U.S. mortgage financing practices are out of whack. The problem is, nobody quite knows who is bearing the risks.

Talk about a U.S. housing bubble has been rampant for years now. What is happening to the market, and why do lenders keep on lending?

It is true that our nation is showing clear signs of being bubble-esque. Just a quick glance at housing prices is enough to convince most analysts. Housing in the U.S. has been getting steadily more expensive since 1980. That's 25 years without a break. Since this date average prices have increased by 185 percent. In just the past three years housing prices in 55 key locations have risen by at least 30 percent, according to a recent study by the Wall Street Journal.

Mortgage rates are a key driver of this phenomenon. During the eighties rates were in the mid-teens, whereas this year they are hovering around 5 percent. Some might ask, if rates are so cheap, doesn't that mean that you'd be stupid not to buy?

Well, maybe we should take a look at how people really manage their purchases. There are several other industry changes that are affecting consumers' buying decisions in addition to the nominal interest rates. First are the risky forms of mortgage financing. The traditional package of a 20 percent down payment and a fixed interest rate is disappearing. According to the National Association of Realtors, 42 percent of all first-time buyers and 25 percent of all buyers made no down payment on their home purchase last year. In fact, homebuyers often walk out of the bank with enough borrowed cash to cover 105 percent of their buying costs. This just doesn't make sense.

Many mortgages are structured as adjustable-rate loans that start out as a bargain but then can become a beast with the slightest uptick in rates. Some have flashy features that allow a borrower to pay only the interest due for an extended period, or, even more risky, with the "option" to pay less than the interest due each month while adding the unpaid portion to the loan balance.

The worst part is that these kinds of borrowing arrangements are attracting relatively hard-pressed borrowers. With the mortgage business having typically been a profit center in the good old days, lenders are living in the past and continuing to encourage even the most unworthy of borrowers to take out loans. These kinds of people tend to be those who wouldn't be able to afford a traditional fixed-rate loan - even at the current rock-bottom rates.

Given all these hints about potential future defaults, why are lenders being so carefree with their risk-return decisions?

The fact is that it's unusual for lenders to bear the entire risk of the loans they make, thanks to the world of mortgage-backed securities. Once lenders seal a mortgage deal, they turn around and sell it to private investment banks, which slice and dice it into various securities - often separating the mortage into an interest-only portion, and a principal-only portion. Those securities are then sold to other investors, like mutual funds, pension funds, hedge funds, European insurance companies and the central bank of China, to name a few. The point of this is to diversify risk - which is exactly why investors aren't caring as much. The brunt of any upcoming fall will be pushed to outsiders.

So what's the total damage? The latest data show that investors out there now hold $4.6 trillion in mortgage-backed securities.

That's more than the outstanding value of United States Treasuries.

A troubling lack of transparency, meanwhile, is a growing risk in its own right. With this second market of mortages throwing risk this way and that, passing it from hand to hand, it is hard to tell who exactly will be holding the bag when the market tanks. The investors taking the most risk are believed to be hedge funds and other unregulated entities, but because these entities are not subject to the same disclosure requirements as other firms, there's no way to even know whether this risk is spread out or concentrated in a few funds.

In the meantime, lenders keep lending, lending, lending, not knowing exactly where the risk is traveling once the contracts are signed. This is a classic example of the problem with misalignment between decision makers and the ultimate responsible parties. And this kind of market malfunction is going to cost us boatloads.

It's just a matter of time.

Posted by Michelle Smith on July 11, 2005 08:02 AM