Mortgage Loan Problems: Some Thoughts on Implications of Lin, Cho, andYang, Credit Risk of “Exotic” Mortgage ProductsPaper presented by Tyler T.L. Yang at IGPA Research Conference, New Frontiers in Policy Research: The Subprime Mortgage Crisis, University of Illinois, October 27, 2008. Comments by Joseph W. Trefzger, Professor of Finance, Illinois State University.The findings of Lin, Cho, and Yang (hence LCY) are important pieces of a massive puzzle that we must put together in finding the right road for escaping the housing market’s current problems. It seems reasonable to assume that, regardless of one’s academic discipline or political inclinations, we would all see an effectively functioning home mortgage finance system as essential for addressing the difficult issues seen in the recent housing crisis, and for moving toward an uncertain future in ways that promote affordability, accessibility, and transparency. LCY correctly note the problems arising from many borrowers’ lack of understanding of the complex terms that exist in some mortgage loan products. They also briefly discuss our inability to analyze recent loan controversies through the option-based framework that had gained favor over the last 25 years. The call option (ability to prepay) and put option (ability to default) embedded in mortgage loans are particularly difficult to value in loans such as negative-amortization option ARMs, and amid the recent turmoil even for standard fixed payment loans, since developers of the traditional models could not have foreseen the recent crises in the housing and mortgage finance markets. The main feature of LCY’s excellent work is a systematic framework for understanding some things we intuitively would have expected – especially the dangers borrowers and lenders face with loans like option ARMs. LCY help identify these problems, and they offer recommendations that include encouraging banks to finance with greater capital (sources of money other than insured deposits) when making “exotic” loans, even if they are not forced to do so in meeting regulatory capital requirements. (A suggestion for additional study might be to run simulations with assumed loan-to-value ratios of 90% and 80%, in addition to the 95% assumption that LCY used.) The crucial pieces of the important puzzle LCY provide will help our collective efforts to prevent responses from public & private sectors that would “throw baby out with bath water” by dismantling institutions & products that play vitally productive roles if used properly. Concerns Being Voiced in the Current EnvironmentAll of us hear friends, colleagues, and people in the media complain about the alleged:- ill-advised idea of a secondary mortgage market- evils of mortgage loan securitization (the dreaded “tranches”)- horrible idea of adjustable-rate mortgage loans- despicable nature of negative-amortization loanswhen, in fact, they all have the capacity to be tremendously beneficial tools. But as with any tool, each must be used the right way, and for the right job, or someone can be hurt. Important perils we must guard against, in using these tools, are agency problems, inadequate initial equity levels, and politicizing financial transactions. Agency problemsAgency problems come about through the conflicts of interest that arise whenever one party makes a decision that affects another. Agency problems can be seen in the home mortgage loan market when lenders can avoid the risks of questionable loans by selling them into the secondary market, and when home buyers buy too much house or borrow too much money because they need not contribute much if any equity and thus have upside potential with no downside risk. The expectation that a home buyer should have ameaningful financial stake in the purchase has steadily weakened over the past 30 years. These problems are reduced when lenders retain the loans they make “in portfolio” (the “old-school” model), yet without the ability to sell notes to secondary market buyers a local lender can quickly lose the ability to replenish its lendable funds. The problems also decline when secondary market buyers have recourse against originating underwriters who generate notes that show excessive default rates, and when borrowers put meaningful amounts of their own money down when making home purchases. Original equity levelsInitial interest rates, and changes in interest rates, are important determinants of default risk, as LCY explain. But so are the down payment and – old-school lenders believed – the method by which the down payment was obtained. The willingness-to-pay issue (vs. the solely income-based ability-to-pay issue) that LCY connect with “underwater” loans (collateral value has fallen below unpaid principal balance) actually might be expected to be correlated with several variables:- Negative equity, which relates to the home’s current value and the equity cushion the lender initially enjoys (home’s initial value minus down payment made by, or on behalf of, the borrower)- Utility the borrower places on remaining in the local community- Interaction of the borrower’s wealth that is not tied up in the house, and the borrower’s truly discretionary income, with the existence of deficiency judgment laws in the state where the house is located- Whether a borrower-supplied down payment was saved, was a gift, or was a loan disguised as a gift LCY, like earlier researchers, have had to do the best they could with very limited data. The four bullet points above are listed in order of data availability and reliability: the firstpoint can be estimated from appraisals and other loan application documents (though “low-doc” and “no-doc” loans obviously pose special challenges), the second possibly can be inferred from employment rates and other macroeconomic measures from the local area, the third can only be speculated on (since no one can know what a particular household views as necessities), and the fourth would rely almost entirely on self-reports,with borrowers saying what they think lenders or researchers want to hear. 2Every down payment generates an equity cushion that protects the lender. However, a saved down payment is the most desirable situation, because it provides evidence that theborrower can meet immediate expenses and still set money aside. A gift from relatives raises concerns: it gives the borrower an initial