BLOG VIEW: What’s Next For Mortgage Banking?

(This week's column is guest authored by Dr. Edward J. Deak, professor of economics at Fairfield University in Fairfield, Conn. Phil Hall's Monday column will return next week.)

Well, here we are at the end of 2008 and in the middle of the largest global financial/economic crisis since the Great Depression of the 1930s. While I am not expecting a 21st century style depression in 2009-2010, it is going to take a great deal of money, global cooperation, patience and confidence to free ourselves from this mess.Â

Most people have a lot of questions about the problem: How did we get here? Who is responsible? How bad will the recession be? When will it end? How will we gain the traction to escape the recession? What will our economic world look like after this crisis passes?

My task is to look at some of these questions within the context of the residential mortgage banking market. But as an aside, the next shoe to drop will be from the failures in the commercial mortgage backed securities market, which will surface early in 2009.Â

First, this is a crisis of the financial system, not in the financial system. On the other side of the eventual recovery, we will face a national and global financial system for raising, moving and lending money that will be smaller, more regulated and less interested in risk taking than the one that we have been experiencing for the past dozen years or so.Â

For the housing/financial industries, it will be a bit more difficult to secure the loans to buy, build and sell houses. It won't be as easy for lenders to sell off existing home loans to get new money in support of new home loans. Underwriting conditions for borrowers will be tighter. Local builders will find it harder to get loans for the land purchase and construction of uncommitted homes. And the legion of Baby Boomers who want to sell their most valuable asset to help finance their retirement and move elsewhere will find fewer potential buyers and lower prices for their homes.

In the most narrow sense, the current housing/mortgage crisis could have been avoided. Above all, regulatory oversight was caught napping. Federal and state auditors/regulators should have asked more and tougher questions about underwriting conditions, the ability of borrowers to pay once the low ‘teaser’ rates reset, the potential for fraudulent loan applications, how much of the loan pool was being carried by banks off their balance sheets, and the lack of transparency associated with the alphabet soup of securities (MBSs, ABSs, CMBSs, CDOs, etc) that were being sold off in pieces to investors here and around the world.Â

Interestingly, a segment of the mortgage banking industry – the community banks, were generally following traditionally sound lending practices and holding most or all of the mortgage loans on their balance sheets as income generating assets. Here in Connecticut and nationwide, the majority of these banks are financially viable – and will offer support for the housing industry after the dust from the ‘big guys’ settles.

In the broader sense, a major financial crisis, mortgage-based or otherwise, was probably inevitable. The size, flow and interconnectedness of the global financial system had become too unfathomable and unmanageable for even the most sophisticated participants.

Financial leverage, the borrowing of vast sums – mostly short-term to support longer-term lending instruments – had run wild. Many investment banks and other private lenders were borrowing 30 to 50 times their own participation capital to support the lending process.Â

In good times, leverage creates huge profits for those employing the technique. But no amount of triple-A ratings and default insurance could have saved the financial system once the cashflow from the repayment process that supports the leverage breaks down.Â

Operating in reverse, deleveraging is akin to a giant Ponzi scheme with the U.S. taxpayer now holding the bag. You and I own parts of the ‘too big to fail’ commercial banks that made the bad loans; the investment banks that bought, repackaged and sold the loans to private investors; and Fannie Mae and Freddie Mac, the government-sponsored eEnterprises that bought over $1 trillion of supposedly well-underwritten loans.

In effect, the existing financial system privatized the profit from the bubble of excessive leverage, while leaving the taxpayer to shoulder the burden of its costs. It will be the responsibility of President-elect Barack Obama and the members of the new Congress to figure out how to successfully manage this huge intrusion into an obviously unruly and poorly regulated domestic financial system.

I expect that the federal government will have successfully exited the private financial market over the next five to seven years, and put in place a new system of oversight and regulation. What should concern us all is that the new regulatory system is not so punitive that it destroys the ability of the private financial system to innovate and take reasonable risks. We will all suffer if that were to occur.

Lastly, I look for the mortgage banking industry to recover in response to a massive federal stimulus package that will approach $1 trillion in size and be spread over at least three to four years. It will contain a foreclosure mitigation component to help keep a million or more homeowners from losing their property. This will effectively establish a bottom in the housing market by mid-2010, with cautious lending according to traditional standards to be in place by 2011.

The high-risk, high-profit, financial gunslingers will have moved on from the housing market to establish their own hedge funds, private equity firms or boutique investment banks. Â

And as people with money begin to forget the lessons of excessive leverage, as painfully learned from the 2006-2011 upheaval, the next financial crisis will appear 20 years or so thereafter, following another period of spectacular leverage-induced private profit and stock market gain.Â

I hope I am wrong, but as 400 years of financial history teaches, bubbles followed by crises are really just part of human nature.


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