Reward the Good Guys

By Justin Fox

The last big mortgage debacle, the savings-and-loan crisis, was made mostly in Washington. The S&Ls were required by law to borrow short (via savings deposits) and lend long (via 30-year, fixed-rate mortgages). When that led to big losses in the inflation-racked early 1980s, Congress encouraged thrifts to grow their way out of trouble, in part by financing commercial real estate, with disastrous results.

This year's mortgage crack-up comes with a different story line. It was made not in Washington but in the strip-mall offices of mortgage brokers and on the trading floors of Wall Street. The general rule this time around has been that the farther away from the prying eyes of federal bank examiners a transaction occurs, the more likely it is to cause trouble.

Does this mean we need more regulation? Maybe, maybe not. It does indicate, though, that the mortgage business might be due for a return to its roots.

The modern mortgage industry consists of several sectors, some regulated tightly by the feds and others covered by only a porous patchwork of state oversight. The least regulated are the independent mortgage lenders, which sell the loans they write to Wall Street or to one of those government-sponsored enterprises with a funny name--Fannie Mae, Freddie Mac, Ginnie Mae. Some of these lenders are perfectly respectable. Others, such as subprime biggies New Century Financial and American Home Mortgage, are now bankrupt.

Next are the mortgage lenders that belong to the same corporate family as a bank or a thrift. They're subject to oversight by either the Federal Reserve Board or the Office of Thrift Supervision but not to regular supervision. In this category are HSBC Finance and CitiFinancial, among others.

The only lenders subject to regular visits from the feds are actual banks and savings institutions, from national brands like Washington Mutual and Wells Fargo to your neighborhood savings bank. They are so closely regulated because taxpayers are on the hook for insuring the safety of their deposits. And so far this year, they've stayed out of big trouble. "The banking industry is in pretty good shape," says Bert Ely, an Alexandria, Va., banking consultant and expert on the S&L meltdown. "What came out of the aftermath of the S&L crisis was a very concerted effort--and it's been mostly successful--to move risk out of the banking system."

Selling off fixed-rate mortgages was one way of moving risk out of the banking system. The growth in the 1980s and 1990s of Fannie and Freddie--which can buy loans of up to $417,000--and of private markets for bigger, or jumbo, loans made this possible. It also enabled the rapid rise of independent lenders, Countrywide most prominent among them, that sold all their loans on the secondary market.

These firms face little of the interest-rate risk that bedeviled S&Ls. And they can shove most of the credit risk--the chance that a loan will go bad--onto the buyers of their mortgages. As a result, investors were initially willing to purchase only the lowest-risk loans--the good-credit, 20%-down variety. Fannie and Freddie still do that because they're required to by law. But in the past few years, private investors looking for higher returns began pouring money into iffier loans, underestimating the danger.

Now those investors have turned shy, and banks and thrifts, which sell some loans and hold on to others, have begun regaining lost market share. Countrywide, the biggest mortgage lender in recent years, is trying to join them by moving more of its business to a bank it bought in 2001.

Ely would like to see Washington encourage this trend. "There needs to be a shift of mortgage risk back into the banking industry," he says. "There's risk--it's not gonna go away--but we need to have it in banks." The banks and thrifts have natural incentives to ferret out and manage credit risk. They're also in a better position than dispersed mortgage markets to restructure troubled loans. And it looks as if the regulators who oversee them may have learned from experience how to prevent financial crises rather than cause them.