This paradigm is simply new ways of transferring credit risk. In the old days the risk transferrence was pretty simple, directly upon the depositors at Ye Olde Building & Loan. The lending officers at Ye Olde knew their borrowers, could drive out to Mr Borrower's homestead to scope out the collateral and could catch up on Mr Borrower's financial comings and goings from the gossip at the Elks Lodge.
Under the new paradigm, risk transference is way more complex and generally is cut up into teeny tiny chunks and offered up on Wall Street and gobbled up by pension funds, mutual funds, foreign governments and other institutional investors. This spreading of risk is not a new concept, I think Lloyds of London came up with it first in like 1600 or so.
On the surface, this is a fabulous system as spreading the risk lowers the cost for all, and dramatically increases the liquidity in the mortgage system. The only downside to the system is the buyer's of the risk are utterly reliant on third parties to gauge the risk they are buying. Whereas typical corporate equity and debt securities are only as good as the companies they are issued on; mortgage backed securities are only as good as the underlying loans in the package. Where corporations can be judged by the credibility of their financial statements, mortgage backed securities can be judged by the credibility of, what? Their average weighted FICO score and LTV? Where a company like Enron can pull the wool over the eyes of Wall Street, for a while, by the cunning and skill of highly educated financial pros who if nothing else have to stand behind what they sign off on; the mortgage industry only has layer upon layer of transient, nameless, undertrained paper jockeys who can do whatever then vanish into the wind.
I believe the upper management types in the mortgage world know full and well the (maybe) shakiness of the documentation in their files, speaking mostly of income docs and appraisals, but are confident that they are managing that risk appropriately through the use of FICO scoring and loan pricing. I don't believe the institutional investors have such an understanding. The great unknown is how these recently originated loan packages will age in an era of slowing prepayment speeds. Consider that the average life expectancy of a 30 year mortgage loan today is something like 30 months. 30 months is not a lot of time to go bad. In a rising rate environment, or in a little or no appreciation RE market, the average life will expand tremendously, maybe even back to the old 12 year standard. You WILL see default rates increase with those kind of lifespans.
What will the institutional investors do should default rates go beyond expectation? What will they do should they see shinanigans in the underlying loan packages? Dump mortgage backed securities and start playing the blame game I imagine. Most importantly, what would this sudden loss in liquidity do the mortgage industry and real estate market?
Creative new ways of analyzing income or making payments wouldn't mean much in such an environment.
Of course I could be very wrong in my assumptions regarding the amount of false information in mortgage documentation or the due dilligence that institutional investors or Wall Street analysts put forth in assessing these things but something Brad Ellis said a few pages back keeps coming back to me:
But, since you say our pronouncements are given no weight in the overall scheme of things, and since Wall St. keeps on buying the paper, I do not believe they are panicking. So, why should we?
Hey if nobody else is worrying why should I?
