Skin in the game?

The mortgage crisis has produced cries of skin in the game. First, the lenders are required to hold 5 percent of their loans in their own portfolios. It is reasoned that if they have skin in the game, they are less likely to make risky loans. So when those loans are sold, there will be less risk to the investors. This of course assumes that the investors are fools. The investors will have to price the loan packages without regard to the underlying risk of the loans. We know that this is not true. Subprime packages were priced assuming a 10 percent default rate. Prime packages were priced assuming a 3 percent default. All mortgages have reps and warranties and are put back to the originator if these are violated. Purchasers of pools closely scrutinize originators and reprice their loans or stop buying them if default rates exceed the norm.

The crisis occurred when the default rates for both subprime and prime mortgages doubled over what was anticipated, driving the packages under water. The defaults were more a result of real estate prices falling than in defaults rising though an inability to repaid. As one study pointed out, people defaulted mainly because the value of the mortgage was less than the amount owed. What the skin in the game will result in will be fewer mortgages made and higher mortgage rates. Why? It is the old economic theory about lemons. The market will now assume that the lenders will cherry pick and select the best mortgages for their on portfolios. The resulting mortgages will all be priced as if they are lemons. This means lower prices for mortgage pools and fewer mortgages made by lenders. The second skin-in-the-game is the mandate proposed by the Fed that mortgages with minimum downpayment of 20 percent will be exempt from the 5 percent rule. Since fully 40 percent of mortgages have downpayments of less than 20 percent, many potential homeowners will be pushed out of the market. These mortgages will be priced even higher. Some will say this is a good thing because these people are higher risk. The market prices this risk now and as a result of the rule change will price them even higher. This will adversely affect the homeownership of minorities. So why isn't the press and the civil rights folks screaming the obvious? These requirements are blatantly racist! I can only surmise it is because both want to keep minorities dependent upon the government and not become more self-reliant. But more on that later.