Smith Faculty Opinion Article	September 27, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

The Perils of Going Slow to Clean Up Mortgage Lending and Bond Rating

If the hearings at the Senate Banking and House Financial Services Committees demonstrate anything, fixes to the broken mortgage lending and bond rating processes will come only slowly, and that is bad for U.S. home buyers and capital markets more generally.

The Treasury and Federal Reserve favor minimum intervention and letting market discipline establish transparency in credit markets as much as possible. However laudable that might be, it is apparent that such approaches have already failed. That is how we got into the fix we find ourselves.

Standard & Poors, Moodys and others, enjoying robust profits from their government-sanctioned, semi-official franchises, are suggesting meaningful but inadequate changes in the corrupted network of transactions among mortgage agents, commercial and investment bankers, loan servicing enterprises, and bond rating agencies.

Suggestions by rating agencies for independent audits of mortgagee incomes and residences are useful but those would do little to address the inherent conflicts of interest elsewhere in the mortgage writing and collateralization processes. For example, the home appraisal process has been problematic for decades, because of the obvious conflict of interest in the selection of appraisers by mortgage companies and their desire to close deals and collect commissions and fees.

Similarly, bond rating agencies up to the 1970s were supported by subscriptions and not payments by underwriters that create inevitable problems. A return to subscriptions and fees might take away the rating agencies government-granted monopoly profits, but it would significantly enhance bond-buyer confidence in the reports and ratings they produce.

If improvements in mortgage lending system and bond rating systems are not forthcoming, the volume of collateralized debt and other structured financial products issued will decline. However, a return to greater reliance on banks to lend money and hold mortgages and other loans would raise the cost of mortgages and debt financing through the economy.

When banks hold debt instead of securitizing loans, they borrow short and lend long and that entails obvious, difficult-to-manage risks. Collateralization eliminates that risk--it takes it off the table. Without that collateralization, mortgages would be more expensive and home values would be lower.

Similarly, without more general reforms at the credit rating agencies, the complexity of structured financial products will decline, and costs will increase for financing the reorganizing and rationalization of U.S. corporate assets in a rapidly changing global competitive environment. That will not be good for U.S. investment and economic growth.

If mortgage markets and bond rating agencies are not cleaned up, the amount of structured financial products issued will be reduced, the cost of capital, for all borrowers and equity issuers, will rise, and U.S. economic growth will be needlessly taxed and slowed.

Economic Forecasts

Forecast Previous Period September 28

Personal Income - Aug 0.3% 0.5
Per Con Expenditures 0.3% 0.4
PCE Deflator -0.1% 0.1
Core PCE Deflator 0.1% 0.1
Real Per Consumption 0.4% 0.3

Construction Spending - Aug 0.0 -0.4
Chicago PMI _ Sep 53.0 53.8

Mich Cons Sentiment - Sep 84.0 83.8

Week of October 1

October 1

ISM Index Sept 53.0 52.9
ISM Prices 62.0 63.0

Auto Sales - Sept 16.11m 16.27*
Car Sales 7.45m 7.34 Domestic 5.15 5.03*
Truck Sales 8.66 8.93 Domestic 7.30 7.54
*SAAR as published by Motor Intelligence

October 2

Pending Home Sales Aug 88.2 89.9 (-1.7%)

October 3

ISM Services - Sept 55.5 55.8
ISM Prices 56.5 58.6
ADP Employment - Sept 50 38

October 4

Factory Orders - Aug -2.4 3.7
Durable Goods Orders -4.6% 1.3
Nondurable Goods Orders 0.0% 6.0

October 5

Non-farm Payrolls - August 110k -4
Manufacturing Payrolls -10k -46K
Unemployment Rate 4.7% 4.6
Ave. Hourly Earnings 0.3% 0.3
Ave. Work Week 33.8 33.8
Consumer Credit Aug $9.5b 7.5

Week of October 8

October 10

Wholesale Inventories - Sept 0.3 0.2
Wholesale Sales - Sept 0.4 0.1

October 11

Export Prices - Sept 0.2% 0.2
Import Prices - September 1.3% -0.3 Import Prices, ex petroleum 0.1 -0.1 Import Prices, petroleum 7.0 -1.3
Trade Balance - Sept -$58.1b -$59.2
Treasury Budget -- Sept $95.0b -117.0

October 12

Retail Sales - Sept 0.2% 0.3
Retail Sales (ex autos) 0.5 -0.4
New Vehicles and Parts -1.0 2.8
PPI - Sept 0.2% -1.4
Core PPI 0.2 0.2

Business Inventories - Aug 0.3 0.5

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.