Lenders, Know Your Borrowers

CU360
February 18, 2009 | COMMENTS

As the U.S. struggles to cope with the worst housing slump since the Great Depression, some have sought to explain the latest boom and bust in mortgages as innovation gone awry.

But much of it isn't new at all. There were six U.S. mortgage meltdowns between 1870 and World War II and all taught the same lesson—some loans should never be made. Analysis reported via Reuters news service points out lessons for policy makers, and it emphasizes the role of community-based financial institutions.

"Apparently no single person on Wall Street knew about these six earlier blow-ups. If they had, they would have held back," Robert Wright, financial historian at New York University 's Stern School of Business.

"They all happened for the same reason and that is the same reason that the seventh one blew up: the originators had incentives to make as many mortgages as quickly as possible and not to really care about the borrowers' long-term ability to pay."

To prevent future housing crashes, analyst suggestions run the gamut from returning to more community-focused financial institutions to market mechanisms to prevent bubbles from developing.

Meanwhile, lawmakers in Washington are scrambling to find remedies for the high-risk loans that were repackaged into complex securities and sold to investors.

Securitization is nothing new

Mortgage securitization appeared in six different forms between 1870 and 1940, according to research by Kenneth Snowden, associate professor of economics at the University of North Carolina at Greensboro . Each time the market for mortgage-backed securities grew rapidly for a few years and then collapsed.

In all of the breakdowns, the willingness of bankers and agents to write loans that never should have been made played a crucial role.

"In securitization, what you have are originators who are really very distinct from the ultimate holders of the risk," Snowden tells Reuters. "How are the incentives maintained through that chain to maintain good credit quality?” he asks. “That's key, and that's what's proven to be difficult to do," says Snowden.

Look to George Bailey

In the 1946 film "It's a Wonderful Life," leading man James Stewart demonstrated the valuable link between lender and borrower in the film's bank-run scene. Here, protagonist George Bailey convinces small-town depositors to stick with the local building and loan society he runs.

Bailey's clinching argument is that they know their money is safe because they have loaned it to other residents of Bedford Falls . The community building and loan survives because the investors know who they're underwriting. "That's the scene where he explains basically the philosophy and rationale of community banking," says Wright.

Fast-forward to the latest debacle and ask whether investors have the same confidence. The answer is a resounding "no," expressed in loss of confidence throughout the global financial system.

The credit crunch shows the virtues of a community-based financial services system, says Wright, where financial institutions operate locally, originate their own loans and tend to hold onto the debts as investments. "They know their borrowers," he adds.

Greater emphasis on this approach may also help lay the foundations for a more stable housing market in the future. Currently, however, the main burden is on regulators and financiers to figure out the conundrum that has undone so many U.S. mortgage booms.