(This is Part 1 of a six-part series. Read Part 2, Part 3, Part 4, Part 5 and Part 6.)
Consumer groups believe that lenders should not allow borrowers to take mortgages that aren’t suitable for them. Lenders who do allow it should be held liable.
The case for suitability looks both simple and plausible, and it seems to be making headway in Washington, D.C. A federal suitability rule has worked in the securities industry, or so goes the argument, so why wouldn’t it work with home mortgages?
One major difference between the two markets is that the securities market has only one problem to which suitability is directed: preventing unsophisticated investors of limited means from being sold securities that are too risky for them. The home mortgage market, in contrast, has multiple problems for which suitability has been offered as a remedy.
Borrowers are often steered to the wrong mortgage, to a mortgage that is unaffordable, to a refinance that provides them with no net benefit, or to a high-price-loan provider. It would be surprising if a suitability standard were the remedy for every problem.
My procedure in this series of articles will be to examine each of these problems, ask whether a suitability standard is an appropriate remedy, and if suitability would not work, whether there is another remedy that would work.
I begin with the problem of bad mortgage selection. This is the closest analogy to the securities market problem, because bad mortgage selection in many cases means placing borrowers in mortgages that are too risky for them.
The following letter is a composite of many I have received recently from borrowers who took out option ARMs (OAs) in 2005 and 2006:
“I took this loan because the monthly payment was much lower than any of the alternatives … The interest rate was only 1 percent because I qualified for a special program … I was led to believe that it would last for five years … I realize now that it didn’t and that my loan balance has been going up every month … I am afraid that next year my payment is going to increase so much I won’t be able to afford it … How do I get out of this mess? Do I have recourse against the loan officer (broker) who talked me into it?”
OAs, along with interest-only mortgages (IOs), which have some similar features, are marketed to borrowers who are attracted by the lower payments. In all too many cases, however, they don’t understand why the payments are lower, and are not prepared for the risks of higher payments in the future. The marketing, furthermore, is often based on deception.
Until recently, bad mortgage selection was a minor problem. That changed in 2005 and 2006, however, when the volume of OAs and IOs exploded.
If lenders were held liable for making unsuitable mortgages, they would have to delegate operating responsibility to those who deal directly with borrowers: loan officers and mortgage brokers, who I will call “loan providers.” But having loan providers judge suitability would be like having the coach of a contending team also serve as the referee.
Loan providers have a personal financial interest in the outcome. Their business is selling loans. Judging that a loan is not suitable for a borrower would cost them money.
What has made the suitability standard workable in the securities industry is that the short-term interest of brokers in selling unsuitable securities is usually overruled by their long-term interest in maintaining a roster of satisfied clients. While transactions-oriented operators looking for the fast buck exist, they are on the periphery of the industry.
In the home mortgage market, in contrast, client-oriented loan providers are the minority group. The majority sell loans.
But determining mortgage suitability by a referee wouldn’t work even if the referee were uninvolved in the outcome. Determining the suitability of an investment or a mortgage requires balancing the objectives of the client against the risk of the instrument. In the case of investments, this is relatively easy because the client’s objective can almost always be framed in terms of rate of return.
The objectives of mortgage borrowers, in contrast, are diverse, complex and often not known by the loan provider. Here are five objectives that have been reported to me by borrowers who have selected IOs and OAs:
- Reduce cash outflow to invest the excess in securities;
- Reduce cash outflow to pay down a second mortgage;
- Pay principal when convenient;
- Buy more house; and
- Reduce payment to avoid default.
I sometimes get involved in an interchange with borrowers on whether their particular objectives are worth the risk, and sometimes I express my opinion to them quite forcefully. I would not want the legal right to overrule them, however, because I am not that smart.
An alternative approach to the problem, which has recently been proposed by an interagency group of federal regulators, will be discussed next week.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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