Home >> Daily Dose >> What the Mortgage Industry Can Learn From Its Past
Print This Post Print This Post

What the Mortgage Industry Can Learn From Its Past

What caused the housing crisis, and what can we learn from it to prevent another? In her paper titled “Failure to learn from failure: The 2008 mortgage crisis as a déjà vu of the mortgage meltdown of 1994” Natalya Vinokurova, Assistant Professor of Management at the Wharton School, cites several key factors as instrumental in the Great Recession of 2008, including the introduction of mortgage-backed securities and the development of tranching.

First, Vinokurova notes that when they were introduced, mortgage-backed securities (MBS) were not believed to be bonds. MBS were originally introduced to, according to Vinokurova’s research, find funding for the baby boomers as they began to buy houses in the 1970’s.

According to Vinokurova, MBS and bonds are different “on a number of levels.” Investors would have the risk of a mortgage-backed security being payed off earlier than expected.

“The dimension that bond investors were most concerned about in the 1970s and early 1980s was prepayment risk, with the idea being that mortgage-backed securities are bundles of mortgages,” said Vinokurova. “Your average borrower can repay his or her mortgage at any time. Most of the time, these borrowers would not incur a penalty. As an investor, this meant that if you were buying a security backed by 30-year mortgages, there was a very small chance that the security would still be around 30 years out.”

“As a bond investor, somebody’s trying to sell you something and they can’t even tell you how long this thing is going to be around. Obviously, bond investors pushed back,” Vinokurova added.

Tranching was an important development in getting investors to accept MBS as bonds, as it divided the investors into different levels of risk.

“You had the junior tranches, which were supposed to absorb the risk,” said Vinokurova. “The senior tranches were protected by the fact that you had the junior tranches as part of the security.”

The first security only had three tranches, but by the 1990’s there were securities with up to 68 tranches. When Freddie Mac issued the collateralized mortgage obligation in 1983, bond investors in each tranch were finally given a ballpark range of repayment. After a while, though, the junior tranch disappeared, leaving the senior tranches vulnerable. Vinokurova’s paper discusses how the faith in tranching, followed by increased bond investor capital into the mortgage market “is exactly predictive of the events of 2008.”

According to Vinokurova, the solution is to force people who work in the industry to remember the previous cycle and its mistakes.

“Once the securities were introduced, you don’t see any of these actors making specific appeals to these prior experiences. As they don’t remember the history, they literally repeat it,” said Vinokurova.

“The question is, are we now back at the end of the cycle, heading toward another recession?

I think that house price inflation is an incredibly potent signal of us being in a bubble, of us being on the verge of a crisis,” she said. “I think the quantitative easing, which is effectively creating liquidity by printing money, has been shown by folks like Markus Brunnermeier at Princeton to bring about crises.”

“When you have too much money chasing too few attractive options, you end up in the bubble. And the bubble will have to burst,” Vinokurova added.

The best solution, according to Vinokurova, is to just learn from the past.

“I feel like one of the challenges reformers often face is that they think they are the first people who tried to reform the system, and I feel like learning from the people who came before them would actually be helpful.”

Find the Wharton School interview on Vinokurova's paper here.

About Author: Seth Welborn

Seth Welborn is a Harding University graduate with a degree in English and a minor in writing. He is a contributing writer for MReport. An East Texas Native, he has studied abroad in Athens, Greece and works part-time as a photographer.
x

Check Also

Survey: Homeownership Remains Elusive for Baby Boomer Renters

A recent look into housing affordability by NeighborWorks America has found that three in five long-term baby boomer renters feel homeownership remains unattainable.