A message to lenders: know your borrowers

By Burton Frierson - Analysis

NEW YORK (Reuters) - The sweltering days of late July may seem an odd time to revisit the Christmas classic "It's a Wonderful Life," but the 1946 movie teaches a timeless lesson in finance: that lenders must always know their borrowers and have a stake in the debts being repaid.

As the United States struggles to cope with the worst housing slump since the Great Depression, some have sought to explain the latest boom and bust in mortgages as innovation gone awry.

But much of it is not new at all. There were six U.S. mortgage meltdowns between 1870 and World War Two and all taught the same lesson -- that some loans should never be made.

"Apparently no single person on Wall Street knew about these six earlier blow-ups. If they had they would have held back," said Robert E. Wright, financial historian at New York University's Stern School of Business.

"They all happened for the same reason and that is the same reason that the seventh one blew up: the originators had incentives to make as many mortgages as quickly as possible and not to really care about the borrowers' long-term ability to pay."

To prevent future housing crashes, analyst suggestions run the gamut from returning to more community-focused banking to market mechanisms to prevent bubbles from developing.

Meanwhile, lawmakers in Washington have crafted a package to rescue the market and shore up Fannie Mae and Freddie Mac, which own or have guaranteed almost half of the $12 trillion in U.S. mortgage debt outstanding.

There are also efforts to tighten standards among the brokers who made the high-risk loans that were repackaged into complex securities and sold on around the world to investors eager for the extra bit of interest on offer.

NOTHING NEW

According to research by Kenneth Snowden, associate professor of economics at the University of North Carolina at Greensboro, mortgage securitization appeared in six different forms between 1870 and 1940. Each time the market for mortgage-backed securities grew rapidly for a few years and then collapsed.

The expansions included financing booms for building cities in the American West, settlement of the Great Plains and agricultural expansion during and after World War I.

In all of the breakdowns, the willingness of bankers and agents to write loans that never should have been made played a crucial role.

"In securitization what you have are originators who are really very distinct from the ultimate holders of the risk," Snowden told Reuters in a telephone interview.

"How are the incentives maintained through that chain to maintain good credit quality? That's what's key. That's what's proven to be hard to do," says Snowden, adding, though, that he thinks securitization is beneficial when properly done.

Snowden says as housing markets grow increasingly exuberant, maintaining credit standards becomes more difficult, especially as companies fight to maintain market share. He suggests putting in place regulatory mechanisms to cool off markets off when they begin to expand too rapidly.