October 3, 2018

The Next Mortgage Crisis

The economy is humming right now. Home prices have been going up but at least in some markets and segments might have peaked. Interest rate increases may explain part of this. But what role will mortgage-backed securities play in the future health of the market? The 'Great Recession' started a little over ten years ago. Are there parallels between then and now?

Knowledge@Wharton interviewed management professor Natalya Vinokurova in a piece titled 'Is the U.S. Headed for Another Mortgage Crisis? about her research into the mortgage market and the development of mortgage-backed securities. She notes that when Freddie Mac launched the collateralized mortgage obligation in 1983 they convinced investors that it was like a bond by adding tranches or slices to estimate likely maturity of each piece of the 'bond.' This encouraged more funds to flow into the mortgage market. But the seeming certainty was washed away when interest rates dropped and prepayments accelerated since the mortgages had no prepayment penalties. Strangely the fact that investors had entered the CMO market provided the funding for borrowers to refinance.

That prepayment experience contributed to greater investment in subprime mortgages since some of these included prepayment penalties. As Vinokurova note '(i)n a way, the movement towards these nongovernment-backed, mortgage-backed securities with default risk was driven by the fact that they were seen as being a safer bet.'

Vinokurova also discusses the history of the mortgage market and past failures. In the 1920s mortgage insurance companies issued securities similar to CMOs. Many of these companies went bankrupt when defaults rose and property values dropped following the stock market crash. A similar event occurred with AIG in 2008. History repeating itself.

I think a good analogy here is the Food and Drug Administration. This is an entity that tries to force memory. If your drug failed to do certain things or it poisoned people in the 1960s, you can’t reissue it and say, “Oh, let’s do this again.” -- Professor Natalya Vinokurova

It seems that the soundness of the mortgage market takes a back seat to providing access to credit to more people at the lowest cost possible. As Professor Vinokurova notes 'I can think of no other country in the world where you have these fly-by-night mortgage originators that disappear after every bust.'

So given we haven't addressed some structural faults in the mortgage system what should we look at for warning signs of market risk? Vinokurova thinks that 'house price inflation is an incredibly potent signal of us being in a bubble, of us being on the verge of a crisis. ' And while the Fed is cutting back on quantitative easing she references research that shows that QE can lead to crises. We also have 'too big to fail' banks that are now even bigger. Even though they have more capital cutting back on bank leverage would help stabilize the system further. Regulations including Dodd-Frank and the CFPB both are being neutered which may increase market risk.

So have we learned any lessons from the Great Recession? Have we addressed structural weaknesses? Unfortunately the answer is No. Now we just need to watch and hope that somehow avoid the next mortgage mayhem.

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