What if the Mortgage Companies Failed?

Would there really be a problem if these entities just failed? Are they like banks in that they would start contagion

This is the question asked by James K in a comment on a previous post.

The answer is, I'm not sure. I'm not an expert in the mortgage industry by any means. But what happens is that the mortgages get packed and sold to investment firms. As the high-risk packages, made up of the sub-prime mortgages, are not being repaid, nobody wants to buy those right now, and so the investment banks that sell them are currently refusing to make funds available to the subprime mortgage firms. That is, the investment banks are the secondary lenders that make money available to the primary lenders (who make the money available to the home buyer), which, if I understand correctly, they do by purchasing the loans from those primary lenders (that purchase refills the coffers of the primary lender, so they can make more loans).

If I have that wrong, I hope someone corrects it.

So I suppose the danger is that large losses accrue to the investment banks themselves, reducing the supply of credit available in general, perhaps wiping out mom and pop's lifesavings, and in general creating the "contagion."

But I have doubts the contagion would create a long-term depression, as opposed to a short-term slump--a "correction: if you will. Keep in mind that it's primarily the sub-prime loans that aren't being repaid. Those are buyers who over-extended themselves. Most of them aren't impoverished, and haven't gone to living on the street, but have had an income decline they couldn't afford because they were living on the edge. Foreclosures are at about 1 in every 200 homes, and housing prices have declined--in some areas--by 10-20%. That sounds horrible, but it's only .5% of homes, and the values haven't been totally lost. That is, the lenders can regain some of the money that the defaulters can't repay by selling the house at a lower price.

So the lenders will lose money. Fannie Mae and Freddie Mac--government created, but publicly traded, lenders--have lost, respectively, $1.3 billion in the last quarter and $5 billion in the last year. That's big amounts for those firms, but they're also the biggest mortgage backers in the country, so they're taking the lion's share of the losses. Quadruple that amount and it's still not that big a chunk of the U.S.'s $13 trillion economy.

And of course saving the mortgage firms doesn't come free. There's not some great untapped reserve of money that can be used painlessly to save them; the money will be diverted from other uses. Or more likely, we'll try to borrow more by selling more federal securities, thus continuing upward pressure on interest rates, with the attendant economic effects. Notably, what I've noticed in the arguments for rescuing the mortgage industry is a focus only on the primary effects on the industry itself--I haven't seen much on the secondary effects of industry failure or secondary effects of industry rescue. I rather suspect Bastiat's ghost might be muttering something about the seen and the unseen. I think the real question is which course of action has the greatest benefit/cost ratio.

If there is some reason to mitigate the losses, I think it would be wise to do the minimum--do what it takes to keep the effects from snowballing and wreaking great harm to the economy (and let's face it, at 5.7% unemployment, our economy is a long way from being wrecked), but not enough to let the lenders off the hook for their bad decisions.