The housing collapse the U.S. has endured over the past few years has forced the industry to question some of its most basic assumptions. For decades, the market believed that housing couldn’t broadly decline in value, particularly not substantially. It was wrong. We now know that a bubble can actually result in overinflated housing prices and subsequent national home price declines. As banks and lenders adjust, they may have to revisit the mortgage products they used to believe were very safe. Will the 30-year fixed-rate mortgage survive?
Look Out: Default Risk!
The big surprise the mortgage market has to cope with is default risk. Even though the government-sponsored enterprises like Fannie Mae and Freddie Mac used to guarantee many mortgages, the private sector often didn’t feel that guarantee was necessary. After all, there wasn’t significant default risk. Sure, interest rates might change, and prepayments could come in more quickly than anticipated. But lenders wouldn’t actually lose money on mortgages — they just might not make as much as they thought they would.
Now that they know they could lose money, they must adjust accordingly. One way to do this would be to just have the government guarantee all mortgages. That approach is championed by some. But in this political climate, nationalizing the mortgage industry might not be easy. It’s pretty likely that the government will at least want to make it possible for the private sector to originate some mortgages without a federal guarantee. In order to do so, however, what can lenders do to avoid losses if homes lose value?