Talleyrand said of the French aristocrats when they returned to power after the abdication of Napoleon that “They learned nothing and forgot nothing.” Einstein said “The definition of insanity is doing the same thing over and over again and expecting a different result.” Welcome to mortgage policy in Washington in 2016.
As the crisis of 2008 unfolded, the Sages of the Potomac browbeat the lending industry into tightening lending standards. Of course, they had previously browbeaten the industry into loosening lending standards to increase home ownership, based on the premise that a surge in home ownership would generate a tidal wave of model middle class citizens. “Compassionate Conservatism” at work. It doesn’t work that way. Unfortunately, homeownership isn’t a cause of anything; it’s an effect of prudence and hard work. Put somebody into a house he or she can’t afford, and what do you get? You get 2008.
Now that 2008 is ancient history, we see the Sages of the Potomac browbeating the lending industry into loosening lending standards again. The GSE’s are buying mortgage loans based on a 3% down payment. They are vitiating the “ability to pay” standard that was part of lending policy tightening. Because that criterion actually did tighten credit, the regulators are now forcing consumer credit rating companies to revise their methods of calculating credit scores so that more loan applicants will pass the underwriting screens. This is like drawing the target around a pre-existing bullet hole. And lenders, true to form, are applauding this new mechanism for enabling imprudent but profitable lending. Profitable in the short term, that is.
The GSE’s have shifted some risk onto the lenders by requiring them to retain part of the exposure on loans sold by them to the GSE’s. But, of course, the GSE’s are now offsetting this sane measure by eviscerating the loan buyback policies that were the basis of the successful recoveries against lenders who peddled negligently underwritten loans based on shoddy appraisals and misstated income. The claim is that buyback relief will only be afforded to loans which are approved by the GSE’s proprietary software designed to ensure that the loans have been properly underwritten. Automated underwriting software was in general use before 2008, and we all know how much good that did. And the beat goes on.
There is only one way this can end. Remember, the mortgage-backed security was not invented by guys in suspenders working on Wall Street in the 1980’s. It was invented by guys in suspenders working on Wall Street in 1906 (when they were called certificates of participation). It only took five years for the Sages of Albany to decide in 1911 that mortgage-backed securities were a perfectly acceptable investment for financial institutions. Fast forward to 1932. Defaults by underwater borrowers caused defaults on MBS’s held in investment company portfolios. The mortgage insurance industry (and the title insurance industry) went broke. MBS’s were also very popular with small investors, because what could be safer than a mortgage? They were wiped out as well. 1932, 2008 — it happens every time.
So now here we are in 2016. The GSE’s and the private lenders are securitizing away. Their latest product is an MBS made up of “rehabilitated” loans, i.e., loans to borrowers who have already proven that they cannot be relied upon to make their mortgage payments, but have been bailed out so that they can hang on by the skin of their teeth. The banks are once again shoveling bad loans out the back door to be securitized as MBS’s, then shoveling them right back in the front door by purchasing MBS’s.
Origination quality is already heading into the sewer. The First American Loan Application Defect Index (available at http://www.firstam.com/economics/defect-index/) shows that:
“•The frequency of defects, fraudulence and misrepresentation in the information submitted in mortgage loan applications increased 2.5 percent in May 2017 as compared with the previous month.
When this new bubble bursts, who do you think is going to pick up the tab?