Forcing Banks To Put More 'Skin In The Game'

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A portion of the financial reform package announced by President Obama on Wednesday takes aim at the reckless lending practices that led to the collapse of the housing market and a nationwide epidemic of home foreclosures.

Some experts think mortgage companies were sloppy in part because they didn't have any money at stake. In other words, they had no "skin in the game."

During the housing bubble, mortgage companies were throwing money at just about anybody who wanted it, and getting a home loan started to feel sort of like buying a used car.

It didn't used to be like that. Banks used to be really careful about whom they lent money to; their own money was on the line.

Banking industry consultant Bert Ely, 67, remembers when sitting down to apply for a home loan was like going before a judge. "You sat down with a sober banker," he says. Today, "these mortgages are made with the intent of selling, not keeping."

Ely explains that over the years, banks and mortgage lenders started making loans and then selling them off to investors, and when that happened, lenders became more like salespeople. Mortgage brokers and loan officers got their commission regardless of whether a loan was good, and it was somebody else's problem if the loans went bad.

"The lender doesn't care as much about the riskiness of the loan or the eventual likelihood of default if he's going to sell it and not retain any risk," Ely says.

So basically, lenders often don't have skin in the game the way they used to because they're not lending out their own money any more.

Regulation On The Horizon

There were plenty of other problems inside the industry that led to the mortgage debacle and the financial crisis. Ratings agencies failed to determine how risky a lot of these home loans were. But this skin-in-the-game issue has now become one of the targets for reform — both for the Obama administration and for top Democrats in Congress.

"If I can make a whole bunch of loans and sell the entire right to collect those to somebody else, at that point I don't care ... whether or not they pay off," says Rep. Barney Frank (D-MA), chairman of the House Financial Services Committee. "We have to prohibit that."

The House recently passed legislation co-sponsored by Frank that would limit how many loans lenders could sell off to investors. That's called securitizing the loans, because they are bundled up into securities when they are sold.

"We're basically saying now, 'You've got to keep 5 percent of that.' So that if there are losses, you lose money, too," Frank says.

Essentially, the banks have got to have skin in the game.

"That's exactly right," Frank says. "I'm convinced now, if you do not diminish the number of bad loans at the outset, you cannot solve this problem. And one way to do that is to say to the people who are the originators, 'Yes, you can securitize. You can take 95 percent of that and sell it, but you've got to hold 5 percent.' ... And that way we'll just get better-quality loans made in the future."

The Obama administration is pushing for this 5 percent change as well. The president also wants to have mortgage brokers' commissions tied to the longer-term performance of the loans they make.

Unintended Consequences

All this might sound reasonable. But the industry has some concerns.

"On its face, it sounds like a good idea, but there are some unintended consequences," says Tom Deutsch, one of the top directors at the American Securitization Forum, which represents mortgage lenders.

Deutsch says retaining more risk would require lenders to have more cash on hand to cover losses on loans. That could make it harder for banks to lend money, he says. And Deutsch doesn't think the reform is necessary. He says mortgage lenders' inherent interest in their own reputations already gives them enough skin in the game.

"Hundreds of mortgage originators have gone out of business because they sold bad products to investors who wouldn't buy their product again," Deutsch says.

Still others think the 5 percent proposal doesn't go far enough. Ely, the banking consultant, would like to see the U.S. shift more toward what are called "covered bonds" to finance mortgages, an approach that is widespread in Europe. With covered bonds, the banks stay on the hook for 100 percent of the loans that they make. With that much skin in the game, he says, lenders would be much more careful about making loans.

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