they played virtually no role in it – but they had flat-out nothing to do with the last one.
Instead, the reason for the S&L crisis lay in two problems effectively addressed by securitization (when done right, we hasten to add). First, securitization makes it a lot easier to match the interest rate received on a mortgage with that of the debt taken on to fund it. The S&Ls funded thirty-year mortgages with passbook savings accounts that could be emptied in a single day. Securitization doesn’t eliminate interest-rate risk, of course, but it transfers it from lenders to investors in the form of liquid investments that require far less long-term funding. The GSEs took on all sorts of interest-rate risk, but that’s not because they engaged in securitization – rather, it’s because they got greedy and held lots of loans in portfolio, obviating the maturity-transformation magic securitization creates.
The second big benefit of securitization is risk diversification. Instead of having lenders concentrated in a single asset – think S&Ls – securitization permits lenders to make lots of loans that they need not hold on portfolio. They can thus hold some mortgages and MBS, but also small-business loans, auto paper or whatever else looks good in their market. It might seem like securitization doesn’t accomplish this because of the demise of some big loan originators in the crisis (think WaMU), but that’s because they too got greedy. They essentially became big mortgage loan origination shops wholly dependent on secondary-market access – when the crisis hit, these originators hadn’t any liquidity to handle even short-term disruptions in the securitization process. The rest is, of course, RIP.
Today, without prudent securitization, the U.S. can’t have a thirty-year mortgage and fixed-rate loans of lesser term will be few and far between. And, without securitization, lenders will either again hold big books of concentrated mortgage risk or need to drop the total amount of credit to this sector to keep their portfolios appropriately diversified.
This might seem like a good idea when one considers how many people are suffering due to the unsustainable mortgage loans they got. However, a huge percentage of these bad mortgages didn’t go to first-time home buyers unqualified for their loans. Instead, these loans were far more often cash-out refinancings for people who had gotten perfectly good traditional, securitized mortgages before they succumbed to the siren song of easy money. If we cut the supply of mortgage credit by disentangling securitization, the supply of mortgage credit will shrink so sharply and so fast that fundamental macroeconomic and, we might add, political tenets will be shaken.
This brings us back to servicing. If loans are sold into the secondary market, someone has to be sure that borrowers pay and, then, that these payments go to the investor, insurer, municipalities and others to whom funds are owed. This will become even more essential when new escrow requirements (mandated in the Dodd-Frank Act) are implemented, as borrowers will be sending checks with funds due to lots more parties. Escrows are a good way to protect borrowers from force-placed insurance and tax liens, but they require a servicing infrastructure.
All of this leads to the conclusion that either the U.S. continues to have third-party mortgage servicers or it goes back to the simple world of single-family lending. Despite the Leave-It-To-Beaver quality of memories of old-fashioned mortgage finance, that world is gone for good. To sustain home ownership at anything like the level on which communities depend and the macroeconomy expects, the U.S. needs a secondary market and secondary markets need servicers.
It’s perhaps for this reason that the Administration is contemplating systemic regulation in this sector. Should this come, the new regulatory scheme will need to take careful heed of other problems for example, how mortgage loans are assigned when transferred. It will also need to refine the systemic framework to reflect the fact that mortgage-servicing risk is almost entirely operational – not the credit or liquidity risk for which the systemic framework is fashioned. And, of course, it will need to be sure that the regulatory cure – new rules – is not so much worse than the disease – mangled mortgage servicing procedures – that the overall mortgage-finance system suffers irreparable harm just as recovery comes into sight.