The subprime home loan debacle sure has exposed the huge and complicated marketplace to careful scrutiny as to how it handles risk management. Sterling banking firms and mammoth investment organizations have lately lost untold amounts of money on U. S. mortgage-backed securities. When some of the better finance minds the world over get dragged into a mess like this there must be something fundamentally questionable about it all.
Let's take a closer look. For residential mortgages, the current risk management function rests on two legs.
The well-known element is the one where a weak borrower is charged a higher interest rate than the borrower with solid credit credentials. No one argues with that. This is so far pretty basic and widely supported. But what happens to the premium that is collected from the weak borrower is where the system's drawback becomes glaring. If there are no immediate losses to cover, the proceeds from the premium are generally counted as income by the mortgage security holders, the investors.
So, under normal market conditions, many years will go by with mortgage defaults bouncing within a predictable loss range and the premiums will easily take care of any deficits. All the excess is entered into the books as income, year after year. Business is good and everybody is happy. But all of a sudden a major market upheaval, like the one we are seeing today, generates huge losses and since there are no reserves put aside, the investors are hit hard. The current premiums are far too little to bail them out and they are taking a serious bath.
Mortgage insurance is the other leg. When a borrower has less than 20% down payment, he is required to buy mortgage insurance to cover the extra risk. The big difference here is that about .50 cents of each premium dollar collected goes to a reserve fund and it is there as a backup when the market hits the skids. During low default years the accounts grow substantially and are much better prepared to tackle any future tough years.
The investor community could be planning some changes to the existing interest rate premium system, the obvious weak link here. It could introduce a still higher premium and then a fraction of that is put into a reserve account and the rest is kept as income, essentially preserving their current income stream. Mortgages, though, would now become more expensive to the borrower. Leaving the current risk premium intact but giving up some of it as a reserve would cut into their own profits. Probably a non-starter.
Maybe they won't do anything. These market blow-outs happen every 20 years or so and they figure they can live with that.