In this Krugman-inspired post, I think Zubin Jelveh misunderstands what the proposed requirement for loan originators and brokers to hold 5 percent of any security they sell actually means. It's not intended, as Jelveh and Krugman propose, to keep big banks from selling away risk. It's targeted at mortgage originators, and in fact already came up in Barney Frank's anti-predatory mortgage lending legislation earlier in the year.
In the current system, a mortgage originator can put together a package of sub-prime home loans and sell all of them as securities. Once those loans are sold, the originator doesn't have to worry about them anymore, and the consumer and the investor take the heat if and when the loans fail. The 5 percent requirement is designed so that these originators must hold on to at least some of their loan portfolio to provide an incentive for them not to make bad loans (George Soros thinks it should be 10 percent). But it's not targeted at the investment banks who buy and sell these securities -- the author both Krugman and Jelveh reference, Hyun Song Shin, seems to be talking about something else as well: "US leveraged financial institutions, such as commercial banks, securities firms, and hedge funds," not mortgage brokers and originators targeted by this provision. True, there is some overlap in the institutions originating mortgage loans, but this is a regulation targeted mainly at firms who make their money pushing bad loans and getting them off their balance sheets quickly.
So I do think this is a good idea. But consumer advocates aren't impressed with the financial incentive and think that the real solution is extending legal liability, so that an investor can sue an originator over bad-faith lending, and consumers can sue investors who own their loans if they are predatory. Setting up a chain of legal accountability might be smarter than counting on small financial risks. You can read all about it in our July/August issue, which includes a special report on the credit crisis and a piece on consumer credit by yours truly.
-- Tim Fernholz
