The nation's two largest sources of mortgage funds have agreed to sponsor a new home appraisal watchdog group to prevent inflated home values, Reuters reported Tuesday. Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) will provide $12 million each over the next five years to create the new independent organization to monitor the new appraisal standards.

Seeking to avoid multiple lawsuits by New York Attorney General Andrew Cuomo, the two also agreed to a code of conduct to take effect January 1, 2009, The Wall Street Journal reported Tuesday (subscription required). Further, as the largest purchasers of mortgages, the code will become the effective new standard for the U.S. mortgage industry.

The new code bars lenders from using appraisals ordered by mortgage brokers, and also bars them from pressuring appraisers to supply inflated estimates of property values, which many believe were a major factor in the mortgage crisis.

With media outlets and politicians heaping sympathy on subprime borrowers on the brink of losing everything, it's important to keep in mind the real victims on this mess: that's right, the mortgage brokers who got us into it.

As if plummeting earnings from the decline in subprime lending weren't bad enough, subprime write down poster child Countrywide Financial (NYSE: CFC) canceled its annual ski party at the Rittz-Carlton Bachelor Gulch in Avon, Colorado, where the company puts up 30 of its most valued correspondent lenders (at $725+ per night) and treats them to skiing and $140 caviar and Kurobuta pork osso bucco at Wolfgang Puck's restaurant.

It looks like this year the closest they'll be getting to Spago is the Wolfgang Puck canned dumpling soup available for $31.20 per 12-pack on Amazon.com. Even that might be a stretch in this market. But there's always Chef Boyardee.

The Wall Street Journal [subscription] reports that the way bankers get paid makes them do things that hurt the economy. They get paid based on closing deals -- e.g., sales volume -- not deal quality or profit.

Gary Becker, a Nobel Prize winning economist at the University of Chicago, achieved distinction for highlighting the ways that people respond to economic incentives. His insights have sensitized me to how incentives have skewed behavior in the recent securitization bubble, and I have posted on this topic for the last year and a half (for example, here, here, here, and here).

But the Journal provides details I had never seen until now. Here they are:

• Mortgage broker gets 0.5% to 3.0% of deal volume based on loan size, types, and terms
• Lender gets 0.5% to 2.5% of loan for selling the mortgage to an investment bank
• Bank/bond issuer gets 0.25% to 1.25% of Collateralized Debt Obligation (CDO) issue
• Ratings agency gets paid by bond issuer to give the highest rating
• Bank CEO gets big pay day even as he departs for making the bad loans

During the recent housing boom, people with lousy credit were not the only ones financing their purchases with subprime mortgages. The Wall Street Journal [subscription required] reports that in 2005, 55% of borrowers with good credit ratings -- who could have signed up for prime mortgages at lower interest rates -- got subprime mortgages instead.

Specifically, the Journal analyzed $2.5 trillion in subprime loans made since 2000 and found that as the number of subprime loans mushroomed, an increasing proportion of them went to people with credit scores -- above 620 -- high enough to often qualify for conventional loans with far better terms. The study by First American LoanPerformance, a San Francisco research firm, found the proportion rose to 61% by the end of 2006, up from 41% in 2000.

Why did this happen? The mortgage brokers got higher commissions for selling subprime loans. On average, U.S. mortgage brokers got 1.88% of the loan amount for originating a subprime loan, compared with 1.48% for conforming loans. As a result, the brokers did not notify borrowers with good credit of the "yield spread premium" equal to 2% of the loan amount -- or $8,000 on a $400,000 loan -- if a borrower's interest rate was an extra 1.25 percentage points higher than the listed rates of the subprime lender, in this case the now defunct New Century Financial.

How could we keep this from happening in the future? Bright red letters on the cover of a mortgage document disclosing the broker's compensation scheme might be a good start.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.

This morning UBS AG (NYSE: UBS) said it expects a loss of up to $690 million while Citigroup (NYSE: C) said it expects a 60% decline in profit -- but still managed to expect a profit. The difference? European banks like UBS were only marginally brighter than the poor U.S. subprime mortgage borrowers because they actually fell for the line that packages of subprime mortgages were safe, high yielding investments.

It's worth remembering that the mortgage industry value network is complex. No longer does a mortgage bank issue a mortgage and keep it on its books. What happens now is that a mortgage broker convinces a borrower to sign a mortgage contract. The originating mortgage bank then turns around and sells that mortgage to a Wall Street investment bank that packages the mortgage into a mortgage-backed security (MBS) which it quickly gets off its books -- and onto those of European and Asian investors, like UBS, which are now paying the price for their gullibility.

How big of a price? UBS is taking a $690 million loss and firing 1,500 workers due to the $3.4 billion writedown of the value of its MBSs -- but I think it's curious that it still has $19 billion of MBSs with which it is "comfortable." Meanwhile Citigroup's problems are more complex -- it will take $1.4 billion in pretax write-downs on leveraged buyouts it is helping to finance, $1.3 billion in pretax losses on subprime MBSs and $600 million in pretax losses on fixed-income trading.

Citigroup looks like a better diversified sucker. While Citigroup took pain from its MBSs, it also suffered from LBO loan writedowns. Nevertheless, Citigroup looks like it will stay in profitable territory.

But with its shares down 16% in 2007, its performance is nothing to cheer about.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns Citigroup shares and has no financial interest in UBS.

Almost 60% of customers of mortgage brokers with adjustable-rate mortgages were unable to refinance their loans, according to a truly frightening survey released today by Campbell Communications.

Sub-prime borrowers were having difficulty refinancing because the programs that had been available to them had dried up and prime borrowers were being hurt by appraisals and high loan-to-value ratios, according to a Reuters story.

The implications of this are huge.

Without refinancing, millions of people with adjustable-rate mortgages whose interest rates are set to increase are in danger of foreclosure as are countless prime borrowers. People may be less likely to do home improvements such as adding decks or upgrading kitchens and bathrooms, which often had been paid for by second mortgages. Homeowners may keep a closer watch on discretionary spending by cutting back on things like vacations.

To be sure, many of the people who are in a precarious financial position are speculators who thought they could make a quick buck "flipping" houses. Others, though, were victimized by unscrupulous mortgage brokers and deserve assistance from the government in finding an affordable loan.

This data bolsters the argument for Federal Reserve Chairman Ben Bernanke to cut interest rates. But the power of the Fed isn't going to do much to help people facing a huge increase in the costs to stay in their homes.