| Bram Cohen ( @ 2007-08-23 17:27:00 |
Mortgage Lending
With the current (apparent) crisis in the mortgage market in the united states, I'd like to point out a central fact of that system which is completely berserk:
Credit scores are the primary mechanism for determining creditworthiness for getting a mortgage.
This is more than a little bit nuts. Credit scores are designed to tell how much returns a credit card lender can get by giving someone a line of credit. Mortgage default risk is something else entirely. A person who has a huge rotating debt on their credit card and pays off the minimum every month is a great credit card risk because they'll have payed off several times what they were loaned in the first place by the time they go under, but a terrible mortgage risk because they're likely to go under, while a person who never has any rotating debt is a terrible credit card risk because they never rack up any interest but a great mortgage risk because they're unlikely to get into financial distress.
Why then, are credit scores used? First I have to explain what kind of risk mortgage lenders are taking on. Historically, mortgages were so absurdly overcollateralized that the risk of default isn't that the money doesn't get paid back, but that it gets paid back too early, requiring that some new sucker be found to loan the money to to get the expected returns. It's obviously a bit of a stretch to call this 'risk', but that's the way things have been.
So about using credit scores - since there's very little risk being taken on, mostly it's about who can be beat up. Whatever sociopolitically justifiable games banks can play to increase interest rates they do, and as it happens people with lower credit scores are viewed as Bad People and collusion against them is a lot simpler.
What, then, would be a reasonable thing to do? Obviously drop credit scores, but replace it with what? Well, the current situation can tell us a lot. What's happened recently is that housing prices have actually fallen, so a number of mortgages are underwater, so there's a risk not only of the money being paid back early, but of it not being paid back at all. The way to gauge risk of this is something which is already used in mortgage assessment, but not heavily enough, which is percentage down. By definition, if a houses's value drops by ten percent then any mortgage with less than ten percent down will be underwater, but mortgages with more than that will still be just fine. The current mortgage mess is in part difficult to unwind because when mortgages got packaged up and resold they were clumped by credit rating and not percentage down, so the effects of real estate prices going down on them are quite difficult to infer.
As for aftershocks, I don't think this is such a big deal. The people holding on to mortgages right now are mostly hedge funds, which by definition only have accredited investors as shareholders, and accredited investors by definition have enough money that they can afford to suck it up if their investments go bad. Hopefully that's what will happen.
In the future, I think mortgages will continue to be much as they have been right before this crisis. This historical business of mortgages only coming in one risk class (damn near risk-free) and getting returns as if they were taking on real risk was a bad thing, and I anticipate that if there isn't any bailout this time then the mortgage industry will get together and start handing out interest rates which actually make sense - very high rates for anything interest-only, and rates only a hair above fed funds for anything with 50% down, regardless of the borrower's credit-worthiness.
With the current (apparent) crisis in the mortgage market in the united states, I'd like to point out a central fact of that system which is completely berserk:
Credit scores are the primary mechanism for determining creditworthiness for getting a mortgage.
This is more than a little bit nuts. Credit scores are designed to tell how much returns a credit card lender can get by giving someone a line of credit. Mortgage default risk is something else entirely. A person who has a huge rotating debt on their credit card and pays off the minimum every month is a great credit card risk because they'll have payed off several times what they were loaned in the first place by the time they go under, but a terrible mortgage risk because they're likely to go under, while a person who never has any rotating debt is a terrible credit card risk because they never rack up any interest but a great mortgage risk because they're unlikely to get into financial distress.
Why then, are credit scores used? First I have to explain what kind of risk mortgage lenders are taking on. Historically, mortgages were so absurdly overcollateralized that the risk of default isn't that the money doesn't get paid back, but that it gets paid back too early, requiring that some new sucker be found to loan the money to to get the expected returns. It's obviously a bit of a stretch to call this 'risk', but that's the way things have been.
So about using credit scores - since there's very little risk being taken on, mostly it's about who can be beat up. Whatever sociopolitically justifiable games banks can play to increase interest rates they do, and as it happens people with lower credit scores are viewed as Bad People and collusion against them is a lot simpler.
What, then, would be a reasonable thing to do? Obviously drop credit scores, but replace it with what? Well, the current situation can tell us a lot. What's happened recently is that housing prices have actually fallen, so a number of mortgages are underwater, so there's a risk not only of the money being paid back early, but of it not being paid back at all. The way to gauge risk of this is something which is already used in mortgage assessment, but not heavily enough, which is percentage down. By definition, if a houses's value drops by ten percent then any mortgage with less than ten percent down will be underwater, but mortgages with more than that will still be just fine. The current mortgage mess is in part difficult to unwind because when mortgages got packaged up and resold they were clumped by credit rating and not percentage down, so the effects of real estate prices going down on them are quite difficult to infer.
As for aftershocks, I don't think this is such a big deal. The people holding on to mortgages right now are mostly hedge funds, which by definition only have accredited investors as shareholders, and accredited investors by definition have enough money that they can afford to suck it up if their investments go bad. Hopefully that's what will happen.
In the future, I think mortgages will continue to be much as they have been right before this crisis. This historical business of mortgages only coming in one risk class (damn near risk-free) and getting returns as if they were taking on real risk was a bad thing, and I anticipate that if there isn't any bailout this time then the mortgage industry will get together and start handing out interest rates which actually make sense - very high rates for anything interest-only, and rates only a hair above fed funds for anything with 50% down, regardless of the borrower's credit-worthiness.