Wednesday, December 5, 2007

FHA: Don't raise the caps just because ...

Interesting piece on sub-prime, from the auto market experience (from NBER).

Money quote:

This kind of sensitivity of repayment to loan size is the driving force in moral hazard models of credit imperfections.
Some evidence that the proposed reforms of the FHA, specifically to raise the cap and to pretend that protection to do so exists by raising insurance premiums at the outset, is the wrong way to go.


As best one can say, from a distance, is that sub-prime lending works best, (a), when amounts are small, (b), leverage in the loan portfolio held by the bank is kept low and, (c) the packages held are financed long-term.

All three of these good-business practices seem to have been violated.

Low doc real estate loans let the amounts lent grow. Those holding the portfolios leveraged up, maybe even as much as regular-way mortgages held. Last, a lot of brokers with portfolios and, apparently, SIVs, ended up with liquidity nightmares, because they financed a big bucket in the short-term markets.

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