Why Not Protect Borrowers? (Subprime Edition)

So far, it hasn’t gotten much attention in the mainstream business press, but Bloomberg and the Financial Times are very much on top of the story: the House Financial Services Committee is moving forward with proposals to impose new regulations on subprime lending. And Democrats and Republicans are largely on the same page.

There are several key notions in play. One of that of creating liability for “mis-selling” and holding not only the lender but the mortgage broker and conceivably even the packager and underwriter liable. According to the FT:

In particular, senior figures in Congress hope to force the financiers who buy mortgages and create mortgage-backed securities to share some of the liability – and thus financial cost – that might arise if mortgages were mis-sold to borrowers who proved unable to meet payments.

The move, which will be debated by the House financial services committee next week, could reduce the flow of finance from capital markets into the mortgage sector. Some politicians in part blame such flows for the lax lending practices that developed in the subprime market in recent years.

It forms part of a package of measures that politicians are proposing to prevent a recurrence of the subprime lending problems – initiatives that will also include tougher rules about how mortgages are sold to home buyers.

“We will regulate mortgage brokers,” Barney Frank, chairman of the financial services committee, told the Financial Times yesterday….

But Mr Frank said he hoped the measures would be passed by the end of this year. “It is no part of my concern whether investment banks make money . . . the purpose of housing finance is to get people in houses, not to finance the US financial markets,” he said. He added that securitisation had been “a part” of the recent rush of liquidity into the sector.

“Securitisation has not been an unalloyed good thing,” he said. “We have a situation where unregulated entities have made these loans and no one now is responsible for it. There is a complete absence of any place to look when things go wrong.” Mr Frank, a Democrat, said yesterday he had still not agreed with Republican politicians on the financial services committee on the details about how mis-selling liability might be assigned to those involved in securitisation.

However, Spencer Bachus, Mr Frank’s Republican counterpart, has backed an “assignee liability” system that would essentially mean investment banks and others who repackage mortgages into bonds would be liable to pay compensation to borrowers if loans turned out to have been mis-sold, unless they can show they conducted due diligence. Such a move would make it less attractive to repackage these loans and to buy mortgage-backed securities.

Bloomberg reported that New Jersey’s approach was being considered as an approach:

Bachus [the ranking Republican on the Financial Services Committee] said he favors legislation similar to a law enacted in New Jersey in 2003 enabling homeowners whose loans are the result of predatory lending to gain compensation from lenders and investors who purchased the mortgages. The indemnity includes attorneys’ fees, the borrower’s total loan payments and the cost of terminating the borrower’s remaining liability.

The New Jersey law erected safeguards against predatory lending, including a requirement that lenders certify that borrowers can repay the loan. The borrower must receive financial counseling when financing mortgage points and fees, which may not exceed 2 percent of the total loan amount.

Note that the New Jersey law provides for the assignee liability mentioned earlier, because it allows them to recover damages from funding sources.

I will discuss these particular proposals and the pros and cons of assignee liability in a later post. Let’s focus on the general case: why borrower protection is a good idea.

Before I hear howls that regulation interferes with the operation of “free” markets, let me point out that markets that have any degree of efficiency are highly regulated. The mortgage securities markets that provided the subprime monies are subject to SEC regulation about disclosure (ie, the description of the securities and the issuer); closing and settlement; how brokers quote prices and take orders; what conditions a firm has to satisfy to be a broker/dealer (which include having its principals and customer staff pass certain exams to prove their knowledge of relevant laws). Banks are subject to a different, but similarly elaborate, set of regulations. I could go on, but you get the point. We aren’t talking about regulating an unregulated sector; we are talking about possibly adding a few provisions to a large body of existing regulations.

And note that the subprime problem originated with over-zealous mortgage brokers, the least regulated entities in the mortgage securitization chain.

Securities regulation has two objectives: investor protection, and preserving the safety of market participants (meaning the firms). Banking regulation is skewed somewhat more in favor of institutional soundness, since federal deposit insurance was considered to take care of the main element of customer risk, namely, safety of deposits. However, there are consumer regulations, such as “fair lending” (meaning anti-discrimination) and proper disclosure. Note also that there was existing legislation, “The Home Ownership and Equity Protection Act” which was specifically designed to curb predatory practices in the subprime mortage market. It was ineffectual because it was inadequately enforced and only a minority of participants in the subprime market were subject to it.

To recap: investor protection is a central notion in securities regulation; by contrast, borrower protection is a spotty, case-by-case affair. Why? After all, what investors stand to lose is savings, meaning surplus (remember these laws were enacted before the days of widespread retirement accounts, which are subject to a separate set of regulations under the Bureau of Labor). Borrowers who go bust can not only lose savings, but have their wages garnished. The risk to their financial security is arguably greater.

The answer is, until fairly recently, no sensible bank (and lending was done only by banks or by friends and family) would knowingly make a loan it was unlikely to have repaid. So the bank’s interest in prudence was aligned with the borrower’s interest not to go over his head. Now this did make for some intrusive procedures, like income verification and inspection and recording of collateral.

Several factors intervened. First was banks’interest in promoting efficiency over prudence. As Tanta of Calculated Risk pointed out:

Telling the difference between the victims and the victimizers, the predators and the prey, and the fraudulent and the defrauded, is getting a lot harder when you have borrowers not required to make down payments able to lie about their incomes in order to buy a home the seller is overpricing in order to take an illegal kickback. The lender is getting defrauded, but the lender is the one who offered the zero-down stated-income program, delegated the drawing up of the legal documents and the final disbursement of funds to a fee-for-service settlement agent, and didn’t do enough due diligence on the appraisal to see the inflation of the value. Legally, of course, there’s a difference between lender as co-conspirator and lender as mark, utterly failing to exercise reasonable caution, but it’s small comfort when the losses rack up….

I want to talk about the extraordinarily widespread “insufficient caution” problem in this industry: the lenders who are just too easy to defraud….It often seems as if the industry just stopped believing that it could ever really be at risk….

Asking for income documentation, ordering tax return transcripts prior to closing, requiring settlement agents to fax the final purchase contract to the lender for approval prior to close, enforcing arm’s-length transaction rules: this stuff isn’t hard to do, and it will not catch everything but it will sure catch a lot, and it’ll catch it before you close, which is really the cool part. So what’s the response whenever you suggest these things? It costs too much. It takes too long. It drives up transaction costs and therefore puts a drag on home prices. It “unfairly” takes its bites out of our favorite new borrower segment: first time homebuyers, self-employed entrepreneurs, real estate “investors.” It makes loans harder to sell and securitize instantly and cheaply. It makes it harder for an originator to make those representations and warranties based on the bliss of ignorance. It could bring down the whole secondary market as we know it!….

As an aside, let me point out something unpopular. The economy functioned before we had a subprime market. And some economists believe that homeownership is bad for workers (meaning all of us who don’t clip coupons), because it lowers labor mobility.

The second factor was securitization. When you change banks from lenders to originators, you also change their incentives and mindsets. And the rich fees for subprime origination created a very large incentive to push product.

The third was increased product complexity. Let us face it: if you present a consumer with a mortgage that has points and resets, how many are capable of modeling it to judge the risks to them? So as the lenders are getting less cautious, they are also serving up product that are harder for borrowers to assess. And behavioral finance has found that most people are overly optimistic. So if they harbor some doubt about their ability to repay, they are highly likely to honestly underestimate it.

Fourth is unwitting signalling by lenders. Let us (generously) assume we have a mortgage broker that is merely, um, generous (as opposed to predatory, like Ameriquest, which paid a $295 million settlement for its abusive practices). Person wants to buy house. Broker tells him how much he can borrow, which is much more than he expected. Person starts to fantasize and goes out and looks at bigger houses than he would have otherwise. Person comes back with specific house to obtain mortgage. Broker shows him terms. Person is smart enough to recognize that he will almost certainly have to refinance when his mortgage resets in two years, and goes ahead.

What went on here? Twice the lender signalled confidence, first in the borrower in offering a bigger loan than expected, second by offering a loan that both parties understood would have to be refinanced in any reasonable scenario. The second signal was a vote of confidence in the housing market, that it would appreciate.

Aside from the fact that these signals stroke the borrowers’ ego and/or greed, the borrower has every reason to think that the lender is more expert than he is. He is in the market every day, evaluating customers and properties. This optimism from a source that historically has been conservative likely had a bigger impact around the margin than is commonly recognized.

Fifth is that debt defaults have a bigger impact on borrowers than before. Under the new bankruptcy law, recently purchased houses are not protected (and the repayment terms are draconian). A mortgage default not only prevents the consumer from borrowing on anything but very expenisve terms for seven years, until it rolls off his credit record, but may bar him from certain jobs, since employers increasingly review credit reports as part of their due diligence.

All these factors point to changed circumstances that make greater borrower protection a reasonable measure. It took the crash of 1929 and the destruction of investor wealth to produce our effective and widely copied securities laws. The subprime meltdown is not of the same magnitude, but it is nevertheless a crisis for a significant number of individuals and certain communities. While no solution will be perfect, it would take only a small number of new provisions to forestall many of the problemmatic practices that led to overly generous, and ultimately destructive, subprime lending.

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