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The CDO Market Solution for Future Housing Bubbles

Published by Lawrence Roberts | December 26th 2008 | Views:

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The solution to preventing future bubbles in the residential real estate market lies in the market for collateralized debt obligations and conforming loans insured by the government sponsored entities (GSEs). The GSEs created the secondary mortgage market in the 1970s, and the CDO market is the extension of this market bringing large amounts of investment capital to residential real estate. During the Great Housing Bubble the CDO market did not properly evaluate the risk of default on the underlying mortgage notes they pooled.

If the CDO market were to evaluate mortgage default loss risk based on the income approach rather than the comparative-sales approach, the performance of CDOs would be greatly improved, and investor confidence would return to the market. It is only after the risks are properly evaluated that capital would return to this market.

If the CDO market evaluates risk based on the income approach, the lenders that originate loans hoping to sell them to CDOs would be forced to do the same. If lenders originate loans based on the income approach, the irrational exuberance that creates financial bubbles would not be enabled. People would still be free to overpay for houses with their own money, but the scope and scale of financial bubbles would be limited to the funds of buyers, and the banking system would not be imperiled by the foolishness of the market masses when prices fall to fundamental valuations based on rent and income.

As was demonstrated in the aftermath of the Great Housing Bubble, these periods of lender losses can imperil the entire banking and financial system. The only way to prevent the pain of loss is to recognize the end-game risks when prices are increasing and choose not to participate in that lending environment. Many lenders did not participate in the crazy lending of the Great Housing Bubble, and they were not significantly damaged in the aftermath; however, the hunger for mortgage loans from the CDO market compelled many lenders to participate or get buried by their competitors. The only real market-based solution to the problem of originating bad loans must come from the CDO market.
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