How to fix the mortgage business

We don't need a revolution: Just a tweak here and there, and it will be as good as new

By Andrew Leonard
Published October 24, 2008 9:33PM (EDT)

Writing in The Economist's Voice, Berkeley economics professor John Quigley has some intriguing suggestions on how to fix the mortgage business so as to prevent a repeat of the subprime meltdown.

Quigley zeroes in on the screwed up incentives that allowed, nay, encouraged, the propagation of so many bad loans. Simply put, everyone involved was paid on the basis of generating loans, and not on whether the loans turned out to be good loans.

The incentive structure that arose for firms in this specialized industry set the stage for the collapse. The incomes and fees generated are all transactions-based, that is, payments are made at the time the transaction is recorded. The originator of the loan, typically a mortgage broker, is paid at the time the contract is signed. Brokerage fees have varied between 0.5 and 3.0 percent. The mortgage lender earns a fee, between 0.5 and 2.5 percent, upon sale of the mortgage. The bond issuer is paid a fee, typically between 0.2 and 1.5 percent, when the bond is issued. On top of this, the rating agency is paid its fee by the bond issuer at the time the security is issued. All these fees are earned and paid in full within six to eight months after the mortgage contract is signed by the borrower.

Italics mine. Although some subprime loans made in 2007 went into default almost immediately, usually 6-8 months is too short a time period to get a fix on whether the loan is likely to go into default.

Quigley offers one very simple fix: Extend the period over which the various parties get their fees, contingent on the performance of the loan. More provocatively, in the case of the ratings agencies, compensation could be paid "in shares of the bond being issued" -- so remuneration would depend on whether the security actually deserved its high rating over the long run.

Too often, the debate between regulation and deregulation is treated as if it is a clash between matter and anti-matter, when in fact, smart tweaks can make a big difference. Quigley's ideas sound smart. Barney Frank and Chris Dodd -- are you listening?

Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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