Perhaps a dozen books now in print blame much of the banking meltdown on a lack of government oversight right across the financial services spectrum and, of course, Wall Street greed. However, mortgage lending can't be accused of being one of those too lightly regulated industries no matter what its role in the housing crisis.
Since FDR's New Deal and the creation of FHA and Fannie Mae, the federal government has consistently kept its hand in the primary and secondary mortgage markets, for better or worse.
The mortgage industry must ready itself for the other federal regulatory hand now that President Obama has signed into law the Dodd-Frank financial reform legislation. Federal agencies now will design and implement lending standards that will significantly alter the residential mortgage industry.
The law's intent is to encourage prudent mortgage origination and securitization through sounder underwriting and risk management.
One way it is trying to achieve this is a requirement that lenders, loan packagers and securitizers retain on their balance sheets at least 5% of the credit risk from each loan in the pool underlying mortgage-backed securities.
The theory underlying 5% risk retention: If these institutions maintain an economic stake in the loans they originate and package, they will make better decisions in order to ensure credit quality. And better management of underwriting and risk would be expected to entice investors back into the secondary market.
The law also sweetens risk management incentives by letting lenders and securitizers retain less than 5% of the credit risk on mortgages that meet underwriting standards to be promulgated by federal banking agencies.
But will credit-risk retention help heal the secondary market and bring investors back? Will lenders be more careful in originating loans if they know more of their money is at risk?
Credit-risk retention seems to work well in the smaller mortgage markets of Europe. But will it work in the largest market in the world?
Let's look at another issue of sharing risk — borrower down payments and loan-to-value ratios — to see whether we can find any answers.
At the onset of the mortgage and housing crisis, a finger of blame pointed to loans that required little or no money down.
If borrowers had been required to put more skin in the game, to take a greater financial stake in the property, then they would be less likely to default and walk away from their properties, according to this rationale.
If this theory holds true for borrowers, will it work for lenders as well?
But would a 5%, or even 10%, financial stake in a property have helped borrowers in circumstances as severe as the housing bubble and subsequent crash?
One lesson we've learned from this crisis: When companies or individuals default on loans, the size of their original financial stake does not matter if they are now swimming underwater in negative equity.
We must remember that excessively high LTVs were not the only risky aspect of mortgage origination before the crash in 2008.
Most loans in the run-up to disaster were closed without verification of the accuracy of borrower information, as well as few controls to authenticate appraised values.
And as we learned the hard way, a large share of these loan decisions were based on incorrect information.
A 5% risk investment by lenders and securitizers by itself probably will not do much to solve the issue of bad loans. If the 5% rule had been in effect five years ago, we would still be facing the same crisis.
The only way to ensure that mortgages comply with financial reform guidelines is to investigate the actual loans.
To ensure that loans are sound requires insight, and for that we need to impose a high level of transparency throughout the mortgage process.
Lenders, securitizers, investors, Fannie Mae and Freddie Mac must be able to see the important details of any and every loan in the process of origination through post-closing and throughout the loan's life.
All parties that share in a loan's risk must be able to evaluate each mortgage in detail.
Let's stop treating this long-term investment as a short-term sale.
The responsibility to evaluate mortgages does not end at the time of sale, that's when it really begins.
New federal directives alone in a heavily regulated industry will not avert a future mortgage crisis. However, the 5% retention of credit risk can help us achieve better-quality mortgages if it works in tandem with a serious industry effort to develop and maintain a significant level of loan transparency throughout the mortgage cycle.