Now that Olympia Snowe has joined Susan Collins and Scott Brown, it looks like the financial "reform" bill will pass the Senate. Dear Sen. Snowe opined that the bill "wasn't perfect" but she did not want to see another financial collapse happen. Excuse me? Has she read the bill? It says nothing about the causes of the financial collapse and offers no reforms that are remotely relevant. But I have gone down that road before. Consider this: the bill has a provision in it that requires originators of mortgages to keep 5% of them in their own portfolios. Supposedly this will lessen risk since the originators cannot sell it to a bunch of dupes who have no idea about the quality of the loans. Well in the real world, the market prices the loans based on historical defaults - which is why they all were in trouble when the default rates exceed what was anticipated. However, the buyers have always tracked defaults to see if originators were not doing their jobs. There are early put back clauses in all the contracts so if a loan defaults within a set number of days, it is returned to the originator. Also buyers who have loans default often sue the originator for violating the reps and warranties that come with each deal. Lastly, the buyers will either stop buying from originators with high default rate or will price their loans accordingly. Holding back 5% means that the buyers will assume - unless assured otherwise - that the originator will retain the best loans and sell the rest. This will result in lower prices being offered for loans unless the originator demonstrates that the loans are randomly chosen for the portfolio. And one last item: New Century Financial, the leading originator of subprime mortgages was organized as an REIT which meant it was required by law to hold a certain percentage of its loans in its own portfolio. Has anyone used New Century as an example of how originators will underwrite less risky loans if they have to hold them? Quite to the contrary. New Century was the press' favorite whipping boy during the implosion of the subprime market. So this one little part of the financial "reform" bill will result in lower prices paid for whole mortgages and for packaged mortgages, will do nothing to lessen risk-taking in strong markets and will do nothing to prevent the bursting of the next asset bubble.
Harold A. Black is professor emeritus in the Department of Finance, University of Tennessee, Knoxville having retired after 24 years of service. He has served on the faculties of American University, Howard University, the University of North Carolina - Chapel Hill and the University of Florida. His government service includes the Office of the Comptroller of the Currency and as a Board Member of the National Credit Union Administration. He also has served on the boards of directors Home Savings of America and its parent company, H. F. Ahmanson & Co., Irwindale, California prior to its merger with Washington Mutual Savings Bank, on the board of New Century Financial Corporation, Irvine, California, then the nation’s largest real estate investment trust and as director and later chairman of the Nashville Branch of the Federal Reserve Bank of Atlanta. He writes an occasional article for the Knoxville News-Sentinel at http://www.knoxnews.com/staff/dr-harold-black/. His web page is haroldablackphd.com