Wednesday, September 10, 2008

Jeffrey Lubell: Skin in the Game

Jeffrey Lubell

Here’s the six million dollar challenge facing the housing community: how can we create a safer lending environment that does not unreasonably restrict homeownership opportunities for low- and moderate-income families?

One of the most promising ideas I’ve heard is to make sure that all parties have a financial interest – some “skin in the game”– in a successful outcome. It sounds like a simple and common-sense proposition. But by most accounts, this straightforward market discipline was sorely lacking during the boom years that led to the foreclosure crisis.

One hears this argument most frequently as justification for larger borrower down payments. But if all parties are to retain “skin in the game,” we need to consider as well the incentives applicable to mortgage lenders and brokers.

One promising approach – particularly for nonconforming loans that cannot be sold to Fannie Mae or Freddie Mac – is for lenders to use “covered bonds” to raise funds to issue mortgages. Since lenders retain the credit risk, they have a strong financial stake in a positive outcome.

Here’s another approach: What if a substantial portion of the compensation of mortgage originators were tied not to the issuance of the mortgage, but to its performance over time? Arguably, this would create a financial incentive for originators to ensure that borrowers can afford their mortgages, without handcuffing lenders and borrowers by limiting what products may be offered, and without exposing originators to liability under a yet-to-be-defined legal standard.

There are obviously many questions that would need to be resolved to implement this policy. How would successful performance be defined? How much of the total compensation would have to be deferred until loan performance could be ascertained? Who would enforce the policy?

But as we move beyond the immediate crisis, these and other approaches for ensuring that all parties keep some “skin in the game” merit serious consideration.

Jeffrey Lubell is executive director of NHC's research affiliate the Center for Housing Policy, which specializes in developing solutions through research.

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