Mortgage Industry Regulatory Reform

Having had the temerity last week to propose some regulatory reforms, I have had feedback from a number of quarters. So let me amplify with six ideas that I have seen proposed in print recently and explain why they should be rejected, and then move on to the six that I think have some legs. My claim to some authority in this area is that I worked as an economist for four years for the Federal Reserve Board and the FDIC in Washington, founded the Journal of Financial Education in 1971, and have taught finance to MBA students for 20 years. But I’m not a mortgage industry practitioner and I greatly appreciate both the practitioners and the consumer advocates who have filled me in on some of the nuances of the business. Their hope has been that I will come up with a useful list of proposals. Here’s where I am now.

Six Rejected Ideas

1. “Make it a free-for-all. Let Wal-Mart compete. Could it be worse?” Comment: It already is a free-for-all. The competition is tough and with property values turning down there are too many brokers in the industry. It will be devastated enough without letting Wal-Mart loose on what is left during the next few years. All of the brokers have been originating to the guidelines of a lender or securitizer.

2. “Require mortgage brokers to serve clients. The documentation is too hard to read and understand.” A mortgage broker has to serve both the lender and the client. A broker’s career and assets are continually at risk. In a normal market prior to 2000, brokers who delivered lousy paperwork were finished. A real estate purchase is a complicated transaction. The options are to check the details, ask a friend, go to a government or nonprofit counselor for help - or pay for an attorney.

3. "End loan fees and commissions. Too many people were put into the wrong mortgage because their broker was paid extra.” Loan fees have been shrinking. Every line of work has its shady operators. But brokers provide an important service and have to eat. The fact is, brokerage firms of any kind earn more income from loans that carry higher rates.

4. “Allow any organization in the mortgage-making process to rebate a business partner to get extra sales." Most state laws at present prevent a broker from providing kickbacks, and so do HUD’s RESPA rules. Why would kickbacks be an improvement? Combine this proposal with letting in Wal-Mart and…

5. “Prohibit stated-income mortgages.” When stated-income mortgages were first introduced in 1980, they worked. These loans had special requirements that were unfortunately eased in 2000, i.e., a higher down payment, reserves after closing corresponding to income claimed, and a minimum two-year documented history.

6. “End the size limit on conforming loans for government-sponsored mortgage packagers.” The conforming loan size limits make sense for several reasons. Fannie Mae and Ginny Mae are not meant for mortgages on mansions. The diversification of loans works better with many small loans than a few big ones.

Six Serious Ideas for Regulatory Reform

Bernard Shaw said that the lesson of history is that we don’t learn from the lessons of history. But it doesn’t have to be so.

The Fed was created because of the Crash of 1906, during which the Dow dropped from a high of 103 to 53 in 1907, contributing to the Bankers' Panic of 1907. The FDIC and SEC were created out of the stock market crash of 1929 and the bank panics that followed. The Office of Thrift Supervision was created to supervise what was left of the Savings and Loan industry after its meltdown following the recession of the early 1980s. Sarbanes-Oxley was created in July 2002 after the two largest bankruptcies in U.S. history, Enron and Worldcom following the stock market declines of 2000-2001. Now we have another stock-market decline and a financial-market freezeup on our hands. Can we introduce some regulatory reforms that will stave off another phony boom and real bust soon? How about these:

1. Establish an Interagency Committee on Affordable Housing and Keep It Going Afterwards. The Council should be created immediately as a multi-stakeholder initiative, bringing together all the regulators – FRB, OCC and OTS, FDIC, SEC, HUD – and representatives of industry, consumers and local government. It’s important to include everyone. We don’t want a fast-track set of laws that are then the subject of contention for years (as in the case of the Sarbanes-Oxley law). HUD has been working on behalf of people trying to finance the purchase of a home for 30 years.

2. Introduce New Prohibitions against Predatory Lending. Some state laws aimed at predatory lending have been praised. The North Carolina Predatory Lending Law of 1999, for example. It applies to mortgages of $300,000 or less that carry a rate of 8 percent above a benchmark U.S. Treasury rate. It prohibits negative amortization, interest-rate increases after a borrower default, balloon payments and other features associated with predatory loans, say three Wharton professors.

3. Stop SIVs. By enforcing existing bank regulatory laws and FASB principles, end the dangerous Structured Investment Vehicles, which can be spun off with no capital and potentially disastrous contingent liabilities to the issuer.

4. Mandate that the SEC Watch Wall Street’s New Instruments. Someone has to keep a risk-assessing eye on what is cooking in the Wall Street derivative kitchen. The SEC was missing in action from due-diligence oversight back in 1999 when the dot-com IPOs were cooking and then again when the toxic CDOs were on the stove.

5. Encourage the FDIC to Price Risk More Aggressively. The FDIC has some latitude in requiring higher deposit insurance premiums and it should have more. Introduce the Basel II bank capital-adequacy guidelines ahead of schedule. Financial innovation should never override the basic mission of the bank regulatory agencies, which is to ensure orderly markets. The Northeast United States has not had as serious a problem with subprime loans as the rest of the country. The credit for this should go to stuffy Northeast bankers.

6. Raise the Profile of the Fed's HOEPA Consumer-Protection Activity and Make Basic Financial Education a National Priority. The Affordable Housing Council should provide counselors in every city that will look at proposed deals, provide free advice to would-be borrowers, and keep an eye on local credit practices. Counseling works. Just as a buyer of a drug at a pharmacy must sign a waiver of consultation on a prescription that is filled, every borrower must sign a statement saying that they are aware of the availability of local counseling services (with addresses and phone numbers provided). The counselor should be empowered to report an especially bad deal to an oversight body. States with counselors at the state and county level help ensure that low-income mortgages have default rates below the FHA's.

MORTGAGES | Where Were the Regulators?

Feb. 17, 2008–Matthew Padilla asked in the Feb. 15, 2008 Orange County Register, "Where Were the Regulators?" He says he started writing on loan delinquencies in June 2006 with a critical profile of Irvine's ECC Capital, which was accused of the now-familiar offense of making loans to borrowers who could not afford them long term (e.g., after the teaser rates expired). It was this issue that state attorneys general raised (and settled) with Ameriquest Mortgage in Orange.

Padilla asks whether it is the government's job to protect consumers from making bad choices. Should the government have cracked down on brokers who pursued bigger commissions by selling consumers loans that were unaffordable over time? He specifically asks whether the Fed should have done more with its 1994 HOEPA consumer protection powers and whether the FDIC moved quickly enough (e.g., on Fremont Investment & Loan). He also asks whether California was too lax and what role California's AG play in getting a 49-state settlement with Ameriquest in 2006.

Comment: Matt has a lot of good questions. With hindsight, the regulators surely should have intervened earlier. But Chairman Greenspan told the Greenlining Institute (as reported by Gretchen Morgenson of the NY Times on December 18) that he didn’t want to interfere with financial innovation. Would Edward Gramlich have taken such a benign view of lax regulation if he were rewriting his article for the Kansas City Fed from today's vantage point? How many of the 12 million homeowners financed by the subprime industry since 1993 will be left owning their homes in 2010 than there would have been if the economy had avoided the excesses of the last few years?

The financial system broke down at both ends of the mortgage process and the weaknesses fed on each other. At the mortgage origination end, rules were not enforced by anyone, and at the securitization end the CDOs appear to have been orphans in the regulatory arena. The ability of the mortgage brokers to engage in predatory lending activity depended on the insatiable demand for mortgage paper, and this demand in turn came from the massive mispricing of collateralized debt obligations that raised yields 1,2,3 while raising risks 1,2,4. Even Milton Friedman accepted that the government has to set the rules of the game – and enforce them.

Fixing the regulatory system may seem like calling in a locksmith after a theft, but after the mortgage lending mess of the 1980s the Office of Thrift Supervision was supposed to have been the cleanup. Obviously the OTS was not enough.

Here are a few ideas for a concerned Senator or an incoming President seeking to clean up the mess: (1) Can the near-bank mortgage lenders and bank-like SIV structures be brought under some kind of regulatory umbrella?
(2) Could the SEC look at new financial products as they come on the market and to evaluate their risk?
(3) Should the FDIC be pricing risk more aggessively in its deposit insurance premiums, and can the Basel II bank capital-adequacy guidelines be introduced ahead of schedule?
(4) Can the Fed raise the profile of its HOEPA activity and beyond that make basic financial education a national priority. How about a comic book (with a cautionary tale about a young couple hornswoggled into borrowing for a house that they can't afford when the teaser rates end) on how to borrow money for your first house?
(5) Where has HUD been on all of this? Anyone who has ever bought or sold a house is familiar with pages in the closing document that warn buyers about closing costs. When did someone with a consumer orientation last take a look at these pages? 2/17/08 John Tepper Marlin, Blogspot, Where Were the Regulators?