Licensing alone won't prevent bad loans

"The Associated Press recently ran a story about how the mortgage crisis was leading the federal government and states to tighten licensing and other requirements for operating as a mortgage broker. Will this have a material effect in curbing the abuses that led to the crisis?"

No, because mortgage brokers played only an incidental role in the crisis. Blaming the crisis on brokers makes as little sense as blaming it on greed. Brokers have been with us for decades; greed has been with us forever; and neither suddenly caused a financial crisis.

I hasten to add that I believe that mortgage brokers should be licensed and required to pass a competency examination, for the same reason that plumbers and morticians are. They all provide important services to the community, which has a stake in their being performed effectively at reasonable cost. Licensing and examination weed out some of the worst players, and encourage professionalism and self-restraint by the rest. But it will barely touch the deep-seated ills of the mortgage industry.

The main rap against mortgage brokers is that they led and encouraged borrowers to take mortgages that were not suitable for them. This includes option adjustable-rate mortgages (ARMs), which allowed very low payments in the early years that did not cover the interest, and 2/28 ARMs offered to subprime borrowers, which had relatively low rates and payments until the first rate adjustment after two years. In both cases, borrowers were vulnerable to large payment increases in the future, and in many cases these have led to default.

Not all brokers did this, by any means, but enough did to justify the charge. Yet brokers were not alone in encouraging borrowers to select unsuitable mortgages. Loan officers employed by lenders, who are cut from the same bolt of cloth as mortgage brokers, did the same. Quite properly, the uniform licensing and registration system called for by the Secure and Fair Enforcement for Mortgage Licensing Act (SAFE Act), enacted last year, applies to "all loan originators, including mortgage brokers and loan officers."

It will be good to have all loan originators licensed and certified, but don't expect major changes in the way the system works. The primary motivation of loan originators will remain what it was -- to close loans -- because that is what their income depends on. There are some who will tell a client that refinancing is not in their interest, thereby forgoing any income, but they are few and they will continue to be few. Selfless behavior depends on character, and character cannot be legislated.

If loan originators can't be depended on to protect naive borrowers from making mistakes, who can? To sharpen this question, it is useful to focus on the option ARM, which many borrowers were seduced into accepting during the years 2000-2007, and on which the default rate today is horrendous. How could this have been prevented?

The obvious answer is that the borrowers should have educated themselves before making the plunge. The information they needed was readily available, on my Web site as well as others. But naive consumers are trusting and not aware of their need to check out what they are told.

Some observers propose that complicated instruments like option ARMs should be made illegal. That would have eliminated the problem, but at the cost of eliminating a useful option to some borrowers. There should be a way of discouraging people from making bad choices that does not restrict their right to choose.

There is such a way -- it is called mandatory disclosure -- and it is a responsibility of government. There could have been a required disclosure specific to option ARMs that would have dissuaded most borrowers (who can read and who were contemplating an option ARM based on a misconception about how they worked) from going ahead.

Alas, the actual disclosure borrowers received on option ARMs was the same one that all ARM borrowers received; it is voluminous, largely garbage, and of little value to anyone.

Our system of mandatory disclosures, which should be a critical line of defense against bad borrower decisions, has been a complete failure. Disclosures are excessive, overwhelming borrowers with trivia while omitting what is critical. Disclosures take forever to change and are never up to date. Responsibility is divided between two agencies that do not coordinate their disclosures. And the regulators adhere to the inane principle that disclosures should be "balanced," meaning equal weight given to the pluses and minuses, as if borrowers were not already bombarded with plusses by loan originators.

Yet these are system failures, and systems can be fixed. I will be writing about how to fix it in the near future.

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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