Reforming the Mortgage Industry

The major contributing factor of the financial crisis was the bad mortgages. When people started defaulting the bad debts eroded the banks capital reserves. To prevent a repeat regulation is necessary, but do you stop the home-owner borrowing or the bank lending?

Some people propose protecting the home-owner from themselves. Proposing limits on loan-to-value ratios and loan-to-income ratios. Essentially it becomes a one size fits all solution that locks first time buyers out of the market. A frugal person is able to afford more, a person may have other assets, interest rates effect the repayments not the loan value. Instead of a bank taking these factors into account they will simply tick the regulators boxes.

The better way is to put the regulation on the banks. If a banks lends more than the value of the collateral the extra becomes an unsecured loan. The regulator can require the bank to classify is loans by risk criteria, eg, secured, unsecured, in arrears, etc. and require a higher capital reserve for higher risk loans. Combined with this is need to ban self certified mortgages to reduce fraud by borrowers and mortgage advisers.

For securitization, the bank can define a set of criteria for each security and bundle the mortgages that meet the criteria. This would enable the buyer to know what they are getting rather than relying on the credit rating agency’s opinion. In addition, this would remove the dominance of Freddie and Fannie.