Rather Than Their Heads, Obama Just Wants Some of Bankers' Skin

As Megan pointed out earlier, President Obama has announced a host of proposed measures to reform financial services. One of these measures is to force mortgage originators to have a little skin in the game. Specifically, mortgage originators would be forced to retain 5% of the mortgages they create. The idea being that they will have less incentive to originate shady mortgages and sell them to other unsuspecting banks, because if the mortgages go bad, they lose too. I think this is another one of those suggestions where the administration's heart is in the right place, but needs a little deeper thought.

The most obvious observation I would make about our current situation is that these originators had plenty of skin in the game. In fact, I would argue they had entirely too much skin in the game. That's why some banks had tens of billions of dollars in write-downs. That's why mortgage companies like Countrywide, Ameriquest, and New Century no longer exist. No one had to force these originators to keep some skin in the game, as they willingly did so.

While the idea of forcing banks to have skin in the game sounds great in theory, in practice it fails to address the real problem: originators were stupid. They were stupid to think that the mortgages they originated would be okay. They were making the kool-aid and drinking it themselves. Otherwise, they wouldn't have kept all those mortgages and mortgage-backed securities. The problem was that people had irrational expectations about the housing market -- not that they didn't have anything to lose. They had plenty to lose, and lost a great deal.

Even if you think this plan might be a good one, I'm still a little unclear about the logistics of how it would actually work. An originator can do three things with its mortgages: sell them, hold them or securitize them. The latter two of those options don't pose any technical difficulty: if it holds them, the originator incurs any losses anyway; if it securitizes a big pool of its own mortgages, it can just take 5% of losses that would have been passed on to investors.

But what happens when an originator sells loans that becomes part of a bigger pool of loans from other sources that are then securitized? How do you determine what portion of the pool's losses that originator should be exposed to? I guess you could somehow try to reference each loan to its originator, but that's a mess. A pool of loans could have any number of originators, so I sure would not want to be the servicer who has to deal with that problem. Servicers already charge a few percentage points as a fee for servicing. Time will tell how this additional arduous task will increase servicing fees, which in turn, will make mortgages more expensive for consumers.