by Christopher Peterson
In today's Wall Street Journal, Ted Frank, with the American Enterprise Institute, argues that the current meltdown in the subprime mortgage market justifies neither legislative nor judicial reform. In his view the market is currently adjusting to the problems in mortgage origination. Everything will work out if we just leave the markets alone because "lenders have every incentive to lend only to those who can repay."
I disagree. The current legal system creates the incentive for loan brokers and originators to (1)take large commissions and closing costs, (2) pass off bad loans to the secondary market, (3) distribute the revenue from lots of closings to management and employees, (4) wait for the bankruptcy code's preference window to close, then (5) declare bankruptcy when the secondary market tries to exert its recourse options.
Mr. Frank’s analysis ignores the agency costs of front line players in the industry, and it conflates the profitability of loan originating companies with the profits kept by the management of those companies. While there is nothing inherently wrong with securitization of mortgage loans, or other financial assets, we must accept the reality that the current system of funding subprime mortgages does not preserve the traditional mortgage market’s underwriting incentives. Instability and predatory lending will persist as long as the secondary market, and in particular, the investment banks that package mortgage backed securities can pass off bad loans to investors without fear of liability.