Are We Under-Pricing Mortgage Risk?

by Peter G. Miller
February 17th, 2008

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Speaking in Washington last week, Edward Lazear, Chairman of the President’s Council of Economic Advisers offered some interesting comments.

“This year’s most significant economic events revolved around housing and credit markets. An apparent under-pricing of risk was revealed first in mortgage markets, and later in a variety of credit markets. The President was quick to respond to these issues by focusing on borrowers through programs like FHA Secure, suspension of the tax liability on mortgage write-downs, and HOPE NOW programs. Additionally, the Federal Reserve acted to pump liquidity into the market. Some credit markets have become more stable since the acute tightening that occurred in the summer.”

Under-pricing of risk?

If risk is under-priced then how come long-term mortgage rates are falling and the Federal Reserve is dropping short-term rates? Don’t such rate drops suggest that risk is being discounted?

If risk is under-priced, then would it not help to spend fewer public dollars and lower the national debt? Why not have an energy independence policy that’s more than a PR statement?

“We think,” says Lazear, “that FHA reform is important and will be useful for a variety of reasons. If you look at places like California right now, the FHA business in California is essentially shut down, and the reason for that is obvious: Houses in California are much more expensive than they are in the nation as a whole, and so what happens is that these limitations on FHA’s ability to insure those loans has differential impacts in certain regions of the country. So making FHA loans be a bit more sensitive to local conditions we think is a good idea.”

This would be a great idea — except that investors are not thrilled with high-risk, super-jumbo loans. It doesn’t matter if you raise loan limits — as was done for 2008 under the just-enacted stimulus package — if investors won’t buy such products. Already there is resistance to the new and larger loans by investors, that’s why the industry wants to package them in separate mortgage-backed securities.

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