What mortgage-backed securities and lemons have in common

By Justin Fox | July 21, 2009 | +

Stanford profs Kenneth Scott and John Taylor had an op-ed in yesterday’s WSJ arguing for “mandated transparency” in mortgage securitization. This brought to mind a conversation I had last week with Andrew Dubinsky, who runs a lending software company called Encomia and would love it if somebody mandated more disclosure in mortgage securitization.

Right now, of course, mortage applications are paper extravaganzas, and the vast majority of what gets written on that paper never makes its way to investors. Dubinsky estimates that 2,000 to 2,500 data points are collected when you get or refinance a mortgage. Bundle that mortgage with 499 others into a mortgage-backed security and you’re talking about between 1 million and 1.25 million “discrete pieces of data,” as Dubinsky puts it.

What happens when that MBS is brought to market? The rating agencies get to see 16 data points. Investors get access to two.

These would seem to have the makings of a market for lemons, no?

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http://www.knowingandmaking.com/ Leigh Caldwell

Hi Justin

An important and indeed absolutely fundamental idea.

Sam Robbins and I proposed something very similar – though broader, covering all banking assets and not just mortgages. We have submitted this proposal to the UK’s Walker Review of finance sector corporate governance which reports back in October, so if we’re lucky there may be some chance of it finding its way into the regulatory conversation. Further details:

http://www.knowingandmaking.com/2009/06/our-submission-to-walker-review.html

Banks may at first fight this, because a lack of transparency is of course a natural part of maintaining a premium price. This is why your lemons argument is important, because in a lemons market, it’s in the interests of both sellers and buyers to create transparency.
pneogy

“These would seem to have the makings of a market for lemons, no?”

Given recent experience, the answer would seem to be “yes.” But it does not necessarily have to be so. The rationale for sixteen data points would seem to be that, properly derived, they can adequately characterize the statistical characteristics of the cohort and allow the rating agencies to do a meaningful job. And there is no reason why investors shouldn’t have access to the same sixteen data points to permit them to make an independent judgment.
bryanfromhouston

But if I get to see the same 16 data points as the ratings agency, why would anybody pay attention to them? Especially after their recent poor showing??
pneogy

@bryan: I’m not sure that the sixteen data points are insufficient to characterize the bundle. The problem maight have been with the way they were derived, or the way they were interpreted.