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On a grand level, the problem with Dodd-Frank and the Obama Administration’s attempts to reform the financial system is that they are trying to turn mortgage lending into a no-risk activity, when real estate investing is inherently risky.  We can not re-legislate the laws of economics to change this reality.

The real problem was never weak lending standards to begin with.  It was “free money” created by the Federal government, which ran loose monetary policies under Alan Greenspan from 1997 to 2004.  This was compounded by reckless fiscal policies under the Bush Administration (which have been replaced by the even more reckless fiscal policies of the Obama Administration.)  When you combine these developments with massive Federal subsidies and government backstops in the mortgage lending market, you create a market that provides a “free lunch” to commercial lenders, so long as they can find a way to make more loans.

We have not corrected any of these underlying problems.  Instead, we’ve decided that the symptoms of this flawed system (weak underwriting standards) were actually the true problem, because it’s easier to blame the banks, rather than for the politicians in Washington to blame themselves.

What’s been completely lost in mortgage lending is an analysis of the underlying real estate market itself.  Instead of analyzing a home purchase as a real estate investment (which is what it is), we analyze it under a completely flawed prism where home ownership is some sort of divine right.   Lenders should focus more on whether the underlying real estate is a good investment, and base their analysis on economic alternatives, such as renting out the units.

If price to rent ratios are low, it’s much less likely that a borrower will default in the future, because they’d be giving up an economic profit to do so.  If price to rent ratios are high, this indicates a higher level of risk associated with the pricing of a property, meaning that property value declines are much more likely, and default risks are elevated.

Obviously, analysis of the lender is important, too, but on a basic level, a bank could employ subpar lending standards and still make out OK if the underlying real estate turned out to be a good investment.  Whereas, a mortgage lender could lend out to the most qualified applicants in the world, and still fare terribly if real estate values plunge 40%+, and the borrowers have an economic incentive to default.

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