The Mortgage Crisis Is One of Confidence

By Jack Guttentag
Saturday, January 5, 2008

The current mortgage crisis will probably enter the U.S. record book as the second-worst in the past 100 years.

The worst was in the early 1930s, when thousands of banks failed and the mortgage market shut down entirely. It has not shut down this time, thanks in large part to federal institutions created in the '30s to deal with that crisis.

The housing finance system is really two overlapping systems. One consists of portfolio lenders, mostly depository institutions, which hold the mortgage loans they originate. The portfolio system was the larger part of housing finance before the savings-and-loan crisis of the 1980s but gradually lost ground thereafter.

The other system consists of temporary lenders who either sell loans in the secondary market to firms that securitize them or resell to still other firms that securitize them. Securitization means putting mortgages in a pool and issuing mortgage-backed securities (MBSs) against the pool. This secondary market system began in the early 1970s and grew at the expense of the portfolio system -- until the recent crisis.

The crisis originated in the subprime segment of the secondary market system and quickly spread. The crux of the crisis is a loss of confidence by the investors who purchase mortgage-backed securities and their retreat to the sidelines. When investors stop buying, the secondary market system grinds to a halt.

One part of the secondary market system, however, has continued to function more or less normally. That is the "conforming loan" market, which covers loans no larger than $417,000 that meet the eligibility requirements of Fannie Mae and Freddie Mac. Investors have retained their confidence in the two federally chartered companies, which they assume would be supported by the government if it were necessary. Hence, they continue to purchase the MBSs issued and insured by the agencies.

The crisis has also re-energized the portfolio system. Portfolio lenders have raised additional funds from channels unaffected by the crisis: by selling certificates of deposit, which are insured by the Federal Deposit Insurance Corp., and by borrowing record-breaking amounts from the Federal Home Loan Bank system. The banks raise money by selling bonds, and, like Fannie Mae and Freddie Mac, they continue to have the confidence of investors.

Portfolio lenders have been turning more often to mortgage insurance, both from the Federal Housing Administration and from private mortgage insurers. The FHA's business shrank markedly from 2000 to 2006 as the subprime mortgage market expanded, while private mortgage insurance had been hurt by lender self-insurance in the form of second-mortgage "piggybacks." Both trends have been reversed.

Four of the five federally created institutions now supporting the market were formed during the financial crisis of the 1930s. The exception is Freddie Mac, which was created in 1970. If not for those institutions, the current crisis would be much worse.

But it is bad enough. Portfolio lenders have replaced only part of the shortfall left when investors deserted temporary lenders. The portfolio lenders live in the same world as secondary-market investors, see the same frightening data on foreclosures and have tightened their underwriting requirements across the board. Further, many are constrained by capital requirements, especially those who participated in the secondary market system as investors and have suffered capital losses.

The upshot is that, just as many loans were made during 2005 and 2006 that should not have been made, today there are loans that should be made that aren't. Further, the prices of all deviations from underwriting perfection contain a "fright premium" and are therefore higher than they ought to be. That is true even in the conforming market, where Fannie Mae and Freddie Mac have raised the price increments on borrowers with less-than-excellent credit.

This semi-paralyzed market will continue until investor confidence is restored. Key players are the investment banks and hedge funds who sold MBSs when prices were high in expectation that they could buy them back later at lower prices. At some point, they must go into the market to cover their short positions. They will do that when they decide that MBS prices have reached a bottom.

That will not happen before we see the end of unpleasant surprises -- large value write-downs by major U.S. firms and revelations by previously unknown foreign institutions in trouble because they, too, bought subprime-contaminated securities. Most firms come clean at year-end, so perhaps the surprises will stop soon.

Once the surprises stop, investors will look for a bottom in house prices and a peak in foreclosures. When both become clear, they will make their move.

Next Saturday: What is needed for recovery, and how much help will the relief plan provide?

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,

Copyright 2008, Jack Guttentag

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