(This is Part 3 of a six-part series. Read Part 1, Part 2, Part 4, Part 5 and Part 6.)
Consumer groups believe that lenders should be held liable if they allow borrowers to take home mortgages that aren’t suitable for them. The first two articles in the series looked at suitability in connection with mortgage selection — borrowers taking mortgages that are excessively risky for them.
I concluded that loan officers and mortgage brokers have neither the incentive nor the competence to apply a suitability standard to mortgage selection. The appropriate remedy to selection of excessively risky mortgages is a sharply targeted disclosure rule.
This article looks at suitability as a possible remedy for another problem: unaffordable loans. Suitability proponents argue that loan providers should be held responsible for making loans that borrowers cannot afford. But what exactly does that mean?
There are two kinds of unaffordable loans. The first kind is based solely on the value of the house, so it may or may not be affordable. The loan provider doesn’t consider affordability in underwriting the loan. Suitability proponents believe that such loans should never be made, and that view has been echoed by regulators from five federal agencies.
I disagree. Reverse mortgages, which are growing rapidly in popularity, are based strictly on collateral. Affordability is not an issue with reverse mortgages because the loan will be repaid out of the eventual sale of the property.
Reverse mortgages are not an exception that proves the rule. I have encountered numerous situations where collateral-based lending was clearly in the interest of the borrower. Some are based on the premise that the loan will be repaid by sale of the property.
In one case, described in detail on my Web site, I worked with a mortgage broker to keep a low-income widow in her home for the five more years she wanted to stay there. She had a lot of equity but couldn’t afford the taxes. The mortgage that allowed her to stay in the house would not meet any affordability test.
Other cases involve financial stringencies viewed as temporary by the borrowers, which collateral-based loans allow them to weather. Because of the collateral, the lender need not second-guess the borrower’s judgment that the stringency is temporary, a critical point when the loan amount is too small to justify high origination costs.
If collateral-based lending were ruled illegal for institutions, the borrowers who need them would have nowhere to go except to the “hard-money lenders” — individual investors who specialize in collateral-based lending at high prices.
The second type of unaffordable loan is not known to be unaffordable when it is made but proves to be unaffordable in the event. Nobody makes loans known to be unaffordable at the outset except collateral lenders, as discussed above, and perpetrators of fraud. In all other cases, loans are considered affordable when they are approved, but some turn out to unaffordable.
Is the volume of unaffordable loans too large? That would mean that underwriting requirements are too liberal. Underwriting requirements are the rules that must be met for loan approval. These rules cover the down payment, housing-expense-to-income ratios, property type, documentation of income and assets, credit score, loan purpose, and other factors.
There is no question that the standards have become more liberal over the years, as lenders have learned how to offset high-risk factors with low-risk factors, and to price for varying degrees of overall risk. The positive side of this is that millions of households have become homeowners who in earlier decades would have been shut out of the market.
Perhaps the costs associated with borrowers who fail, both to them and their communities, more than offsets the benefits to those who make it. The interagency group set up last year to provide guidance on “nontraditional mortgage product risks” recommended a number of measures to restrict underwriting standards. However, they provided no evidence that existing standards are too lax.
My major concern is that a suitability standard of affordability will be applied after the fact to make lenders responsible for failed loans. Most failed loans had weaknesses when they were made, so it is all too easy, with the benefit of hindsight, to argue that they never should have been made.
But a very large proportion of mortgage loans have weaknesses when they are made, yet the great majority of those pay on schedule. Making lenders responsible for those that don’t would be a back-door way to force a tightening of underwriting requirements. This would reduce the availability of loans to the weakest categories of potential borrowers, most of whom repay their loans. They are a silent majority.
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.
