America’s Mortgage Market Is Still Broken

(Bloomberg) -- Regulators have done a lot to reform the financial system since the 2008 crisis, but they still haven't fixed the market where the trouble started: U.S. mortgages. It's an omission they need to put right before the next crisis hits.

Looking back, it's easy to see what made U.S. housing finance so vulnerable. Loosely regulated companies, financed with flighty short-term debt, did much of the riskiest lending. Loan-servicing companies, which processed payments and managed relations with borrowers, lacked the incentives and resources needed to handle delinquencies. Private-label mortgages (which aren't guaranteed by the government) were packaged into securities with extremely poor mechanisms for deciding who — investors, packagers or lenders — would take responsibility for bad or fraudulent loans.

As soon as borrowers started defaulting in significant numbers, chaos broke out. With little cash or capital, non-bank mortgage lenders imploded by the hundreds. Servicers left borrowers in the lurch — some went out of business, while others saw that they could make more money by foreclosing than by modifying loans. The parties involved in securitizations became embroiled in legal battles about who owed what to whom — litigation that goes on to this day.

After the crisis, Congress and regulators took action to prevent a repeat. New rules eliminated the worst of the pre-crisis loan products. Higher capital requirements made banks somewhat more resilient. Yet it's becoming apparent how much the reformers missed.

In recent years, highly regulated institutions such as Bank of America — burned by billions of dollars in fines — have shied away from the mortgage business. Instead, they provide short-term credit to nonbanks such as Quicken Loans and PennyMac, which do the actual lending. Nonbanks now originate some 60 percent of new mortgages.

In one way, this shift from banks to nonbanks is beneficial: It supplies mortgage credit that might otherwise have disappeared. But it's also dangerous, because the nonbanks are both lightly regulated and fragile. State regulators and government guarantors have set standards for capital and liquidity, but they lack resources to follow through and don't share information with better-equipped authorities such as the Federal Reserve. In a crisis, banks might pull the lenders' credit lines, crippling them at precisely the wrong time for the broader economy — and that could leave taxpayers to bear the costs of any bad loans.

The picture is similar in servicing. Nonbanks such as Nationstar and Ocwen have grown, and now handle more than a third of mortgages outstanding. But it's uncertain they could cope in a crisis. Advancing payments to investors when loans go delinquent — a core responsibility of servicers — demands a lot of cash. It also requires ample capital to absorb possible losses on servicing rights, an asset whose value can quickly evaporate if defaults and prepayments eat into expected fees. At the end of 2017, the three largest publicly traded nonbank servicers had less than $4 billion in tangible equity and more than $6 billion in servicing rights — a precarious ratio that has shown little sign of improving.

The private securitization market is looking no better prepared to handle the risks inherent in mortgage lending. Market participants convened by the Treasury Department and the Structured Finance Industry Group, a trade association, have made useful recommendations on how best to balance the demands of lenders, packagers and investors. Ideas include creating a deal agent to look after investors' interests and ensure quick compensation for any badly underwritten or fraudulent loans. Unfortunately, securitization sponsors haven't complied: Some don't even let investors examine a questionable loan until after the property has been foreclosed and sold — a process that can take several years or more. Such unresolved issues help explain why the market remains in the doldrums.

The solutions aren't rocket science. In both lending and servicing, regulators should put banks and nonbanks on a more equal footing. This requires clearer rules on the legal responsibility for bad loans, and higher capital and liquidity requirements for nonbanks. Big institutional investors, such as endowments and pension funds, ought to insist on more standardization and better governance in the securities they buy — including deal agents and mechanisms to ensure that servicers act to maximize loan values. If they won't insist, regulators might have to consider setting standards.

By the way, mending the mortgage market is the precondition for getting to another piece of unfinished business: the future of Fannie Mae and Freddie Mac. These government-controlled mortgage guarantors have been wards of the state ever since their near-collapse in 2008. The government should aim to reduce this kind of involvement in mortgage lending, but the private sector must be made ready to pick up the slack first.

No two financial crises are ever quite the same. The next one won't be like the last. But history teaches lessons, and there's no excuse for ignoring them.

—Editors: Mark Whitehouse, Clive Crook.

To contact the senior editor responsible for Bloomberg View's editorials: David Shipley at davidshipley@bloomberg.net.

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