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Why The Mortgage Market Blew Up

by Peter G. Miller
June 1st, 2010

The Mortgage Bankers Association has just published an unusual study which looks at the causes of the mortgage meltdown. The study is interesting for a variety of reasons, including the fact that the terms “FHA” and “Federal Housing Administration” do not appear.

Nope. FHA loans were not the problem.

Written by University of Maryland business professor Clifford V. Rossi, the new report is a blunt assessment of what went wrong and why. In basic terms, Rossi says lenders blew it by not properly accounting for the additional risk represented by nontraditional loan products, a view encouraged by the desire to increase business revenues and thus stock prices.

“This study contends,” says Rossi, “that expansion into riskier products by mortgage firms that subsequently suffered large credit losses was a strategy intended to grow the franchise and along with it the attractiveness of the firm to investors. Over time investors discounted the growth potential for mortgage specialists for a variety of reasons. Commoditization of prime mortgages via the conforming securitization market, for example, helped keep mortgage borrowing costs and net interest spreads low. Products with higher margin potential such as option ARMs and HELOCs provided these companies alternatives to originating conventional conforming mortgages.”

Risk

In other words, lenders moved away from conventional, VA and FHA mortgage loans to boost margins. That would have been fine had the risks of such new financial products been understood. However, as Rossi explains:

“The period of mortgage product expansion was accompanied by abnormally strong house price
appreciation across most MSAs fueled in part by relatively low interest rates. This favorable economic
environment contributed to a period in which mortgage default rates were very low by historical
standards. As a result, the economic environment tended to bias loss estimates downward in a real
sense. This contributed to further mortgage expansion and vast understatement of potential losses
due to risk layering and the expansion of nontraditional mortgage products such as option ARMs
and piggyback HELOCs. The development of new products and the expansion of risk parameters on
existing products came at perhaps the worst time. With virtually no historical experience with these
new risk combinations and that which existed largely coming from a benign economic environment,
risk models would have little hope to accurately reflect expected loss, let alone loss levels during an
extreme event such as the financial crisis.”

The catch, of course, is that the additional risks represented by nontraditional loan products were obvious. You didn’t need a business degree to understand that an option ARM and an FHA mortgage were fundamentally different financial products which represented fundamentally different levels of risk. FHA loans with full documentation, no gotcha clauses and no prepayment penalties represented minimal risk while the toxic loans marketed during the past few years were as risky as a camp fire in the middle of a match factory.

You can find the complete Rossi study online by going to Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future.

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