Mortgage Lenders Bet on Blue Skies Forever

Both mortgage defaults and hurricanes can be categorized as low-probability, high-consequence events. It's a type of phenomenon I examined during my Ph.D. at Wharton's Risk Management and Decision Processes Center under Paul Kleindorfer and Howard Kunreuther.

In both mortgage lending and insurance, the key to success is correctly judging -- and pricing -- risk.

Insurers have become much better at this, but until Hurricane Andrew struck in 1992, the Florida insurance market was subject to a boom-and-bust cycle: After each storm, consumers rushed to insure their homes, and insurance companies increased rates.

Then, as the years passed without another storm, fewer people would insure their house (ah, how short our memory is) as the disaster became less vivid in their minds, and insurance companies, hungry for business and facing increased competition from new entrants, reduced rates.

The trend continued until the next hurricane struck, and many, if not most, insurance companies went bankrupt because of too-high losses and insufficient capital.

Why were insurers so shortsighted? For the same reason mortgage lenders are: They ignore long-term risk to satisfy Wall Street, which is focused on short-term profits.

How the Risk Spreads

There is another, less obvious reason banks misjudged the risk in mortgage lending, one that is well understood by insurers. This is the underlying dependence in terms of risk between insured -- or mortgaged -- properties in the same area.

For example, a hurricane in New Orleans threatens all New Orleans properties, not only some of them. Insurers will either have to pay claims for damages on no properties or a lot of them. (Think of the difference between making bets either $1 at a time or with
all your money on one number at the roulette wheel.)

Normally, whether or not one homeowner defaults on a mortgage has little bearing on the ability of another homeowner in the same area to pay. But the higher rates that were prevalent earlier this year put downward pressure on housing prices, and that in turn prevented some borrowers from refinancing properties because they didn't have enough equity.

The banks, in a knee-jerk reaction, tightened borrowing guidelines, thus preventing even more borrowers from refinancing.

The risk of default, especially among subprime mortgages, became a case of all-or-none, much like risk of damage to properties in a hurricane-prone area.

The phenomenon started in subprime mortgages, which were most susceptible to becoming correlated, but as borrowing guidelines tightened, mortgages normally considered less risky became correlated as well.

Now you can see why lowering the rates at which banks borrow money won't make it easier for consumers to borrow. The problem is no longer the level of interest rates. The problem is that banks are highly risk-averse, although most likely too risk-averse. They cannot unload those risky mortgages on other banks (the big Wall Street ones) and they don't want to face those now-correlated risks.

Of course, this means that risky loans are priced too low right now, and anyone who buys those mortgages now -- as Bank of America (BAC Quote - Cramer on BAC - Stock Picks) is doing with its purchase of Countrywide Financial (CFC Quote - Cramer on CFC - Stock Picks) -- will probably make out well, because they can pay less than their true value. (Although you have to wonder if Bank of America bargained long enough, and strongly enough, with what is a distressed seller facing foreclosure.)

So cheap money won't induce banks to change borrowing guidelines. As long as borrowing guidelines are tight, few consumers will be able to borrow -- although those who can borrow will enjoy low rates.

Expectations that we are headed for a recession aren't exactly helping, either.

Therefore, the housing market will continue to stagnate, prices will continue to go down, and defaults will continue to rise, because borrowers cannot refinance their adjustable-rate mortgages once the rate rest.

Naturally, banks will continue to respond by becoming even more risk-averse, which is at this point a self-fulfilling prophecy.

What's the solution? Make borrowing easy, but not so easy that it brings about what we've seen in the past several years.

Will it happen? No, so brace yourself to surf the breaking wave. You can make a lot of money if you have good credit and you know what you are doing.

Mortgage Rates in Selected Cities
City	Term	Rate
Boston	30-year fixed	5.875%
New York	30-year fixed	5.5%
Denver	30-year fixed	5.75%
Chicago	30-year fixed	5.774%
Dallas	30-year fixed	5.875%
Source: BankingMyWay.com --no origination fee / 20% down payment / excludes Internet banks / excludes credit unions / loans under $417,000 For more rates, see BankingMyWay.com

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