The Downside of Falling Mortgage Rates

I’m scared by the latest uptick in mortgage financing. Mortgage rates fell sharply yesterday, which is good news for people with good credit. But it might also be good news for people with bad credit — and very bad news for the US taxpayer.

Go read BusinessWeek’s excellent investigation of subprime lenders who are now originating FHA-guaranteed loans, and you’ll see what I’m talking about. The only obstacle standing between these lenders and massive government-guaranteed riches, until now, was that mortgage spreads were still high, and that therefore mortgage rates weren’t following risk-free rates south. If that’s now changing, the US taxpayer might be funding — and, worse, guaranteeing — a brand-new subprime bubble.

The rise of the originate-to-distribute model destroyed enormous amounts of institutional knowledge on the subject of responsible underwriting, as bad lenders drove out good ones. And while there’s an inchoate impression out there that underwriting standards have tightened up sharply, I suspect that in reality they haven’t, and that what we thought was higher underwriting standards was in fact simply a lack of money to lend.

If the Fed’s latest liquidity facility does in fact manage to get the mortgage market lending again, I fear that the new loans will be doled out just as indiscriminately as the old ones were — more so, in fact, given those FHA guarantees. Good loan officers willing and able to say no to people wanting to borrow too much money simply don’t exist in sufficient numbers — and in any case there’s no shortage of bad loan officers who will say yes, given funding availability.

In the first half of 2007, after subprime default rates had already started soaring, I was shocked by how underwriting standards were failing to tighten. Loan officers haven’t changed since then. The last thing we want is to reward the same irresponsible lenders who caused the last bubble — but that seems to be exactly what we’re doing.

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