Aiding Subprime Borrowers: Congress vs. the Fed
In addition to lending a hand to lower income borrowers (see my previous post), the recent bills passed by the House & Senate also propose greater regulation of mortgage lending practices. This is partially a reaction to the Fed's lack of oversight of oversight in this area during the run-up of the housing bubble under Greenspan. And it brings into question who regulates mortgage lenders that fall outside of the US banking system.
The legislation proposes the following:
• Require lenders to have a fiduciary responsibility to their customers
• Require that originators ensure that borrowers have the ability to repay their loans and
• Ensure that refinancing would have a ‘net tangible benefit’ to the borrower.
The purpose is to discourage predatory lending practices. Requiring lenders to have better documentation on customers - such as proof of income, is a good thing and shows that proper due diligence has been done.
As for ensuring a borrower’s "net tangible benefit", the law would have to be VERY clear on how it defines this term. How would a lender ensure this? Would the FHA provide some guidance?
In my experience with regulation, laws with good intentions can backfire in the worse way. Unless the practice of evidencing “net tangible benefit” is clearly accepted within the scope and intent of the law, it will pave the way for litigators to sue mortgage lenders out of business.
As a result, the law as it is proposed can discourage lenders from taking risks, thereby holding back on providing loans, which can reduce homeownership. I doubt that is what Congress intended.
Enter the Fed
The Fed has been criticized for being asleep at the wheel during the housing bubble run-up. According to yesterday's Wall St. Journal, efforts to have the Fed oversee mortgage lenders by non-banking companies were opposed by Greenspan: "Fed's New Rules On Mortgages Draw Hostility":
Alan Greenspan, then Fed chairman, opposed the move, Mr. Gramlich said. Mr. Greenspan has confirmed his opposition. More recently, Mr. Greenspan told National Public Radio there was little the Fed could have done short of a sudden increase in interest rates that would have popped the housing bubble and also "broken the back of the economy."The Fed’s primary oversight responsibility extends to financial services holding companies and banks that are members of the Federal Reserve system.
The Fed’s new plan, unveiled this week, seeks to accomplish the same goals but by taking a different approach:
• Cover prime and subprime borrowers
• Require lenders to assess subprime borrower’s ability to repay loans from sources other than rising home values
• Clamp down on payments to mortgage brokers that can encourage them to earn profits on loans at the expense of customers
o Bar lenders from making high cost loans that rely on unverified income or assets
o Ban lenders from paying mortgage brokers bonuses beyond what consumers have agreed in advance the brokers would receive.
• Require lenders to establish escrow accounts to ensure that subprime borrowers pay insurance and property taxes, a common practice for prime loans.
Both Congress and the Fed want to show they can ensure against anothe subprime meltdown. IMHO the Fed’s approach is more sensible. It has a team of examiners and expertise in bank policy and risk management to provide effective oversight. The issue is that the Fed is showing up late to the game as the plan would address lending practices going forward but won't do much to address those who are already at risk of default. The market is already working itself out in this regard, as mortgage lenders have already tightened up their lending standards and total subprime loan originations have dropped significantly. To the right is a chart showing you the projected drop of subprime loan originations in 2007 to about $200 Billion, far lower than the nearly $600 Billion in subprime loans issued over the past two years. Hopefully either Congress' or the Fed's plan help prevent another mess in the future. This being a hot issue during an election year, however, anything can happen. Stay tuned.
Posted by Jeff Bernstein
Fri Dec 21st, 2007 09:25 AM
I agree whole heartedly with your observation about the un-intented consequences of government regulatory actions taken ex post facto. They usually casue more pain in the asset/investment category that had the abuses. I wrote all about this in my Asset Cycles piece on Urban Digs over the summer. It's typical in bubbles that reactionary legislation makes the down cycle worse. I agree that reforms are needed, but these governemnt entities should be paying a lot of attention to how much they will may accelerate the downcycle in the shorter-term if legislation is too harsh. By the way welcome aboard. I look forward to working with you on Urban Digs.
Posted by Beth Olarsch
Fri Dec 21st, 2007 10:53 AM
Thanks, Jeff - same here!
And you're right, I hope this doesn't turn into another knee-jerk reaction from Congress, like Sox or Glass-Steagall. Exising resources (regulations, agencies) are already available. And it's not just bank regulations, also consumer protection and bankruptcy laws that come into play.
It all comes down to who's the most successful at lobbying Congress.
Posted by drtomaso
Sun Dec 23rd, 2007 01:25 PM
I am of two minds of the coming house/senate legislation. On the one hand, it does seem to have regulations for curbing some of the wanton predatory lending we have seen.
On the other hand it takes a swath of unqualified borrowers, who in decades past would have remained renters, and effectively gives them government insured loans. In that regard, this is a massive easing of lending restrictions. When they continue to default (falling home prices being the single biggest factor in defaults), now mine and yours tax dollars will go to fulfilling the governments promise of insurance.
That said, I think predatory lending is being scapegoated in this whole affair. While I do not doubt it was a problem- I dont think its the main one. The main one is securitization. What incentive to mortgage lenders have to follow common sense lending standards when they will not be left holding the bag when the loan defaults? The loan is sliced and diced and spread to investors accross the world. The market is already taking corrective action on this- this paper is now trading at pennies on the dollar.
For the most part, you didnt have to prey on borrowers- they would gleefully sign their name to any mortgage, even those with ridiculous terms, because hey, "Real Estate always goes up!" Thankfully that message is now only aired in the late night infomercials.