Media Spotlight: Moving Forward

28 March 2011 | By Samuel Dale

The disgraceful sub-prime lending practices by US lenders in the early part of the last decade are well documented.

Loans were given to borrowers who had no chance of ever repaying them but it didn’t matter to lenders. That’s because mortgages were packaged up in a security and sold so that profits were made and the risk passed on.

Nine out of 10 sub-prime loans in the US market were securitised by 2007, according to Inside Mortgage Finance. The negligence of ratings agencies meant junk securities that were packed full of borrowers who couldn’t afford to pay the loan were labelled as AAA.

AAA is the highest grade a ratings agency can give and the risks dubbed low. But the dislocation of risk didn’t end there because these gold-plated securities were combined with other securities to create collateralised debt obligations.

It’s complex madness but in their essay, Eric Belsky and Nela Richardson do a good job of explaining how the brainiacs of this ridiculous financial system thought they had ended risk.

Their essay, Rebuilding The Housing Finance System, is the most relevant essay in Moving Forward: The Future of Consumer Credit and Mortgage Finance - edited by Nicolas P. Retsinas and Eric S Belsky.

Focussing on the US market, it covers securitisations, alternative forms of mortgage finance and the regulation of consumer financial products. But it is the essay on the US sub-prime market that provides the most fascinating proposals for the future of mortgages.

Belsky and Richardson suggest the four causes of the crisis are cheap money, unprecedented risks in mortgage origination, multiplication of these risks through financial engineering, and regulatory and market failures.

When analysing the future market, they support sub-prime lending and recognise that if lenders only lent to flawless borrowers, home ownership would be an impossible dream. But they do offer steps to a safer mortgage market, such as increased transparency of capital markets, greater monitoring of risk and, crucially, tougher regulation.

Their essay recognises the success of broker distribution for allowing banks to avoid expensive branch costs and giving lenders greater reach. And it highlights that brokers provide consumers advice and a guide through the complex world of mortgages and financial services.

But the lack of risk for brokers when originating loans must be addressed. Capital requirements on brokerages and small mortgage firms are dismissed as impractical, but the US equivalent of individual registration, that will monitor brokers more closely, wins support.

More radically, the authors suggest broker remuneration should be linked to the long-term performance of loans. It refers to new rules requiring all issuers of securitisations to retain a 5% share of the risk as an example. They say the industry should ditch upfront fees and introduce trail commission, and if loans fail to perform, brokers lose commission.

Britain’s sub-prime market was nowhere near as mature as that in the US, but you only have to look at the bloated arrears figures of some UK lenders to see many loans that people could ill afford.

A trail-based approach to commission would certainly be food for thought for anyone looking to make easy money off the back of borrowers with crippled credit histories.

Review by Samuel Dale

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